Course Code and Name Essay Example

Fiscal policy Case Study

Fiscal policy Case Study

Question 1

The definition of the fiscal policy has evolved over time from the expression that Edwin R.A. Seligman used to criticize a German economist’s that suggested that suggested that governments should engage in some redistribution of income through their budgetary activities. However, the meaning of fiscal policy changed during the Keynesian revolution where it moved away from the revenues and tax side of the budget to include both revenue and spending. Therefore, from a Keynesians perspective fiscal policy refers to the manipulation of taxes and public spending to influence aggregate demand. Fiscal policies are not necessarily meant to stabilize an economy but also reallocate resources and redistribute income.

One assumption of the fiscal policy theory that the author uses is that there exists a unitary form of government in Australia that has the political power to set the desired objectives and change the policy instruments in a desired direction and by a needed magnitude (Battaglini & Coate 2014, p. 15). What this assumption means is that there exists an all-inclusive budgetary process and no public finance decision is made outside of the budget or at least, all decisions, whether in or out of the formal budget are directly or indirectly controlled by the government (Lewis 2002, p. 14). In addition, the fiscal policy theory also assumes that policy decisions made by government are influenced by public interest. This means that policymakers always avoid making populist policies that go against the public interest even when the policies have short run appeals that could help those in power win the next election. In general, the fiscal theory assumes that the electoral cycle does not play a role in the budgetary decisions (Augello & Guidi 2012, p. 102).

The case study provides some fiscal policy measures that the Howard government put in place in the 2000-01 budgets. There is evidence to prove that the government operates a surplus budget as the forecasted surplus for the current budget was $1.5 billion. Another budgetary policy that was fiscal in nature was the tax break that the budget expected to bring forth for the older generation in Australia. It can be assumed that this was meant to boost aggregate demand among members of this demographic. The tax breaks for motor vehicle manufacturers to claim full tax input to the tune of $600 million as a way of stimulating the economy. Other budgetary policies that are related to fiscal policy relates to the increased government spending on welfare projects such as health so as to create employment opportunities to nurses, and expenditure on the Job Network program and the new working credit scheme that seeks to increase discretionary income among those returning to work by proving income support until one accumulates $1,000 in earnings. This may be assumed to be targeted at the economy to stimulate spending in the economy as a way of growing industries in the economy.

The author’s criticism is based on the skepticism that is associated with the fiscal policy theory in the real world. To start with, it is difficult to establish how to determine public interest due to the heterogeneity of the Australian population. The postponement of the expected privatization of Telstra Corp, which is one of the largest public companies in Australia to 2003-04 has been termed by the author as political as it would generate a public outcry during the electioneering period. Aside from that, there are disagreements between the ruling party and the opposition in the Australian parliament on what should be included in the budget estimates. For example, the leader of the Australian Democrats terms the tax breaks to the old as stated in the budget as a ‘generational port barreling and that the budget has blocked increased government spending that were meant to take effect in the budgeting period. Another failure that the author mentions as making the budget a campaign budget relates to the lack of economic analysis in coming up with the policy decision. There seems to be no serious assessment of the effects a policy decision will produce, and how much it will cost or will generate revenue with a case in point being the tax breaks for motor vehicle manufacturers that would deny the government more than $600 million in revenues. The author also mentions of the decision to increase funding for to the health sector, which is seen as a labor party strong point. The case study is a perfect example of the realist approach to the fiscal policy as it is difficult to have absolute power over budget making as well as difficult to differentiate between public interest and personal interests of the ruling class.

