What is fiscal policy and how can it be used to manage the economy? Briefly describe the current UK fiscal policy, and comment on the effect it may have on the economy.

Fiscal policy is the use of government spending, taxation and borrowing to influence the level and growth of aggregate demand, output and employment. Aggregate demand (AD)= Consumption + Investment + Government spending + (Exports – Imports). Changes in fiscal policy affect both aggregate demand and aggregate supply. (Riley 2006) Fiscal policy is used to achieve macroeconomic objectives such as full employment, price level stability and sustained economic growth. Expansionary fiscal policy is an increase in government expenditures or transfer payments, or a decrease in tax revenue. A tax cut will increase AD because it increases households’ disposable income. The greater the disposable income the greater is the quantity of goods and services demanded and therefore the greater is AD. This will stimulate economic growth in a recession, which will shift the AD curve to the right. (Parkin, Powell and Matthews 2008)

The magnitude of the shift = expenditure multiplier x the increase in government expenditures. In the short run it will increase both Gross Domestic Product (GDP) and the price level. An increase in the price level will increase the money wage rate, which reduces the SRAS. The SRAS curve shifts left until in the long run real GDP = potential GDP at a higher price level. Contractionary fiscal policy is the opposite of expansionary fiscal policy, which through a decrease in government expenditures or transfer payments, or an increase in tax revenues, will shift the AD curve to the left.

The government expenditure multiplier is the amount by which a change in government expenditure on goods and services is multiplied to determine the change in equilibrium expenditure and real GDP that it generates. As government spending is a component of aggregate demand, aggregate expenditure and real GDP are affected when government expenditure changes. The change in real GDP induces a change in consumption expenditure, which brings an additional change in aggregate expenditure. The autonomous tax multiplier is the magnification of a change in autonomous taxes on equilibrium expenditure and real GDP. An increase in taxes decreases disposable income, which decreases consumption expenditure. Tax multiplier = marginal propensity to consume x expenditure multiplier. Because a tax increase leads to a decrease in expenditure, the autonomous tax multiplier is negative. The tax multiplier is less than the expenditure multiplier as a proportion of tax cuts are saved before spending. £1bn in tax cuts has a smaller effect than £1bn increase in government spending. The balanced budget multiplier is the multiplier that arises from a fiscal policy action that changes both government spending and taxation by the same amount so that the government’s balanced budget remains unchanged. Because the tax multiplier is smaller than the government expenditure multiplier, the balanced budget multiplier is greater than zero. Balanced budget multiplier = expenditure multiplier – tax multiplier. (Parkin, Powell and Matthews 2008) The multiplier effects of an expansionary fiscal policy depend on how much spare productive capacity the economy has; how much of any increase in disposable income is spent rather than saved or spent on imports, and also the effects of fiscal policy on variables such as interest rates. (Riley 2006) Automatic stabilizers are mechanisms that operate to stabilize real GDP without the need for explicit action by the government. They include those changes in tax revenues and government spending that come about automatically as the economy moves through different stages of the business cycle. If the economy is growing, people will automatically pay more taxes (VAT and income tax) and the government will spend less on unemployment benefits. In a recession the opposite will occur with tax revenue falling although increased government spending will help increase AD. (Pettinger) But automatic stabilizers do not actually stabilize. They just make fluctuations less severe. These stabilizers operate because income taxes and transfer payments fluctuate with real GDP. As GDP falls, tax revenue falls, transfer payments rise and the budget balance changes. (Parkin, Powell and Matthews 2008) Discretionary fiscal changes are deliberate changes in direct and indirect taxation and government spending to affect AD and stabilize the economy. The biggest source of income for the government is income tax.

The UK’s government spending each year takes up over 40% of gross domestic product. Spending by the public sector is broken down into three main areas: transfer payments, current government spending and capital spending. Government spending is justified on economic and social grounds. It provides public goods and merit goods, a safety net system of welfare benefits, necessary infrastructure, and it manages the level and growth of AD to achieve macroeconomic objectives. The Private Finance Initiative is a way of funding expensive infrastructure developments without running up debts. Rather than borrowing to fund new projects, John Major’s government and the Labour government that followed entered into long term leasing agreements with private contractors. However critics say that private finance is more expensive than public capital and that although the government saves in the short term, the country will pay more in the long run. (Riley 2006)

Changes to fiscal policy can affect the supply side capacity of the economy and therefore contribute to long-term economic growth. Increases in income taxes, for example, lower the net rate of return to private investment, making investment activities less attractive and lowering the rate of growth. It is hard to think of an influence on the private real rate of return and on the growth rate that is more direct than that of income taxes (Easterly 1993). Tax cuts increase labour market incentives and therefore increase aggregate supply. Capital spending contributes to an increase in investment across the whole economy. Lower rates of corporation tax and other business taxes might also be used as a policy to stimulate a higher level of business investment and attract inward investment from overseas. Research and development improve the international competitiveness of domestic businesses. (Riley 2006)

