Discretionary Fiscal Policy
Automatic stabilisers cannot prevent fluctuations. They merely reduced their magnitude. If there is a fundamental disequilibrium in the economy or substantial fluctuations in other injections and withdrawals, the government may choose to alter the level of government expenditure or the rates of taxations. This is known as the discretionary fiscal policy. It involves shifting J and W lines.
UK
in the UK, changes in taxation and some changes in government expenditure are announced by the Chancellor of the Exchequer in the Budget (which usually takes place in March). Some of these changes apply to the coming financial year (April to March), some apply to the next financial year or even the one after that.
Since the budget are normally held only once per year, fine tuning aggregate demand on a week-by-week or month-by-month basis is left to monetary policy - to changes in interest rates. Very occasionally, however, changes are made between Budgets. Thus in September 2008 the government raised the threshold above which stamp duty must be paid on house purchase in an attempt to help first-time buyers. Then, in the pre-Budget report of November 2008, as recession deepened, VAT was cut and planned public-sector projects were brought forward.
Since the budget are normally held only once per year, fine tuning aggregate demand on a week-by-week or month-by-month basis is left to monetary policy - to changes in interest rates. Very occasionally, however, changes are made between Budgets. Thus in September 2008 the government raised the threshold above which stamp duty must be paid on house purchase in an attempt to help first-time buyers. Then, in the pre-Budget report of November 2008, as recession deepened, VAT was cut and planned public-sector projects were brought forward.
Expansionary and Contractionary
A- Expansionary fiscal policy:
By increasing government spending, the aggregate demand will shift to the right (spending on highways, satellite communications). For example if the MPC =0.75, then the multiplier will be 4 and the aggregate demand will shift back to the right by 4 times the amount of government spending (say 5 billion dollars).
By reducing taxes the aggregate demand curve will shift to the right. For example, government cuts personal income taxes by $6.67 billion which will increase disposable income by the same amount. MPC(.75) times $6.67 billion dollars equals $5 billion and saving will increase by 1.67 billion( MPS times 6.67 billion ). The initial increase in consumption spending is $5 billion because of the multiplier effect, the real GDP will increase by $20 billion. If the MPC is smaller then it is needed a higher tax cut.
The combination of both policies( decreasing taxes and increasing government spending)
B- Contractionary fiscal policy: by fighting against demand-pull inflation.
There are 3 cases involved here.
Financing of deficits, and disposing of surpluses.
Borrowing versus new money.
Government can finance a deficit by two ways.
Conservatives advocate that public sector is too large and inefficient therefore they recommend tax cuts during recessions and reductions in government spending during demand inflation.
By increasing government spending, the aggregate demand will shift to the right (spending on highways, satellite communications). For example if the MPC =0.75, then the multiplier will be 4 and the aggregate demand will shift back to the right by 4 times the amount of government spending (say 5 billion dollars).
By reducing taxes the aggregate demand curve will shift to the right. For example, government cuts personal income taxes by $6.67 billion which will increase disposable income by the same amount. MPC(.75) times $6.67 billion dollars equals $5 billion and saving will increase by 1.67 billion( MPS times 6.67 billion ). The initial increase in consumption spending is $5 billion because of the multiplier effect, the real GDP will increase by $20 billion. If the MPC is smaller then it is needed a higher tax cut.
The combination of both policies( decreasing taxes and increasing government spending)
B- Contractionary fiscal policy: by fighting against demand-pull inflation.
There are 3 cases involved here.
- By reducing government spending, the aggregate demand will shift to the left and prices will fall down assuming that there is downward price flexibility( see figure. But real GDP will be the same because of that aggregate supply is vertical.
- By raising taxes, aggregate demand will shift to the left If marginal propensity (MPP) is 0.75, government has to increase taxes by $6.67 billion to reduce consumption by $ 5 billion(.75 * 6.67= 5 billion) and 0.25 * 6.67 billion = $1.67 billion reduction in saving (see figure 12.2).
- Combined government spending cuts and tax increases. For example, a $2 billion decrease in government accompanied with a $4 billion increase in taxes, aggregate demand would shift by how much? Government spending will increase by $2*4 = $8 billion after multiplier effect.; tax cut will be .75*4 billion = $3 billion, and $1 billion of saving(.25*4 billion. After multiplier effect, the effect will be $3 billion times the multiplier (4) = $12 billion. Therefore the combined effect, which is $8 billion + $12 billion = $20 billion, that aggregate demand will decline.
Financing of deficits, and disposing of surpluses.
Borrowing versus new money.
Government can finance a deficit by two ways.
