1. MACROECONOMICS Paul Krugman | Robin Wells
SECOND CANADIAN EDITION
MACROECONOMICS Paul Krugman | Robin Wells
Iris Au | Jack Parkinson
Chapter 13
Fiscal Policy
© 2014 Worth Publishers

2. WHAT YOU WILL LEARN IN THIS CHAPTER
What fiscal policy is and why it is an important tool in managing economic fluctuations
Which policies constitute an expansionary fiscal policy and which constitute a contractionary fiscal policy
Why fiscal policy has a multiplier effect and how this effect is influenced by automatic stabilizers
Why a large public debt may be a cause for concern
WHAT YOU
WILL LEARN
IN THIS CHAPTER

3. The Economic Importance of Government
Government Spending and Tax Revenue for Some High-Income Countries in 2007
Figure Caption: Figure 13(28)-1: Government Spending and Tax Revenue for Some High-Income Countries in 2007
We focus on 2007 because it was a “normal” year, not a year of deep economic slump. Government spending and tax revenue are represented as a percentage of GDP. Sweden has a particularly large government sector, representing more than half of its GDP. The Canadian government sector, while smaller than those of most European countries, is larger than those of Japan or the U.S., mainly owing to more public spending on health and education.
Source: OECD. 3

4. What Does Government Do?
Government Spending (including transfers) in Canada, 2007
Figure Caption: Figure 13(28)-3: Government Spending in Canada, 2007
After the payment of interest on government debt, the two types of spending by the three levels of government are a) purchases of goods and services and b) government transfers. The big items in government purchases are health care and education. The big items in government transfers are social services, including social assistance transfers, public pension payments (e.g., CPP/QPP, OAS, and GIS), workers’ compensation benefits, and veterans’ benefits.
Source: Statistics Canada. 4

5. How Does Government Pay for its Spending?
Sources of Tax Revenue in Canada, 2007
Figure Caption: Figure 13(28)-2: Sources of Tax Revenue in Canada, 2007
Personal income taxes, sales taxes, taxes on corporate profits, and social insurance taxes account for the majority of the tax revenue collected by the three levels of government in Canada. The “other taxes” category include property taxes and other sources of tax revenue. (Numbers do not add to 100% due to rounding)
Source: Statistics Canada. 5

6. The Government Budget and Aggregate Spending
Fiscal policy is the use of taxes (T), government transfers (TR), or government purchases of goods and services (G) to shift the aggregate demand curve (AD).
Recall that: GDP = C + I + G + X-IM
Fiscal policy works mainly through either:
G (government spending) or;
through the effects of tax and transfer policies on C (consumption spending).
More minor possibilities? Taxes could affect investment (I);
trade taxes (tariffs) could affect imports (IM).

7. Expansionary Fiscal Policy: Increasing AD
Expansionary fiscal policy raises AD. How?
Increases government spending on goods and services (G)
e.g. infrastructure spending
Cuts taxes e.g. lower income tax rates, leaves households with more disposable income so consumption spending (C) rises.
Raises transfers e.g. increase EI payments to the unemployed, this raises disposable income and raises C.
The result: AD shifts right! These measures can eliminate a recessionary gap (see diagram).

8. Expansionary Fiscal Policy
Figure Caption: Figure 13(28)-4: Expansionary Fiscal Policy Can Close a Recessionary Gap
The economy is in short-run macroeconomic equilibrium at E1, where the aggregate demand curve, AD1, intersects the SRAS curve. However, it is not in long-run macroeconomic equilibrium. At E1, there is a recessionary gap of YP – Y1. An expansionary fiscal policy—an increase in government purchases of goods and services, a reduction in taxes, or an increase in government transfers—shifts the aggregate demand curve rightward. It can close the recessionary gap by shifting AD1 to AD2, moving the economy to a new short-run macroeconomic equilibrium, E2, which is also a long-run macroeconomic equilibrium.

