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IFT Notes for Level I CFA® Program

R12 Monetary and Fiscal Policy

Part 3


10. Roles and Objectives of Fiscal Policy

Fiscal policy refers to the taxing and spending policies of the government. A government can influence the following aspects of the economy:

  • Overall level of aggregate demand in an economy and hence the level of economic activity. (This is often the primary objective of a fiscal policy; secondary objectives, which are tied to the political motive of the government, are as follows:)
  • Distribution of income and wealth among different segments of the population.
  • Allocation of resources between different sectors and economic agents.

10.1 Roles and Objectives of Fiscal Policy

Primary objective: To help manage the economy through its influence on aggregate national output (real GDP).

Fiscal Policy and Aggregate Demand

Just like monetary policy, fiscal policy can be contractionary or expansionary.

An expansionary fiscal policy can take several forms:

  • Lower taxes
    • Cuts in personal income tax (This increases the disposable income).
    • Cuts in sales taxes (This lowers the prices).
    • Cuts in corporate taxes increase business profits (This means that corporates have more money to invest).
  • Higher government spending on social goods and infrastructure.

Contractionary fiscal policy: It is the opposite of expansionary fiscal policy. Higher taxes or lower government spending are examples of contractionary fiscal policy.

What are the Keynesian and Monetarist views on the effectiveness of fiscal policy?

Keynesian view: Government intervention is necessary in the form of fiscal policy to get an economy out of recession. They believe that the aggregate demand, employment, and output increase with fiscal policy .

Monetarist view: Monetary policy is a more effective tool to tame inflation; monetarists advocate a steady, stable monetary policy. They believe that Fiscal policy only has a temporary effect.

Government Receipts and Expenditures in Major Economies

  • Exhibits 13 and 14 show government revenues and expenditures as a percentage of GDP for some of the major economies. As of 2008, for the U.S., government revenue as a percent of GDP was 32.3%, while the government expenditure as a percent of GDP was 38.8%.
  • The possibility that fiscal policy can influence output can be used to stabilize an economy.
  • The budget deficit is the difference between government revenue and expenditure for a fixed period of time. Government revenue = tax revenues, net of transfer payments; government spending = interest paid on government debt.
  • An increase in budget surplus indicates a contractionary fiscal policy.
  • An increase in budget deficit indicates an expansionary fiscal policy.
  • Two fiscal policies to stabilize the economy include:
    • Automatic stabilizers: When the economy slows and unemployment rises, government spending on social insurance and unemployment benefits will rise. Whereas, if the economy is at full employment, taxes collected will be high and there will be a budget surplus. These happen automatically without the intervention of policymakers, and the focus is primarily on aggregate demand. They help reduce the impact of a recession.
    • Discretionary fiscal policies: Changes in government spending or tax rates. In contrast to automatic stabilizers, this depends on the policy makers. The policies differ primarily with respect to timing.
  • A balanced budget is one where government spending is equal to government revenues.

11. Deficits and National Debt

Government deficit = Revenue – Expenses

Government deficit (national debt) is the accumulation of these deficits over time. Should we worry about national debt? There are two schools of thought.

We should not worry because:

  • The scale of the problem may be overstated because the debt is owed internally to fellow citizens.
  • A proportion of the money borrowed may have been used for capital investment projects or enhancing human capital. We are borrowing now to increase our productive capacity in the future.
  • Large fiscal deficits require tax changes that may actually reduce distortions caused by existing tax structures.
  • Deficits may have no net impact because the private sector may act to offset fiscal deficit by increasing saving in anticipation of future increased taxes. This is known as Ricardian equivalence.
    • The government funds its spending by either increasing taxes or borrowing. It is the future taxpayers who will service the government’s debt. So, it is the taxpayers who bear the burden in both cases. What matters is only the timing: now or later. According to Ricardian equivalence, if the government defers taxation, consumers anticipate higher taxes and the private sector will save enough today to pay for increased taxes in the future. This higher saving results in decreased private demand and increased government demand. The net effect is offsetting, as government spending does not create demand stimulus.
  • If there is unemployment in an economy, then the debt is not diverting activity away from productive uses.

We should worry because:

  • High levels of debt to GDP may lead to higher tax rates in the search for higher tax revenues. This may lead to disincentives to economic activity.
  • If markets lose confidence in a government, then the central bank may have to print money to finance a government deficit. This may lead to inflation.
  • Government borrowing may divert private sector investment from taking place (this effect is called crowding out). If savings are limited and the demand for funds from the government is high, then it will lead to higher interest rates and lower private sector investment.

12. Fiscal Policy Tools

  • Transfer payments: Welfare payments provided to low income households so that they get a basic minimum level of income. Not included in GDP calculation. Ex: pensions, housing, and unemployment benefit, etc.
  • Current government spending: Regular spending on goods and services such as education, healthcare, defense, etc.
  • Capital expenditure: Spending on infrastructure such as building roads, schools, hospitals, etc.
  • Government spending is justified both on economic and social grounds as they ensure employment, economic growth, and a minimum standard of living for lower income households.
  • Government revenue can take different forms.
    • Direct taxes: Taxes imposed on income, property, wealth, corporate profits, capital gains, inheritance, etc. These include taxes levied on individuals and businesses.
    • Indirect taxes: Taxes imposed on goods and services such as excise duty, VAT. Indirect taxes affect alcohol or tobacco consumption more directly than direct taxes.
  • Following are the desirable attributes of tax policy:
    • Simplicity: There should be no ambiguity, loopholes, or scope of interpreting the tax liability differently. It should be simple for the taxpayer to adhere to the rules, and the authority to enforce.
    • Efficiency: The tax policy should interfere as little as possible in the choices individuals make in the market place.
    • Fairness: Are people in similar situations levied the same tax, or are rich people taxed more? For example, should a person earning $1 million a year be in the same tax bracket as one earning $50,000 a year? It is subjective.
    • Revenue sufficiency: Tax revenues collected should be sufficient to cover expenditure.