- Borrowing : if the government borrows money this will lead to interest rate increase and crowd out some private investment spending. For example, decreases in private spending reduce the expansionary impact of the deficit spending.
- Money creation: If the government finances its deficit spending by creating new money, then there is no crowding out of private spending. That is this spending will increase without reducing consumption or investment. This kind of financing is a more expansionary way but more inflationary. Debt retirement versus idle surplus
- Impounding: if the surplus tax revenue are not spent in the economy (idle surplus ), then this will lead to more ant-inflationary impact of the contractionary policy.
1- debt reduction: The government should use the surplus by paying of f the debt. This means that the government buys back some of its bonds, and this will to interest rate decrease and private borrowing and spending will increase.
Therefore, the increase in private spending offsets the contractionary fiscal policy.
Conservatives advocate that public sector is too large and inefficient therefore they recommend tax cuts during recessions and reductions in government spending during demand inflation.
Other Purposes
Note that discretionary changes in taxation or government expenditure, as well as being used to alter the level of aggregate demand (fiscal policy), are also used for other purposes, including the following:
- Altering aggregate supply. Examples include tax incentives to encourage people to work more, or increased government expenditure on training or on transport infrastructure.
- Altering the distribution of income. Taxation and benefits are the government's major means of redistributing incomes from the rich to the poor
Effectiveness of Discretionary fiscal policy
How successful will discretionary fiscal policy be? Can it fine tune demand? Can it achieve the level of national income that the government would like it to achieve. There are two main problem areas with discretionary fiscal policy. The first concerns the magnitude of the effects. If G or T is changed, how much will the total injections and withdrawals change? What will be the size of the multiplier? How much will a change in aggregate demand affect output and employment, and how much will it affect prices?
The second concerns the timing of the effects. How quickly can policy be changed and how quickly will the changes affect the economy?
The second concerns the timing of the effects. How quickly can policy be changed and how quickly will the changes affect the economy?
Magnitude
Before changing government expenditure or taxation, the government will need to calculate the effect of any such change on national income, employment and inflation. Predicting the effects, however is often very unreliable for a number of reasons.
Predicting the effect of changes in government expenditure
A rise in government expenditure of x dollars may lead to a rise in total injections (relative to withdrawals) that is smaller than x dollars. This will occur if the rise in government expenditure replaces a certain amount of private expenditure. For example, a rise in expenditures on state education may dissuade some parents from sending their children to private schools. Similarly an improvement in the National Health Service may lead to fewer people paying for private treatment.
Crowding Out - If the government relies on pure fiscal policy - that is, if it does not finance an increase in the budget deficit by increasing the money supply - it will have to borrow money from the non-blank private sector. It will thus be competing with the private sector for finance and will have to offer higher interest rates. This will force the private sector also to offer higher interest rates, which may discourage firms from investing and individuals from buying on credit. Thus government borrowing crowds out private borrowing. In the extreme case, the fall in consumption and investment may completely offset the rise in government expenditure, with the result that aggregate demand does not rise at all.
Predicting the effects of changed in taxes
A cut in taxes, by raising people's real disposable income, increases not only the amount they spend but also the amount they save. The problem is that it is not easy to predict the relative size of these two increases. In part it depends on whether people feel that the cut in tax is only temporary, in which case they may simply save the extra disposable income, or permanent, in which case they may adjust their consumption upwards.
Predicting the resulting multiplied effect on national income
Even if the government could predict the net initial effect on injections and withdrawals, the extent to which national income will change is still hard to predict for the following reasons:
Random Shocks
Forecasts cannot take into account the unpredictable, such as the attack on the World Trade Center in New York in September 2001. Even events that, with hindsight, should have been predicted, such as the banking crisis of 2007 - 2009, often are not. Unfortunately, unpredictable or unpredicted events do occur and may seriously undermine the government fiscal policy.
Predicting the effect of changes in government expenditure
A rise in government expenditure of x dollars may lead to a rise in total injections (relative to withdrawals) that is smaller than x dollars. This will occur if the rise in government expenditure replaces a certain amount of private expenditure. For example, a rise in expenditures on state education may dissuade some parents from sending their children to private schools. Similarly an improvement in the National Health Service may lead to fewer people paying for private treatment.
Crowding Out - If the government relies on pure fiscal policy - that is, if it does not finance an increase in the budget deficit by increasing the money supply - it will have to borrow money from the non-blank private sector. It will thus be competing with the private sector for finance and will have to offer higher interest rates. This will force the private sector also to offer higher interest rates, which may discourage firms from investing and individuals from buying on credit. Thus government borrowing crowds out private borrowing. In the extreme case, the fall in consumption and investment may completely offset the rise in government expenditure, with the result that aggregate demand does not rise at all.
