1.

Objectives and uses of fiscal policy

Stabilization Allocation

Distribution

2. Risks associated with fiscal policy

Sustainability

of public debt Role of fiscal policy in crises Exit strategies when things go wrong

3. Fiscal reforms

1. The term fiscal policy refers to the use of public finance instruments to influence the working of the economic system to maximize economic welfare 2. Effects of fiscal policy reflect not only the impact of the fiscal balance, but also various elements of taxation, spending, and budget financing 3. Assessing the stance of fiscal policy requires taking account of the activities of all levels of government

1. Stabilization

Fiscal policy influences aggregate demand Through demand, fiscal policy affects output, employment, inflation, balance of payments Fiscal policy also influences aggregate supply
Public

2. Allocation

infrastructure, education, health care

3. Distribution

Through taxes, transfers, and expenditures

Progressive,

neutral, regressive

Fiscal policy can be used to several ends

To achieve internal balance

By adjusting aggregate demand to available supply By achieving low inflation, potential output By ensuring sustainable current account balance By reducing risk of external crisis E.g., through more and better education and health care

To promote external balance

To promote economic growth

Fiscal policy needs to be coordinated with monetary, exchange rate, and structural i.e., supply-side policies

Demand management
E.g., lower income taxes
Aggregate supply in short run Price level

A Aggregate demand Output

Demand management
E.g., lower income taxes
Aggregate supply in short run Price level

Supply management
E.g., lower import tariffs

Price level

Aggregate supply in short run

A

A Aggregate demand Output B Aggregate demand Output

 Central

bank financing involves money creation

Inflation tax: Most inflationary form of financing

Bond

finance is less inflationary

Removes financial resources from circulation Increases real interest rates Crowds out investment

External Evidence

financing can be inflationary from cross-country data

Especially if it leads to currency depreciation Strong links between budget deficits and inflation in developing countries, but not in industrial countries Bond finance, not money finance, is the rule in industrial countries

Before Great Depression 1929-39, many thought that governments needed to balance their budgets from year to year

Even so, US had built is railways through borrowing, for example

Keynes revolted (General Theory 1936)

If private sector failed to consume and invest, government could fill the gap Y = C + I + G + X Z C and I and G appear side by side Guns or butter? Makes no difference Also, could reduce taxes to encourage C and I

Multiplier analysis
It could be shown that, with unemployed resources, an increase in G would raise Y by an amount greater than the original increase in G

Active fiscal policy was used consciously in Sweden even before Keynes and adopted in US and elsewhere after 1960 (Kennedy-Johnson administration)
Coincided with buildup of US as a welfare state with greater emphasis on public services and social security, like in Europe Active fiscal policy came naturally to Europe

Fiscal policy can affect

Aggregate demand, output, and price level Cut taxes: Consumption, output, and prices rise Rate of monetary expansion and inflation Increase spending financed by credit expansion: Money expands (M = D + R), so inflation goes up Aggregate supply and economic growth Boost education and health care: Efficiency and long-run growth go up Current account of balance of payments

Raise taxes: Disposable income and imports fall, so current account improves unless currency appreciates

Impact of fiscal policy actions depends on

Whether economy is open or closed (import leakage) Exchange rate regime (fixed or floating) Type of budget financing (money creation or debt) Degree of confidence in economic policy

Level of government debt Financing constraints Risk premia on debt

Whether fiscal changes are considered temporary or permanent How close the economy is to full employment

In times of financial and economic crisis, fiscal policy plays key role in governments response
Fiscal

policy played a role during Great Depression, even if theory behind it was poorly understood, or even disputed Fiscal policy plays key role in current crisis
Monetary policy is ineffective if real interest rates cannot be reduced without igniting inflation Fiscal policy is more effective

Massive fiscal stimulus in US, Europe, and Asia: it works! Fiscal stimulus is assisted by automatic stabilizers

Fiscal stimulus packages need to include an exit strategy to ensure that solvency is not at risk, and should

Not have permanent effects on budget deficits Provide a commitment to fiscal correction, once economic conditions improve Include structural reforms to enhance growth Should firmly commit to clear strategies for health care and pension reforms in countries facing demographic pressures

Need for financing tends to lift interest rates, so capital flows in and currency tends to appreciate Central Bank must offset incipient appreciation by expanding money supply, thereby reinforcing initial fiscal stimulus Otherwise, exchange rate could not remain fixed

Need for financing tends to lift interest rates, so capital flows in and currency appreciates Appreciation reduces net exports, aggregate demand, and interest rates Process continues until interest rates fall to their initial level So, fiscal stimulus is ineffective with perfect capital mobility