9. Contractionary Fiscal Policy: Lowering AD
Contractionary fiscal policy lowers AD. How?
Lower government spending on goods and services (G)
Raise taxes e.g. raise income tax rates, households have less disposable income so consumption spending (C) falls.
Cut transfers e.g. decrease EI payments to the unemployed, this lowers disposable income and raises C.
The result: AD shifts left! These policies can be used to eliminate an inflationary gap.
(see diagram)

10. Contractionary Fiscal Policy
Figure Caption: Figure 13(28)-5: Contractionary Fiscal Policy Can Close an Inflationary Gap
The economy is in short-run macroeconomic equilibrium at E1, where the aggregate demand curve, AD1, intersects the SRAS curve. But it is not in long-run macroeconomic equilibrium. At E1, there is an inflationary gap of Y1 − YP . A contractionary fiscal policy—reduced government purchases of goods and services, an increase in taxes, or a reduction in government transfers—shifts the aggregate demand curve leftward. It closes the inflationary gap by shifting AD1 to AD2, moving the economy to a new short-run macroeconomic equilibrium, E2, which is also a long-run macroeconomic equilibrium.

11. Can Expansionary Fiscal Policy Work? Some Objections
Government spending displaces private spending $1 for $1.
There is only so much income so that spent by government reduces spending by others.
This is wrong since the extra spending can change output or income especially in recessions.
Government borrowing to finance fiscal policy raises interest rates which crowds out investment spending so rise in G is offset by a fall in I.
This makes some sense (see loanable funds model)
But this effect is likely to be weaker in a recession if extra G raises real GDP.
“Ricardian equivalence”. Increased spending now means higher future taxes – households will respond by spending less, saving more in anticipation of higher future taxes.
This assumes households are very forward-looking.
Even if correct the reduced consumer spending will be spread across many years while the rise in G happens now. So AD will rise.

12. A Cautionary Note: Lags in Fiscal Policy
With fiscal policy, there is an important reason for caution: there are significant lags in its use.
The government realizes there is a recessionary/inflationary gap by collecting and analyzing economic data  takes time
Government develops a spending plan takes time
Implementation of the plan (spending the money  takes time (e.g. planning, approvals, awarding contracts etc.)
Will the problem (gap) still exist when the policy takes effect?
i.e. will the SRAS already have shifted to eliminate the gap?

13. Another Problem: Level of Potential Output
The direction of fiscal policy depends on whether GDP is above or below its “potential” or “full-employment” level.
Potential output is not directly observed.
It must be estimated or inferred from the behavior of other macroeconomic variables.
Incorrect estimates can result in policy mistakes.
Fiscal policy makes most sense when departures from potential are large and so the direction of policy is clear.
US in 2015 provides an example of the problem.
Unemployment rate suggests they are at or near potential.
Employment as a share of population and wage-price behavior suggest it is still below potential.

14. ECONOMICS IN ACTION What Was in Canada’s 2009 Economic Action Plan
The budget impact of the Action Plan can be broken down into four categories:
Infrastructure and other spending $10.97 billion (48%)
Tax cuts $7.56 billion (33%)
Transfer payments to persons $2.19 billion (10%)
Transfer payments to lower level governments $2.03 billion (9%)
The Action Plan included elements that affected G (infrastructure spending), taxes and transfers: all were intended to boost AD.
Note: This is From Previous version of the Chapter.

15. Fiscal Policy and the Multiplier
Fiscal policy has a multiplier effect on the economy.
Expansionary fiscal policy leads to an increase in Aggregate Demand larger than the initial rise in aggregate spending caused by the policy.
Conversely, contractionary fiscal policy leads to a fall in Aggregate Demand larger than the initial reduction in aggregate spending caused by the policy.
As in Chapter 11 multiplier works through interdependence between income and spending.
Critical parameter: MPC = marginal propensity to consume.

16. Fiscal Policy and the Multiplier
The size of the shift of the aggregate demand curve depends on the type of fiscal policy.
Increases in G have a larger effect than equivalent-sized changes in taxes or transfers. Why? A rise in G directly increases spending by the amount of the increase; while only a share of the tax cut/transfer increase is spent.
The government spending multiplier works just like Ch. 11:
Say we have a $50 billion rise in G:
Round 1: $50 b. rise in G immediately raises incomes by $50 b.
Round 2: MPC of this is spent on consumer goods, leading to MPC x $50 billion more output and income
Round 3: MPC of round 2 income is spent giving MPC2 x$50 billion extra spending etc.
End result? $50 billion x 1/(1 − MPC) of extra spending from $50 billion of extra G.