Predicting the effects of changed in taxes
A cut in taxes, by raising people's real disposable income, increases not only the amount they spend but also the amount they save. The problem is that it is not easy to predict the relative size of these two increases. In part it depends on whether people feel that the cut in tax is only temporary, in which case they may simply save the extra disposable income, or permanent, in which case they may adjust their consumption upwards.
Predicting the resulting multiplied effect on national income
Even if the government could predict the net initial effect on injections and withdrawals, the extent to which national income will change is still hard to predict for the following reasons:
- The size of the multiplier may be difficult to predict. This is because the mpc (the proportion that will circulate round the flow) and mpw (proportion of the cut in taxes that will be withdrawn) may fluctuate. For example, the amount of a rise in income that households save or consume will depend on their expectations about future price and income changes.
- Induced investments through the accelerator (Accelerator theory - level of investment depends on the rate of change of national income, and as a result tends to be the subject to substantial fluctuations) is also extremely hard to predict. It may be that a relatively small fiscal stimulus will be all that is necessary to restore business confidence, and that induced investments will rise substantially. In such a case, fiscal policy can be seen as a 'pump primer'. It is used to start the process of recovery, and then the continuation of the recovery is left to the market. But for that it will work, business people must believe that it will work. Business confidence can change very rapidly and in ways that could not have been foreseen a few months earlier.
- Multiplier/accelerator interactions. If the initial multiplier and accelerator effects are difficult to estimate, their interaction will be virtually impossible to estimate. Small divergences in investment from what was initially predicted will become magnified as time progresses.
Random Shocks
Forecasts cannot take into account the unpredictable, such as the attack on the World Trade Center in New York in September 2001. Even events that, with hindsight, should have been predicted, such as the banking crisis of 2007 - 2009, often are not. Unfortunately, unpredictable or unpredicted events do occur and may seriously undermine the government fiscal policy.
timing
Fiscal policy can involve considerable time lags. If these are long enough, fiscal policy could even be destabilising. Expansionary policies taken to cure a recession may not come to effect until the economy has already recovered and is experiencing a boom. Under these circumstances, expansionary policies are quite inappropriate: they simply worsen the problems of overheating. Similarly, contractionary policies taken to prevent excessive expansion may not take effect until the economy has already peaked and is plunging into recession. The contractionary policies only deepen the recession.
Time lag to recognition - Since the business cycle can be irregular and forecasting unreliable, government may be unwilling to take action until they are convinced that the problem is serious.
Time lag between recognition and action - Most significant changes in government expenditure have to be planned well in advance. The government cannot increase spending on motorways overnight or suddenly start building new hospitals. As far as taxes are concerned, these can normally be changed only at the time of the Budget, and will not be instituted until the new financial year or at some other point in the future. As Budgets normally occur annually, there could be a considerable time lag if the problems are recognised a long time before Budget.
Time lag between action and changes taking effect - A change in tax rates may not immediately affect tax payments, as some taxes are paid in areas and new rates may take a time to apply
Time lag between changes in government expenditure and taxation and the resulting change in national income, prices and employment - The multiplier round takes time. Accelerator effects take time. The multiplier and accelerator go on interacting. It all takes time
Consumption may respond slowly to changes in taxation - The short-run consumption function tends to be flatter than the long-run function. If the fluctuations in aggregate demand can be forecast, and if the length of the time lags are known, then all is not lost. At least the fiscal measures can be taken early and their delayed effects can be taken into account.
Time lag to recognition - Since the business cycle can be irregular and forecasting unreliable, government may be unwilling to take action until they are convinced that the problem is serious.
Time lag between recognition and action - Most significant changes in government expenditure have to be planned well in advance. The government cannot increase spending on motorways overnight or suddenly start building new hospitals. As far as taxes are concerned, these can normally be changed only at the time of the Budget, and will not be instituted until the new financial year or at some other point in the future. As Budgets normally occur annually, there could be a considerable time lag if the problems are recognised a long time before Budget.
Time lag between action and changes taking effect - A change in tax rates may not immediately affect tax payments, as some taxes are paid in areas and new rates may take a time to apply
Time lag between changes in government expenditure and taxation and the resulting change in national income, prices and employment - The multiplier round takes time. Accelerator effects take time. The multiplier and accelerator go on interacting. It all takes time
Consumption may respond slowly to changes in taxation - The short-run consumption function tends to be flatter than the long-run function. If the fluctuations in aggregate demand can be forecast, and if the length of the time lags are known, then all is not lost. At least the fiscal measures can be taken early and their delayed effects can be taken into account.