Question 2

Discretionary fiscal policy refers to the deliberate manipulation of government spending, transfers and taxation in order to promote macroeconomic goals such as price stability, full employment and economic growth. In addition, discretionary fiscal policies require the approval of either parliament or the prime minister thus are affected by lags that occur as a result of enactment of the changes in fiscal policy (Auerbach 2002, p. 52). More often, the implementation of the modified fiscal policy requires changes in legislation, thus may take time to implement. An example may be the effecting tax breaks where before the changes in tax law are adopted by parliament and are passed into laws, it may have a moderate impact of increasing the disposable income of the working population, which is meant to increase aggregate demand (Feldstein 2002, p. 153). Discretionary fiscal policy can be used to counter business cycles in two ways; either through expansionary fiscal policy, or through restrictive/contractionary fiscal policy which have different impact on the rate of growth of GDP.

The major assumption of discretionary fiscal policies is that aggregate supply grows constantly and only aggregate demand is affected by the discretionary fiscal policy. The annual budget plays a critical role in the development of discretionary fiscal policy given that it provides an outline of the tax reforms that the government wants to take in place either to increase disposable income or increase government revenue. In addition, the annual budget provides the annual expenditure by the government as well as the sources and targets of the funds. This means that the annual budget provides the discretionary fiscal policy items and is usually dependent on the business cycles. The discretionary fiscal policy is better explained through graphs showing the impact of restrictive or expansive fiscal policies.

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From the graph it is evident that the reduced government spending and increased taxes reduced aggregate demand, which is signified by the arrows in the graph which results in a fall in the real GDP as well as a rise in unemployment. The graph depicts the restrictive fiscal policy. Conversely, where expansionary fiscal policy is applied, the arrows change direction to the reverse with respect to the aggregate demand curve, increasing real GDP and reducing unemployment during periods of recession.

The annual budget plays an important role with regards to fiscal policy given the basic equation of government budget = government purchases (G) + Transfer payments – tax revenue from all sources. Therefore, government budget = G –T where T refers to taxes net of transfers. However, annual budget includes fiscal policy changes not only with G but also with T which results in shifts in consumption (C) and aggregate demand AD. From the equation, we can describe a budget deficit by G-T>0 and budget surplus by G-T<0 while a balanced budget should be described by G-T =0.

Graph of Government Budget

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Budget deficit Budget Surplus

The graph shows the relationship between annual budgets and real GDP in that the budget can move from deficit to surplus and vice versa if the levels of real GDP grow or decline for reasons other than government policy. This is because as real GDP increases tax revenues also grow and with a fixed amount of government spending, the budget moves towards surplus. What this means is that fiscal policy can change course by itself as real GDP moves or it can be changed by discretionary fiscal policy. Taking an example of an economy that is experiencing a recession, the policy makers will use discretionary fiscal policy to increase G or lower T, which moves government budget into a deficit. However, even without the expansionary fiscal policy the budget would have moved into deficit and lower real GDP, meaning that less taxes will be paid and more transfers paid due to unemployment, giving a perfect description of the automatic stabilizers of the economy.

On the other hand, automatic stabilizers refer to structural features of government taxation and spending that smooth fluctuations in disposable income and consumption over the business cycle as described above. The automatic stabilizers are still derived from the basic GDP equation where GDP = C+I+G+NX. However, this equation may be modified into AD=C(Y-T)+I(r) + G+ NX which implies that investment (I) is a function of interest rate (r); thus, when interest rates rise, investments will decrease and where interest rates decline the investments will increase. On the other hand, automatic stabilizers do not require new legislations to enact the countercyclical policy, which increase the budget deficit during periods of recessions and decrease the budget deficit during periods of boom. The fact is that automatic stabilizers have an immediate effect on the economy as well as changes in the business cycles. This is because they are taxation and expenses matters that are already part of the economic program set into place by the government. An example of automatic stabilizers is unemployment compensation where in periods of recession the government’s expenditure on unemployment compensation increase automatically as the majority of the people lose employment. From a Keynesians perspective it is this rise in spending by government that prevents the economy from plunging deep into recession considering what would have occurred if no such compensation existed. Aside from that a progressive tax system is also an example of automatic stabilizer as it is usually meant to tax the high income persons and corporations higher tax rate while charging lower rate to low income earners. In a period of economic slowdown, it is expected that incomes will decline meaning that people will pay less in taxes, thus putting much money in the pockets of people and stimulates private spending.