17. Tax and Transfer Multiplier
Say we have a $50 billion tax cut or $50 billion transfer increase.
Round 1: Spending increases by MPC x $50 billion since only MPC of the extra income is spent, income rises by MPC x $50 billion.
Round 2: MPC of the extra income from round 1 is spent so incomes rise in round 2 by MPC2 x$50 billion
i.e. at each round the effect is scaled down (compared to the effect of a rise in G) by multiplying by MPC
End result? $50 billlion x MPC/(1-MPC) of extra spending from the $50 billion tax cut or transfer increase.

18. Multiplier Effects of Changes in Taxes and Government Transfers
Hypothetical Effects of a Fiscal Policy with Marginal Propensity to Consume (MPC) of (∆Y=change in Y, ∆G=change in G)
So the multiplier is larger for the rise in G than for a transfer increase or tax cut. 18

19. Discretionary and Automatic Fiscal Policy
Discretionary fiscal policy arises from deliberate actions by policy makers rather than from the business cycle.
i.e. changes to G or to tax or transfer policies (like above)
Automatic stabilizers don’t require a discretionary change in policy. They work via the effect of existing policies on the size of the multiplier and automatically reduce the effect of fluctuations in spending. How?
Spending rise, incomes rise but part of the rise goes to government as taxes or reduced transfers leaving less for additional spending (multiplier smaller).
Spending falls, incomes fall but part of the fall is reduced taxes, and part is offset by rising transfers) so spending falls by less than if there was no tax-transfer system.

20. ECONOMICS IN ACTION Multipliers and the 2009 Economic Action Plan
Canada’s Economic Action Plan was an example of discretionary fiscal expansion.
Based on the Department of Finance’s Canadian Economic and Fiscal Model, the stimulus plan would create an estimated 220,000 jobs by the end of 2010.
The size of the multipliers on items in the stimulus plan ranges from 0.3 (corporate income tax change) to 1.7 (measures for low-income people).
(Source: Parliamentary Budget Officer Kevin Page (from T-Bay!))

21. ECONOMICS IN ACTION
Multipliers and the 2009 Economic Action Plan

22. The Budget Balance
How do government surpluses and deficits fit into the analysis of fiscal policy?
Are deficits ever a good thing and surpluses a bad thing?
Recall from Chapter 10: SPublic = T – TR – G
(T= taxes, TR = Transfers, G = government spending on goods and services)
Other things equal, discretionary expansionary fiscal policies—increased G, higher TR, or lower T—reduce the budget balance for that year.
That is, expansionary fiscal policies make a budget surplus smaller or a budget deficit bigger.
Automatic stabilizers also affect this balance in the same direction.
Recessions: T falls, TR rises (deficit growing or surplus shrinks)

23. The Budget Balance
Conversely, contractionary fiscal policies—smaller G, smaller TR, or higher T—increase the budget balance for that year, making a budget surplus bigger or a budget deficit smaller.
Automatic stabilizers work in the same direction during a boom.
Booms: T rising, TR falling (deficit shrinks or surplus grows)

24. The Budget Balance
Some of the fluctuations in the budget balance are due to the effects of the business cycle.
To separate the effects of the business cycle from the effects of discretionary fiscal policy, governments estimate the cyclically adjusted budget balance, an estimate of the budget balance if the economy were at potential output.
See graph (next slide): notice actual deficit is greater than cyclically-adjusted budget when an economy is recovering from a recession

25. The Budget Balance
(Note: Budget deficit >0 means T-TR-G <0 ; blue bars: recessions )
Figure Caption: Figure 13(28)-9: The Actual Budget Deficit versus the Cyclically Adjusted Budget Deficit
The cyclically adjusted budget deficit is an estimate of what the budget deficit would be if the economy were at potential output. It fluctuates less than the actual budget deficit because large budget deficits tend to occur during the same years when the economy has a large recessionary gap.
Source: Statistics Canada; Public Accounts of Canada; Department of Finance. 25

26. Should the Budget Be Balanced?
Most economists don’t believe the government should be forced to run a balanced budget every year because this would undermine the role of taxes and transfers as automatic stabilizers.
e.g. recession ↓T, ↑TR helps maintain disposable income and the level of consumer spending. Requiring a balanced budget would raise T and cut TR and G in recessions making AD fall further (US states in the Great Recession)
Yet policy makers concerned about excessive deficits sometimes feel that rigid rules prohibiting—or at least setting an upper limit on—deficits are necessary.
Will politicians be biased towards deficits if no rules? (European Union has tried with mixed success to establish rules)

