Government's Fiscal stance
The government's fiscal stance refers to whether it is pursuing an expansionary or contractionary fiscal policy. Focus will be on the changes in the size of the deficit and surplus. If the deficit this year is lower than last year, then aggregate demand will be lower this year than last (ceteris paribus). The reason is that either government expenditure must have fallen, or tax revenues must have increased, or a combination of the two. Tax revenue is a withdrawal while government expenditure is an injection.
Remember:
W = S + T + M
J = I + G + X
Remember:
W = S + T + M
J = I + G + X
State of the economy
Another problem is that the size of the deficit or surplus is not entirely due to deliberate government policy. It may not give a very good guide, therefore, to government intentions. The size of the deficit or surplus is influenced by the state of the economy. If the economy is booming with people earning high incomes, the amount paid in taxes will be high. In a booming economy the level of unemployment will be low. Thus the amount paid out in unemployment benefits will be low. The combined effect of increased tax revenues and reduced benefits is to give a public-sector surplus (or a reduced deficit). By contrast, if the economy were depressed, tax revenues will be low and the amount paid in benefits would be high. The public-sector deficit will thus be high.
The relationship between the budget deficit and the budget surplus and the state of the economy is illustrated in the diagram below:
The relationship between the budget deficit and the budget surplus and the state of the economy is illustrated in the diagram below:
The tax revenue function is upward sloping. Its slope depends on tax rates. The government expenditure function is drawn as downwards sloping, showing that at higher levels of income and employment less is paid out in benefits. As can be clearly seen, there is only one level of income Y1, where there is a public-sector financial balance. Below this level of income there will be a public-sector deficit. Above this level there will be a surplus. The further income is from Y1, the bigger will be the deficit and surplus.
During the boom that was experienced by North America and Europe between 1996 and 2000, deficits fell. Japan, by contrast, was experiencing a prolonged recession. Its deficits rose, partly as a result of falling tax revenues and partly from a deliberately expansionary fiscal policy.
Conclusion
To conclude, the size of the deficit or surplus is a poor guide to the stance of fiscal policy. A large deficit may be due to a deliberate policy of increasing aggregate demand, but it may be due simply to the fact that the economy is depressed.
The Structural balance
The public-sector deficit or surplus that would arise if the economy were producing at the potential level of national income is termed the structural deficit or surplus. Remember that the potential level of national income is where there is no excess of deficiency of aggregate demand. In the figure above, if the potential national income were below the intersection point of the two lines, there would be structural deficit.
If the economy is producing above or below the potential level of national income, there will be a cyclical component of the public-sector deficit or surplus. Thus the government could aim for a structural balance ( G = T at the potential level of national income), but be prepared to accept a deficit if the economy was in recession, or a surplus if it was experiencing a boom.
If the economy is producing above or below the potential level of national income, there will be a cyclical component of the public-sector deficit or surplus. Thus the government could aim for a structural balance ( G = T at the potential level of national income), but be prepared to accept a deficit if the economy was in recession, or a surplus if it was experiencing a boom.