Fiscal policy

• Classify the sources of government revenue and the types of government expenditure, and distinguish a budget deficit from government debt.
• State the six goals of fiscal policy and explain how spending and taxation serve each of them.
• Explain, with AD/AS diagrams for the Keynesian and the monetarist/new classical schools, how expansionary and contractionary fiscal policy close output gaps, and what each school concludes about the long run.
• Evaluate fiscal policy against growth, low unemployment and low inflation, using its strengths, its constraints and dated real-world cases.
• Separate the immediate demand effect of government spending from its later effect on productive capacity.

Fiscal policy is the government's use of its spending and its taxation to influence aggregate demand (AD) and, through it, output, employment and the price level. The same decisions also change the distribution of income, the incentives that households and firms face and, over time, the economy's productive capacity.

Government revenue comes from four sources.

• Direct taxes: taxes on income and wealth, paid to the government by the person or firm on whom they are levied. Personal income tax, tax on company profits and inheritance tax are examples. Many direct taxes are progressive: the share of income taken rises as income rises (Progressive tax).
• Indirect taxes: taxes on spending, collected by sellers and passed on to the government. A general sales tax or value added tax, excise duties on fuel or tobacco, and tariffs are examples (Indirect tax).
• The sale of goods and services by state-owned enterprises, such as a state railway, a postal service or a national oil company.
• The sale of government assets, such as land, buildings or shares in a state-owned firm (privatisation). An asset can be sold only once, so asset sales cannot pay for a gap between spending and revenue that recurs every year.

Government expenditure is divided into three types, and the difference matters for the effect on the economy.

• Current expenditure: spending on goods and services that are used up within the year, such as the wages of teachers and nurses, medicines and school supplies. It recurs every year.
• Capital expenditure: spending on assets that provide services for many years, such as roads, power networks, hospitals and school buildings. It is also called public investment, and it can add to the economy's productive capacity.
• Transfer payments: payments for which no good or service is supplied in return, such as unemployment benefits, state pensions and child benefits. They redistribute income. A transfer is not part of government spending (G) in AD = C + I + G + (X − M), because the government buys no output with it; it reaches AD only when the people who receive it spend it, as consumption.

Current and capital expenditure together are government purchases of goods and services: the G in aggregate demand.

The budget compares the two sides over a year. A Budget deficit means that expenditure is greater than revenue, a Budget surplus that revenue is greater than expenditure, and a balanced budget that the two are equal. A deficit is financed by borrowing. Government (public) debt is the total the government owes at a point in time: the sum of past deficits less past surpluses. The deficit is a flow, measured per year; the debt is a stock, measured on a date. Any deficit, however small, adds to the debt, and the debt falls only when the budget is in surplus.

Expansionary fiscal policy is a deliberate increase in government spending, a cut in taxes, or both, intended to raise AD. Contractionary fiscal policy is a deliberate cut in government spending, a rise in taxes, or both, intended to reduce AD. A deficit is not in itself evidence of expansionary policy. In a recession tax revenue falls and spending on benefits rises without any decision by the government, so the deficit widens even if policy has not changed.

Fiscal policy has six goals. The first four concern the level and the stability of economic activity. The last two concern the distribution of income and the economy's dealings with the rest of the world.

• Low and stable inflation. When AD is growing faster than the economy can produce, the price level is pulled up. Lower government spending or higher taxes reduce AD and with it demand-pull inflation. Stable inflation also requires the government not to add to demand when the economy is already at full employment.
• Low unemployment. When AD is too low, firms cut output and jobs. Higher government spending or lower taxes raise AD; firms produce more and, because the demand for labour is derived from the demand for output, they hire more workers. This acts on cyclical unemployment.
• A stable economic environment for long-term growth. Firms invest when they can plan. Predictable tax rates, government debt that is under control and steady capital expenditure on infrastructure, education and health give firms the confidence, and the public capital, to invest for the long term.
• Reducing business cycle fluctuations. Fiscal policy can lean against the cycle: expansionary in a downturn, when private spending is weak, and contractionary in a boom, when it is excessive. The aim is smaller swings in output and employment around the long-term trend.
• An equitable distribution of income. Progressive direct taxes take a larger share of high incomes, and transfer payments raise low incomes, so the distribution of income after taxes and transfers is more equal than before them. Spending on public services such as schooling and health care has a similar effect, because lower-income households could not otherwise afford them.
• External balance. A country's spending on imports rises with its income. Contractionary fiscal policy lowers income and so lowers spending on imports, which reduces a current account deficit; expansionary policy does the opposite. External balance means that payments to and from the rest of the world are roughly in balance over time.

The goals can conflict, so a measure that serves one may work against another. Expansionary policy that reduces unemployment adds to inflationary pressure once the economy is near full employment, and by raising incomes it raises spending on imports, which worsens the external balance. Higher taxes on high incomes make the distribution more equal but may weaken the incentive to work or invest. A government therefore has to decide which goal matters most at the time, and that decision starts from the state of the economy.