27. Pitfalls Deficits versus Debt
Persistent budget deficits have long-run consequences because they lead to an increase in public debt.
A deficit is the difference between the amount of money a government spends and the amount it receives in taxes over a given period. The Canadian budget deficit in the fiscal year of was $26.2 billion.
A debt is the sum of money a government owes at a particular point in time. The Canadian federal debt was at $582.2 billion at the end of the fiscal year.
i.e. debt reflects past deficits and surpluses.
Deficits and debt are linked, because government debt grows when governments run deficits.

28. Problems Posed by Rising Government Debt
Public debt may crowd out investment spending, which reduces long-run economic growth.
(see Ch. 10 and loanable funds model)
And in extreme cases, rising debt may lead to government default, resulting in economic and financial turmoil.
In 2009, the government of Greece ran into a financial wall when most investors lost confidence in Greece’s financial future and no longer willing to lend to the Greek government.
By the end of 2011, Greece had to pay an interest rate around 10 times the rate Germany. After falling rates on Greek debt have risen in recent months (recent election)

29. Long-Run Implications of Fiscal Policy
Figure Caption: Figure 13(28)-10: Greek and German Long-Term Interest Rates
As late as 2008, the government of Greece could borrow at interest rates only slightly higher than those facing Germany, widely considered a very safe borrower. But in early 2009, as it became clear that both Greek debt and Greek deficits were larger than previously reported, investors lost confidence, sending Greek borrowing costs sky-high.
Source: European Central Bank.

30. Long-Run Implications of Fiscal Policy: Money Finance?
Can’t a government that has trouble borrowing just print money to pay its bills?
Yes, it can, but this leads to another problem: inflation.
Episodes of very high inflation are associated with this type of money finance.
e.g. Zimbabwe 2008, Germany early 1920s, Latin America at various times.

31. Deficits and Debt in Practice
A widely used measure of fiscal health is the debt-to-GDP ratio.
This number can remain stable or fall even in the face of moderate budget deficits if GDP rises over time.
Just before the recession, the combined amount of government debt in Canada was about $23,000 per capita in which two thirds of this debt came from the federal government and one third was debt issued by lower levels governments.
How do we compare?

32. Global Comparison: The Canadian Way of Debt
Global Comparison: How does Canada’s public debt stack up internationally? In dollar terms, we’re number one- but this isn’t very informative because the economies of countries can differ so widely in size. A more informative comparison is the ratio of net public debt (government debt minus any assets governments may have) to GDP, which the following figure shows for a number of rich countries at the end of When compared to other countries, Canada has a relatively low debt-to-GDP ratio (33.1%), which indicates that our government’s finances are in a much better position and our debt is far more manageable than most of the other countries. Japan ran up large debts during the 1990s, when it used massive government spending to prop up its economy.
The real debt champions were Greece and Japan with debt-to-GDP ratio exceeded 100%. Italy and Belgium have historically had weak, divided governments that have a hard time acting responsibly. In contrast to the other countries, Norway has a large negative public debt. What’s going on in Norway? In a word, oil. Norway is the world’s third-largest oil exporter, thanks to large offshore deposits in the North Sea. Instead of spending its oil revenues immediately, the government of Norway has used them to build investment fund for future needs. As a result, Norway has huge government assets rather than a large government debt. 32

33. Canada’s Federal Deficits and Debt
Figure Caption: Figure 13(28)-11: Canada’s Federal Deficits and Debt
The burgundy curve shows Canada’s federal budget balance as a percentage of GDP from 1970 to The Canadian government ran budget deficits until the mid-1990s. When the government lowered its spending to address the national debt problem, the deficit became surpluses. The government began to run deficits again during the recession of the purple curve shows Canada’s (net federal) debt-to-GDP ratio. Comparing the curves, you can see that the debt-to-GDP ratio often rose when there were budget deficits. The ratio fell when the deficits became surpluses.
Source: The Department of Finance Canada. 33

34. FOR INQUIRING MINDS What Happened to the Debt from World War II?
The government paid for World War II by borrowing on a huge scale.
By the war’s end, the public debt was more than 100% of GDP, and many people worried about how it could ever be paid off.
The truth is that it never was paid off. In 1946, net public debt was $13.4 billion. After a few years of post-war budget surpluses, the public debt was back up to $13.4 billion by 1962.
By then nobody was worried about the fiscal health of the Canadian government because the debt-to-GDP ratio had fallen below 40%.