The major difference between automatic stabilizers and discretionary fiscal policy is based on the multiplier effect where the marginal propensity to save due to a temporary tax cut is likely to be relatively high (Taylor 2000, p. 21). On the other hand, expansion of an economy increases the demand for money, resulting in interest rates to rise depressing economic activity. In addition, discretionary fiscal policy is affected by lags in relation to the time it takes to approve and implement fiscal policy thus making it a less effective tool for stabilization. In particular, discretionary fiscal policies may be imposed at the wrong time given that they have an intended purpose thus may cause more harm at the time they are being implemented. On the other hand, automatic stabilizers are automatic in nature in that they are self-implementing and thus either increase aggregate demand. It is important to mention that under discretionary policy the government increases spending through making purchases and reducing taxes in periods of recession, which does not have an effect on the permanent income of the households as they view it as a temporary measure thus increase their marginal propensity to save thus reduce consumption resulting in reduced aggregate demand.

Question 3

Some of the expenditures that are proposed in the case study include a $900 million government spending in health care which includes $430 million in Medicare rebates and 4104 million meant to assist rural GP’s to employ practice nurses. The budget provides funds to be spent on a $1.3 billion package of the old people as well as $800 million in net spending on welfare. Aside from the government expenditure, the budget also seeks to implement tax reforms, where the tax-free threshold will be increased for pensioners to $20,000 as well as tax breaks for the motor vehicle manufacturers that are estimated to reduce tax revenues by $6000 million. Due to the fact that the government operates a budget surplus, the increased expenditure and reduced taxation is meant to raise the rate of GDP growth which has been increasing at a slower pace. The other reason why the policies are expansionary is that they lead to higher annual budget deficit and in the case of Australian budget, it will reduce the budget surplus to $1.1 billion for the period 2002-03. The diagram below shows the effects on increase in government spending and decrease in taxes on aggregate demand.

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Output (Y)

From the graph, the aggregate demand curve AD1 intersects the aggregate supply curve at Y1 implying that there is some unused capacity in the economy as they full employment level is Yp. Therefore, the increases in government spending and reductions in taxes increased the money in the pockets of household, which resulted in aggregate demand shifting to AD2 which led to a real GDP growth to Y2 but had the effect of reducing the budget surplus. The rise in aggregate demand is likely to increase the demand for labor, meaning that it would reduce unemployment while increasing the disposable income of the employed people as well as the amount attributable to the pensioners. Reduction in taxes increases disposable income which results in a rise in aggregate demand. This explains the reason why the treasurer expected a 3.25% GDP growth.

Question 4

Available data show indicates that Australia’s GDP grew by 3.194% in 2000 which represented an annual Real GDP of AUD 689,199 billion (Economy Watch 2000, p. 2). In addition, investment as a percentage of GDP was 24.689%, while the rate of inflation was 5.789%. Other economic indicators that are important for describing the position of Australia in 200 include the government total expenditure which stood at AUD 237.967 billion, while government revenues was AUD 249.89 billion this in addition to a total of AUD 11.923 billion in net debts meaning that the country had a balanced budget (Economy Watch 2000, p. 2). Finally, the current account balance as a percentage of the GDP for the year 2000 was -3.839%, meaning it had a negative balance of trade (Economy Watch 2000, p. 2). Therefore, the diagram below shows the situation of the Australian economy prior to May 2001.

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Output (Y)

From the graph, the Australian economy is experiencing growth in GDP as the budget is growing towards a surplus, although there are unexploited resources as their economy has not been able to reach full employment at Yo where aggregate supply grows constantly. The GDP of 3.194% in 2000 can be described by the output Y1 in the diagram with a price level of P1. It is the prospect of a surplus budget and a growth in GDP that necessitate the government to implement the expansionary fiscal policies that not only increase aggregate demand but also aggregate supply as will be described in the diagram below. The increase in aggregate demand is as a result of increased government spending in health in 2001 and in tax rebates for the old and those reentering the job market. On the other hand, tax credits to motor vehicle manufacturers increases aggregate supply which has an effect on the country’s current account and balance of trade.