A fall in household and business confidence reduces consumption (C) and investment (I). AD falls, firms cut production and dismiss workers, and a deflationary (recessionary) gap opens: real GDP is below full employment output and there is cyclical unemployment. Because the cause is too little spending and resources are idle, higher government spending or lower taxes can raise output. The same stimulus is unsuitable when output is held back on the supply side, for example by a shortage of energy or of workers: firms cannot produce more, so extra spending mainly raises prices. The first step in any fiscal answer is to identify the shock.

Fiscal policy reaches AD = C + I + G + (X − M) by three routes. Government spending on goods and services raises G directly. A cut in income tax raises disposable income; consumption rises by the part of the extra income that households spend, and the remainder is saved or used to repay debt. A cut in business tax raises after-tax profit, which gives firms more funds to invest and a higher return on investment, but firms invest only if they expect to sell the extra output. Whatever the route, some of the extra spending goes on imports, which adds nothing to domestic output.

Contractionary policy uses the same routes in reverse. Lower government spending reduces G directly, higher income tax reduces disposable income and consumption, and higher business tax reduces the funds for investment and the return on it. AD falls. The policy is used when real GDP is above full employment output, an Inflationary gap, and demand-pull inflation is rising.

The composition of the measure matters. A public infrastructure project buys output now and, once finished, may lower firms' costs. A transfer to households supports their income and, through consumption, AD, but it is not itself part of G. A tax cut that goes mainly to high-income households raises AD less than the same sum paid to low-income households, who spend a larger share of any extra income.

Expansionary fiscal policy is used to close a deflationary (recessionary) gap and contractionary fiscal policy to close an inflationary gap. In both cases the policy shifts AD. The two schools of thought agree about that shift. They differ about what it does to real GDP and to the price level, because they draw aggregate supply differently.

In the monetarist/new classical model short-run aggregate supply (SRAS) slopes upward and long-run aggregate supply (LRAS) is vertical at full employment output, Yf. Starting below Yf, expansionary policy shifts AD1 right to AD2 and the economy moves up along SRAS: real GDP rises towards Yf and the price level rises. LRAS stays where it is, because a change in demand does not change the economy's productive capacity.

Contractionary policy reverses the chain. Lower government spending or higher taxes shift AD left, which reduces demand-pull inflationary pressure. On an upward-sloping SRAS real GDP and employment fall as well, and this is the cost of the policy. The cost is small when the economy starts above Yf, because output is only returning to its sustainable level.

A lower price level on these diagrams does not mean that prices fall in the economy. Where prices are rising, a contractionary policy leaves the price level lower than it would otherwise have been, so prices rise more slowly. That is Disinflation, a fall in the rate of inflation, and not deflation.

In the Keynesian model there is one aggregate supply curve, the Keynesian AS curve, and the effect of fiscal policy depends on the part of it where the economy starts. On the horizontal part there is spare capacity, and expansionary policy raises real GDP with no rise in the price level. On the upward-sloping part both rise, as bottlenecks appear in some industries. On the vertical part, at Yf, only the price level rises. This is why Keynesians recommend fiscal expansion in a deep recession and not at full employment.

Contractionary policy in the Keynesian model is read from the same three parts. On the vertical part it lowers the price level with no loss of output, which is the case for using it against demand-pull inflation at full employment. On the horizontal part it lowers output and employment and leaves the price level unchanged, because wages and prices do not fall easily.

Both models show a limit of contractionary policy. If inflation is caused by rising costs and not by excess demand (cost-push inflation), reducing AD lowers the price level only by lowering real GDP further, so fiscal contraction is a costly answer to a supply shock. A change in indirect taxes also works on two sides at once: a higher indirect tax reduces households' spending power and raises firms' costs, so an answer has to say which of the two effects its diagram shows.

In the monetarist/new classical model the result of a fiscal expansion depends on where the economy starts and on the time period. Start at full employment output, Yf. Expansionary fiscal policy shifts AD right. In the short run real GDP rises above Yf and the price level rises. Unemployment is now below its natural rate and firms are competing for scarce workers and materials, so wages and other costs rise. Higher costs shift SRAS left, and they go on doing so until real GDP is back at Yf. The lasting result is a higher price level and no gain in output.

If the economy starts below Yf, this school argues that the gap closes without any policy. Unemployment above the natural rate pushes wages down, lower costs shift SRAS right, and real GDP returns to Yf at a lower price level. A fiscal expansion is then unnecessary and, because it works with time lags, it may arrive after the recovery and push the economy above Yf, with the inflationary result just described. Contractionary fiscal policy at Yf works in reverse: AD shifts left, real GDP falls below Yf in the short run, wages then fall, SRAS shifts right, and real GDP returns to Yf at a lower price level.

Keynesian economists reject the assumption that wages fall quickly. Workers resist pay cuts, contracts fix wages for a year or more and minimum wages set a floor, so wages are 'sticky downward'. An economy in a deflationary gap can then stay there, with cyclical unemployment, for years. In the Keynesian model there is no automatic return to Yf, so a rise in AD is needed, and fiscal expansion from a deflationary gap raises real GDP and keeps it higher. The two schools agree about one case: at full employment, more demand raises only the price level.