35. FOR INQUIRING MINDS What Happened to the Debt from World War II?
Vigorous economic growth, plus mild inflation, had led to a rapid rise in nominal GDP.
The experience was a clear lesson in the peculiar fact that modern governments can run deficits forever, as long as they aren’t too large.

36. ECONOMICS IN ACTION Austerity Dilemmas
Suppose that lenders begin doubting whether a government can or will repay its debts, and lending dries up. What can that government do?
The usual answer is fiscal austerity.
The government in question cuts spending and raises taxes, both to reduce its need for borrowed funds and to demonstrate to potential lenders that it has the ability and determination to do what’s necessary to honor its debts.

37. Summary
The government plays a large role in the economy, collecting a large share of GDP in taxes and spending a large share both to purchase goods and services and to make transfer payments, largely for social insurance. Fiscal policy is the use of taxes, government transfers, or government purchases of goods and services to shift the aggregate demand curve. But many economists caution that a very active fiscal policy may in fact make the economy less stable due to time lags in policy formulation and implementation.

38. Summary
Government purchases of goods and services directly affect aggregate demand, and changes in taxes and government transfers affect aggregate demand indirectly by changing households’ disposable income. Expansionary fiscal policy shifts the aggregate demand curve rightward; contractionary fiscal policy shifts the aggregate demand curve leftward.

39. Summary
Only when the economy is at full employment is there potential for crowding out of private spending and private investment spending by expansionary fiscal policy. The argument that expansionary fiscal policy won’t work because of Ricardian equivalence – that consumers will cut back spending today to offset expected future tax increases – appears to be untrue in practice. What is clearly true is that very active fiscal policy may make the economy less stable due to time lags in policy formulation and implementation.

40. Summary
Fiscal policy has a multiplier effect on the economy, the size of which depends upon the fiscal policy. Except in the case of lump-sum taxes, taxes reduce the size of the multiplier. Expansionary fiscal policy leads to an increase in real GDP, while contractionary fiscal policy leads to a reduction in real GDP. Because part of any change in taxes or transfers is absorbed by savings in the first round of spending, changes in government purchases of goods and services have a more powerful effect on the economy than equal-size changes in taxes or transfers.

41. Summary
Rules governing taxes—with the exception of lump-sum taxes—and some transfers act as automatic stabilizers, reducing the size of the multiplier and automatically reducing the size of fluctuations in the business cycle. In contrast, discretionary fiscal policy arises from deliberate actions by policy makers rather than from the business cycle.

42. Summary
Some of the fluctuations in the budget balance are due to the effects of the business cycle. To separate the effects of the business cycle from the effects of discretionary fiscal policy, governments estimate the cyclically adjusted budget balance, an estimate of the budget balance if the economy were at potential output.

43. Summary
Canadian government budget accounting is calculated on the basis of fiscal years. Persistent budget deficits have long-run consequences because they lead to an increase in public debt. This can be a problem for two reasons. Public debt may crowd out investment spending, which reduces long-run economic growth. And, in extreme cases, rising debt may lead to government default, resulting in economic and financial turmoil.

44. Summary
A widely used measure of fiscal health is the debt–GDP ratio. This number can remain stable or fall even in the face of moderate budget deficits if GDP rises over time. However, a stable debt–GDP ratio may give a misleading impression that all is well because modern governments often have large implicit liabilities. The largest implicit liabilities of the Canadian government come from benefits such as Old Age Security (OAS), Guaranteed Income Supplement (GIS), Canada Health Transfer (CHT), and Canada Social Transfer (CST).

45. Key Terms Social insurance Expansionary fiscal policy
Contractionary fiscal policy
Lump-sum taxes
Automatic stabilizers
Discretionary fiscal policy
Cyclically adjusted budget balance
Fiscal year
Public debt
Debt-to-GDP ratio
Implicit liabilities