Fiscal policy is frequently key to addressing balance of payments problems

Or look at it this way: Y = C + I + G + X Z means XZ=YCTIG+T=SI+T-G

Hence, current account balance (X Z) equals sum of private sector surplus of saving over investment (S I) and government surplus of taxes over public expenditure (T G) Equivalently, Z X = I S + G T means that external deficit equals sum of private sector deficit and government budget deficit

Unsustainable fiscal policy can trigger a crisis if public loses confidence in governments macroeconomic policy
Sudden capital outflow can result, weakening balance of payments and leading to a sharp devaluation Financing the budget externally builds up external debt, increasing risk of crisis Fiscal sustainability thus matters not only for debt, but also for balance of payments

Fiscal contraction (spending cuts, tax increases) can slow down inflation, reduce current account deficit Fiscal expansion (tax cuts, spending increases) can shrink unemployment, increase aggregate demand and help restore output to full capacity, i.e., bring actual GDP up to potential GDP, especially if monetary policy is impotent

Objections to fiscal activism

Borrowing to finance increased government expenditures raises interest rates, thereby crowding out investment and reducing multiplier At full employment, increased public spending, however financed, leads to inflation without stimulating output except temporarily Increasing spending or cutting taxes to combat unemployment may impart inflation bias to economic system

Rules vs. discretion

Fiscal activism may tend to expand public sector

Government has vital role to play in modern mixed economies (allocation role)
Education Health care, cf. current debate in US Infrastructure (roads, bridges, etc.)

Some would also stress governments distribution role

claiming that the government should try to secure reasonable equality in the distribution of income and wealth, including poverty alleviation Normative or positive economics?

Partly positive: Equality is good for growth

Per capita growth adjusted for intial income (%)

Two

views Inequality sharpens incentives and thus helps growth Inequality endangers social cohesion and hurts growth 117 countries, 1960-2000

r = -0.27
6 4 2 0 -2 -4 -6 -8 10 20 30 40 50 60 70

Gini index of inequality

Per capita growth adjusted for intial income (%)

Equality

growth No visible sign here that equality stands in the way of economic growth An increase in Gini index by 16 points goes along with a decrease in per capita growth by one percentage point per year

is good for

r = -0.27
6 4 2 0 -2 -4 -6 -8 10 20 30 40 50 60 70

Gini index of inequality

Why not raise government expenditure on public services or whatever and reduce taxes? to buy votes

Supposing all objections could be swept aside

Because this would create a deficit and deficits can lead to inflation, and inflation is undesirable for many reasons it reduces efficiency and growth, for one thing Even so, a modest deficit can be sustained in a growing economy So how modest is modest?

Public wages and employment Provide adequate operations and maintenance spending Eliminate subsidies and target transfers Minimize military expenditure Encourage capital expenditures Eliminate unproductive spending

Identify white elephants Look for proximate indicators of misallocation

Literacy rates Mortality rates

Identify sectoral expenditure imbalances

E.g., high teacher/pupil ratio with inadequate teaching supplies

Identify allocative inefficiency

E.g., generalized subsidies

Tax policy
Consistent with investment-friendly business climate and adequate funding for government

Expenditure policy
Supply productive public goods Address externalities efficiently Restrict monopolies, promote competition Foster good governance, rule of law Provide financial regulation and safety nets Support private sector activity while focusing on those things that government can do better than private sector Avoid inflation, inefficiency, excessive inequality

Creating an investment-friendly tax climate

Moderate overall tax burden that allows financing efficient levels of government activity Focus taxes on consumption rather than income, to reduce double taxation of savings

Modest income tax Limiting payroll tax burden Keeping corporate profit taxes modest

Address double taxation of dividends Keep tax burden competitive with neighboring and comparable jurisdictions; may require moderating corporate profit tax rate

Be serious about stabilization, allocation, and distribution

Keep spending consistent with revenue levels, to avoid heavy debt and debt service levels Build and maintain productive infrastructure Maintain effective education system Maintain cost-effective health care system Maintain impartial and effective courts Maintain appropriate regulatory environment, especially for financial sector and other sectors with important economy-wide externalities

Also, encourage private sector

 Sound

fiscal policy is critical for good macroeconomic management, and can help manage capital flows Fiscal stimulus is usually expansionary, but not invariably Fiscal policy crucially affects BOP, and interacts with monetary policy Fiscal policy, as before, is crucial to responding to financial crises

Especially when monetary policy lands in liquidity trap and loses traction

Fiscal

policy can help foster rapid growth