Some economists believe the supply side effects are large and exceed the demand side effects. Free market economists, while agreeing that supply side effects are present, believe that they are relatively small. They argue that lower taxation and tight control of government spending and borrowing is required to allow the private sector of the economy to flourish. The key is to help provide the right incentives for individuals and businesses. (Pettinger)

Despite all of the benefits of using fiscal policy, there is some criticism of it. Increasing taxes to reduce AD may cause disincentives to work, if this occurs there will be a fall in productivity as AS would fall. However higher taxes do not necessarily reduce incentives to work if the Income Effect dominates. Reduced government spending to decrease AD could adversely affect public services such as public transport and education, causing market failures and social inefficiency. (Pettinger) It is also not easy to tell if real GDP is above or below potential GDP. Fiscal stimulation might occur too close to full employment, in which case it will increase the price level and have no long term effect on real GDP. The legislative process is slow, and it is difficult to take fiscal policy actions quickly. The economy may benefit from fiscal stimulation now, but it will take Parliament many months to act. By the time the action is taken the economy may need an entirely different fiscal policy action. (Parkin, Powell and Matthews)
An expansionary fiscal policy will also cause an increase in the budget deficit, which has many adverse effects. A higher budget deficit will require higher taxes in the future and may cause crowding out. Crowding out is when increased government spending results in decreasing the size of the private sector. If the government increases spending it will have to increase taxes or sell bonds or borrow money, both methods reduce private consumption or investment. If this occurs AD will not increase or will increase only very slowly. (Pettinger) When governments fund a deficit, interest rates can increase because government borrowing created a higher demand for credit in the financial markets. This causes a lower aggregate demand for goods and services, contrary to the objective of a fiscal stimulus. Neoclassical economists generally emphasise crowding out while Keynesians argue that fiscal policy can still be effective especially in a liquidity trap where crowding out is minimal. Monetarists however point to the experience of Japan in the 1990’s where a liquidity trap was not solved by government borrowing. (Pettinger) They believe that the use of fiscal policy will only have a temporary effect on aggregate demand and employment, and that monetary policy is a more effective instrument for controlling demand and inflationary pressure. (Riley 2006) Higher interest rates from government borrowing also attract foreign capital from foreign investors. This is because, all other things being equal, the bonds issued by a country carrying out expansionary fiscal policy now offer a higher rate of return. When foreign capital flows into the country undergoing fiscal expansion, demand for that country’s currency increases. The increased demand causes that country’s currency to appreciate. Goods originating from that country now cost more to foreigners than they did before, consequently exports decrease and imports increase. (Parkin, Powell and Matthews 2008)

In the 1950, 60s and 70s the government was keen to use fiscal policy to stabilize the economy. It was thought that the government could ensure full employment by increasing AD when necessary. During this period it appeared that there was a trade off between unemployment and inflation as suggested by the Phillips curve. In the 1970s however the economy experienced stagflation. This involves an increase in unemployment and inflation at the same time. (Pettinger) Current UK demand policy tends to concentrate on the use of monetary policy, as it is easier to change the interest rate than levels of tax and spending. In 2009, due to the financial crisis, the government also turned to fiscal policy to try to stimulate economic activity. When Gordon Brown was Chancellor, the Labour party officially adopted the ‘Golden Rule’ of fiscal policy. The Golden Rule states that over the full economic cycle the government should only borrow to invest for future needs, current needs should be met by tax revenues. In conjunction with the Golden Rule the UK government also seeks to follow the Sustainable Investment Rule, which would keep national debt at 40% of GDP. By the end of 2008 estimated public debt had already risen to 42%. The justification is that a severe recession needs Keynesian stimulus to revive it. (Caploe)

References

Caploe D. Fiscal Policy. Available from: http://www.economywatch.com/world_economy/united-kingdom/bank-of-england-monetary-fiscal-policy.html (accessed 25.3.11)

Easterly W (1993) Fiscal policy and economic growth. Journal of Monetary Economics 32. 417-458

Parkin, Powell and Matthews (2008) Economics. Essex: Pearson education Limited

Pettinger T. Fiscal Policy. Available from: http://www.economicshelp.org/macroeconomics/fiscal-policy/fiscal_policy.html (accessed 25.3.11)

Riley G (2006) Fiscal Policy. Available from: http://tutor2u.net/economics/revision-notes/as-macro-fiscal-policy.html (accessed 25. 3.11)