Whether fiscal policy works depends on the state of the economy, on how quickly the government can act and on whether it can pay for what it does. A temporary, targeted fiscal expansion is most appropriate when demand is depressed, resources are idle and the government can borrow at reasonable cost. The strengths and constraints below explain each part of that sentence.

The case joins two of the constraints. The tax cuts were politically attractive, but they were announced when inflation and government debt were already high. Investors then required higher interest rates to hold government bonds, which raises the cost of all government borrowing, and the measures were withdrawn. A stimulus that could have been financed easily in a deep recession could not be financed on acceptable terms at that point in the cycle. The constraint of sustainable debt is tightest when inflation and interest rates are already rising.

Each of the three main macroeconomic goals has its own balance of strengths and limitations.

• Economic growth. Strength: in a recession expansionary policy raises AD and so actual output, quickly if the spending is on goods and services, and capital expenditure can raise potential output later. Limitation: the gain in output shrinks as the economy approaches Yf, where extra demand raises the price level instead, and in the monetarist/new classical model it disappears in the long run. Growth bought with borrowing also adds to government debt.
• Low unemployment. Strength: expansionary policy reduces cyclical unemployment, because firms that sell more output hire more workers, and spending can be aimed at the regions or industries where jobs have been lost. Limitation: it does not reduce structural unemployment. Workers whose skills or location do not match the vacancies are not hired when demand rises, and pushing demand higher to employ them causes inflation.
• Low and stable inflation. Strength: contractionary policy reduces AD and so demand-pull inflation. Limitation: it is politically difficult and slow, since budgets are usually set once a year, and against cost-push inflation it lowers prices only by lowering output. In most countries the central bank's interest rate is therefore the main tool against inflation, and the task of fiscal policy is not to work against it.

The two figures in this case answer different questions. The 11.7 million employments supported show how widely the scheme was used. The estimate that about four million more people were in employment than would otherwise have been the case is the evaluation's measure of its effect, and it is uncertain. The difference between them is support paid for jobs that would have survived anyway, which is the price of acting quickly instead of targeting precisely.

This case makes the Keynesian argument from the other direction. When an economy has a great deal of spare capacity and interest rates cannot fall further, a change in the budget has a large effect on real GDP: expansion raises output strongly and contraction reduces it strongly. It also shows the debt constraint at its limit. Greece could not choose to expand, because it had lost access to borrowing, so its real choice was about how fast to cut.

Fiscal policy also divides stakeholders. An expansion financed by borrowing helps workers who would otherwise be unemployed, and firms that sell to the government or to households with more income to spend. Its cost falls later, on the taxpayers who pay the interest on the extra debt and on the users of public services if spending is cut afterwards to pay for it. A contraction reverses the pattern: taxpayers, public-sector workers and people who receive transfer payments bear the cost now, and lower-income households lose most when benefits are cut, while everyone whose income is fixed in money terms gains from lower inflation.

Capital expenditure affects the economy twice. While a road or a power network is being built, government spending is higher and AD shifts right. Once it is completed and in use, reliable transport or power lowers firms' costs and raises the output the economy can produce. The second effect needs its own explanation: if the project is unfinished, badly located or poorly maintained, the spending creates no usable capacity. A rise in AD on its own never justifies shifting LRAS.

When completed infrastructure does raise productive capacity, LRAS shifts right and full employment output rises from Yf1 to Yf2. This is the supply-side effect of fiscal policy, and it is how fiscal policy contributes to growth in potential output. It arrives years after the spending, so it is drawn as a separate shift from the earlier rise in AD. If firms' unit costs fall, SRAS shifts right too and, with AD unchanged, real output rises and the price level falls. In the Keynesian diagram the vertical part of the AS curve moves to the right.

Spending on education, training and health care works in the same way through human capital: it is government spending today and a more productive labour force later. Taxes have supply-side effects as well, because they change the reward for working and investing. These measures are examined as supply-side policies in topic 3.7. In a fiscal policy answer the point to make is that the type of spending decides whether an expansion raises only actual output for a time or also raises potential output.

• Government purchases of goods and services are G in aggregate demand. Transfer payments are not; they reach AD only through the consumption of the people who receive them.
• A deficit is a flow and debt is a stock. A wider deficit does not prove that policy has become more expansionary, because a recession widens it without any decision.
• Expansionary policy closes a deflationary gap and contractionary policy an inflationary gap. In the Keynesian model the effect depends on the part of the AS curve; in the monetarist/new classical model an expansion at Yf raises only the price level in the long run.
• The main strengths of fiscal policy are the targeting of specific sectors and the effectiveness of government spending in a deep recession. Its main constraints are political pressure, time lags and sustainable debt. Each needs its condition and its direction.
• Spending now is a rise in AD. Capacity later is a shift of LRAS, and it needs the spending to be capital expenditure that is completed and used.