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Output (Y)

Where the fiscal policy is adopted in 2001, aggregate supply is expected to grow from AS1 to AS2. More so, aggregate demand is expected to increase from AD1 to AD2 with the result being growth in output from Y1 to Y2 to Z implying the projected GDP growth of 3.25%. However, the rise in both aggregate demand and supply will also have a countercyclical effect of increasing the prices of commodities as the GST was not reduced which was a major cause of debate from the democrats. The output at X shows the impact of the price increase, which brings in the issue of inflationary pressure that result in decreased GDP.

Question 5

Problems associated with the Implementation of Fiscal Policy

One of the major problems with the implementation of fiscal policy is the problem of timing that is a result of lags in the economy that hamper the effectiveness of government policy. The three lags relate to information lag, policy lag and impact lag (Bouman 2011, p. 18). Information lag refers to the period of time during which the economy changes and economists find out that it changes. On the other hand, impact lag refers to the period of time during which politicians have taken action and the impact of the action is actually felt in the economy. Policy lag relates to the period of time when information is received and the period when decisions are taken by politicians (Feldstein 2002, p. 153). As discussed earlier, it is this timing problem that makes it difficult to implement the fiscal policy. The mere fact that Australia is a democracy and requires legislation to pass through a deeply divided parliament makes it difficult to change legislations related to tax reforms and other fiscal policies that require parliament approval.

Fiscal policy brings the problem of crowding out for investment and consumption functions (Auerbach & Hassett 2002, p. 229). For example, where expansionary fiscal policy has been implemented, this increases government spending while reducing taxes, which fund the government spending, thus push the government to borrow in the domestic market, a factor that increase the interest rates, making borrowing expensive for households and businesses, consequently affecting consumption and investment as they are crowded out by increased government borrowing. In addition, when taxes decline, consumptions immediately rise because disposable income increases but since total output is fixed by factors of production and government spending is fixed by fiscal policy; a change in consumption is met by an equal and opposite change in investment implying the crowding out of investment. Another problem with the fiscal policy is the temporary nature with which the households perceive changes in tax structures where if a fiscal policy reduces taxes, the households may perceive this as a temporary measure thus may save more of their saving than spend on consumptions thus the policy not serving its intended purpose.

List of References

Auerbach, A 2002, Is there a role for discretionary fiscal policy? (No. w9306). National Bureau of Economic Research.

Auerbach, AJ & Hassett, KA 2002, “Fiscal policy and uncertainty,” International Finance, vol. 5, no. 2, p. 229-249.

Augello, MM & Guidi, ME (Eds.) 2012, The Economic Reader: Textbooks, Manuals and the Dissemination of the Economic Sciences During the 19th and Early 20th Centuries, Routledge, London; New York.

Battaglini, M & Coate, S 2014, A Political Economy theory of fiscal policy an unemployment, Viewed from

Bouman, J 2011, Fiscal Policy, Viewed from

Economy Watch 2000, Australia Economic Statistics and Indicators, Viewed from

Feldstein, M 2002, Commentary: Is There a Role for Discretionary Fiscal Policy? Viewed from

Lewis, S 2001, Fiscal Policy: All risky political business left for after the election. The Australian Financial Review.

SparkNotes Editors n.d., SparkNote on Policy Debates.
Viewed from

Summers, L 2012, A Theory of fiscal policy: Self-sustaining stimulus. The Economist. Viewed from

Tanzi, V 2006, Fiscal Policy: When Theory Collides with Reality, CEPS Working Documents No. 246, 16 June 2006.

Taylor, JB 2000, Reassessing discretionary fiscal policy. The Journal of Economic Perspectives, vol. 14, no. 3, p. 21-36.