12.1 The Advantages and Disadvantages of Using the Different Tools of Fiscal Policy

Advantages and disadvantages of using different tools of fiscal policy
Advantages Disadvantages
Indirect taxes (such as VAT) can be adjusted almost immediately after they are announced and can influence spending behavior instantly.

Generates revenue for the government at little or no cost to the government.

Direct taxes are more difficult to change without considerable notice, often many months, because payroll computer systems will have to be adjusted. For instance, the government cannot increase income tax every year.
Social policies such as discouraging alcohol or use of tobacco can be adjusted almost instantly by raising such taxes. The same may be said for welfare and other social transfers.
  Capital spending plans (building highways or schools) take longer to formulate and implement; typically, over a period of years.

12.2 Modeling the Impact of Taxes and Government Spending: The Fiscal Multiplier

  • The objective of fiscal policy is to influence output through changes in government spending and/or taxes.
  • The fiscal multiplier tells us about changes in output when there are changes in spending and taxes.
  • The derivation for the fiscal multiplier is given in the curriculum, but it is important to know the formula given below:

Fiscal multiplier = \rm \frac{1}{1 - c(1-t)}


c = marginal propensity to consume

t = tax rate

For example: What is the value of the fiscal multiplier if the tax rate is 20%, and the marginal propensity to spend is 90%?

What is the increase in total income if government spending increases by $1 billion?


Fiscal multiplier = \frac{1}{1 - 0.9(0.8)} = 3.57

A $1 billion increase in government spending increases total income by $3.57 billion.

12.3 The Balanced Budget Multiplier

A balanced budget is a fiscal policy tool where the increase in government spending on goods and services is equal to the increase in tax revenues. The net effect is that there is no change in the budget deficit or surplus.

Since it is a balanced budget, government expenditure and taxes go up by the same amount. If this is the case, then the aggregate output actually rises, how? Because the fiscal multiplier is a function of marginal propensity to consume, c. Since c is less than 1, output Y increases. We will see how this happens using an example.

Assume in equilibrium, output Y = 1,000; C = 900 and I = 100. Assume government spending increases by 200 which is financed by an increase in tax revenue of 200. MPC = 0.9

Fiscal multiplier effect = 10

Taxes increase by 200. Disposable income decreases by 200.

Consumption decreases by 0.9 * 200 = 180

Initial impact on aggregate demand = 200 – 180 = 20

Impact on output because of multiplier effect = 20 * 10 = 200

13. Fiscal Policy Implementation

  • The deficit might not be an indication of the government’s fiscal stance because an economy goes through a cycle. For example, at the peak of a cycle, unemployment would be low and government expenditure would be less with the likelihood of running a surplus. Similarly, if the economy is in a recession year, then incomes are low and taxes collected will be relatively low causing the budget deficit to increase. So, one cannot conclude if the government is following a contractionary or expansionary policy by looking at the deficit.
  • To get an idea of the government’s policy, one should look at the structural or cyclically adjusted budget deficit, this is, the deficit if the economy was at full employment. If the output is at long-run equilibrium, then the surplus or deficit would be called the structural or cyclically adjusted budget deficit.
  • Automatic stabilizers such as social security payments, progressive income taxes, and VAT must be considered to determine the fiscal stance. As unemployment rises, the benefits increase and net tax revenues decrease. These do not require policy changes and automatically kick in to stimulate growth.
  • In addition, there are also discretionary fiscal adjustments used by governments, such as tax changes, or huge spending to build a highway system in a country to increase aggregate demand.
  • The two approaches to fiscal policy vary primarily with respect to timing of implementation. But, fiscal policy does not always stabilize an economy as executing fiscal policy can be difficult for the following reasons:
    • Recognition lag: There is a time lag before policymakers recognize whether the economy is going through a boom or is in recession. This is because it takes time to gather and collate the data: indicators such as unemployment and inflation are often presented weeks later. It is generally referred to as driving by looking in the rear view mirror.
    • Action lag: Once the policymakers acknowledge the problem (recession or economy slowing down or inflation), then they have to decide on an action plan. The appropriate policy takes time to implement and must be passed through the congress/parliament/whatever is appropriate. For instance, increased spending on infrastructure to generate employment and boost growth may take several months to complete.
    • Impact lag: It may be a while before the result of the projects undertaken can be seen.
  • The timing of the policy action is critical. It is important to understand the course of the economy without these policy changes. Is the economy in recovery mode because of a surprise increase in investment spending? Some issues associated with discretionary fiscal adjustments are:
    • If a government is concerned with unemployment and inflation, then increasing AD to full employment may push prices further up.
    • If the deficit is already large relative to GDP, then it may be difficult for the government to borrow more money to provide fiscal stimulus. Interest on government debt would rise.
    • Crowding out effect: Limited savings and increase in government spending → investment available for private sector decreases → less investment spending → less growth.
  • Macroeconomic forecasting models are not accurate and cannot be used for policy making decision effectively.