Mctaggart Econ 6e Esg Ch27

27 FISCAL POLICY C h a p t e r

K e y C o n c e p t s

Government Budgets

The Commonwealth budget is an annual statement of the government’s outlays and tax revenues. Using the federal budget to achieve macroeconomic objectives such as full employment, sustained economic growth, and price level stability is fiscal policy. The Commonwealth budget is prepared by the departments of Finance and Treasury, based on economic forecasts for the year ahead. It is the job of the Cabinet Expenditure Review Committee to ensure the budget is also prepared in accordance with the government’s policy objectives. The federal Treasurer presents the budget papers to Parliament, in May in a televised address. In the weeks, or perhaps months which follow, the proposed revenue raising and spending measures are debated and eventually Parliament enacts laws to pass the budget in its amended form. ♦ Revenue for government expenditure is received

from four sources: personal income taxes, company taxes, indirect taxes and non-tax revenue. The largest source of revenue is personal income tax.

♦ Expenses are classified as transfer payments, expenditures on goods and services, and interest and other payments. The largest expenditure item is transfer payments.

The government’s budget balance equals tax revenues minus outlays. ♦ A budget surplus occurs if tax revenues exceed

outlays; a budget deficit occurs if tax revenues are less than outlays; and a balanced budget occurs if tax revenues equal outlays.

♦ The Australian government had a budget deficit from the late 1980s to 1997/98. From 1997/98 until 2008/09 the budget was mostly in surplus.

♦ Government debt is the total amount that the government has borrowed. As a percentage of GDP, the debt has declined since the 1970s. By 2006 the Commonwealth government debt was less than its assets.

♦ When state and local government budgets are added to the Commonwealth government budget, the size of the budget increases significantly.

♦ The Australian economy is characterised by a “vertical fiscal imbalance”. The Commonwealth government collects 72 percent of total government revenue, but accounts for only 51 percent of expenditure. Large grants are made by the Commonwealth government to the state governments, which in turn enables the Commonwealth to exert some influence on state government spending.

The Demand Side: Stabilising the Business Cycle

Discretionary fiscal policy is a policy action initiated by an act of Parliament; automatic fiscal policy is a change in fiscal policy caused by the state of the economy. Government fiscal policies can have multiplier effects: ♦ An increase in government expenditure increases

aggregate demand. The government expenditure multiplier is the magnification effect of a change in government expenditure on aggregate demand.

♦ A decrease in taxes increases disposable income, which increases consumption expenditure and aggregate demand. The autonomous tax multiplier is the magnification effect of a change in autonomous taxes on aggregate demand. It is smaller in magnitude than the government expenditures multiplier.

♦ The balanced budget multiplier is the magnification effect on aggregate demand of a

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simultaneous change in government expenditure and taxes that leaves the budget balance unchanged. An increase in government expenditure increases aggregate demand by more than an equal-sized increase in taxes decreases aggregate demand, so on net aggregate demand increases and the balanced budget multiplier is positive.

Fiscal policy can be used to change real GDP so that it equals potential GDP. If real GDP is less than potential GDP, a recessionary gap exists and expansionary fiscal policy, such as an increase in government expenditure or a decrease in tax revenues, can be used. Expansionary policy shifts the AD curve rightward. The multiplier effect means that the aggregate demand curve shifts rightward by an amount that exceeds the initial increase in government expenditure or decrease in taxes.

♦ Figure 27.1 shows how the fiscal policy eliminates a recessionary gap by increasing real GDP (from $11 trillion to $12 trillion in the figure) and raising the price level (from 115 to 120 in the figure). The rightward shift of the aggregate demand curve is comprised of the initial increase in government expenditure or tax cut plus the multiplier effect.

If real GDP exceeds potential GDP, an inflationary gap exists and contractionary fiscal policy, such as a

decrease in government expenditures or a tax increase, can be used. Contractionary policy shifts the AD curve leftward. The multiplier effect means that the aggregate demand curve shifts leftward by an amount that exceeds the initial contractionary fiscal policy. Real GDP decreases so that the inflationary gap is closed and the price level falls. Lags limit the use of discretionary fiscal policy: ♦ The recognition lag is the time that it takes to

determine which fiscal policy actions are needed. ♦ The law-making time lag is the time that it takes

Congress time to pass a fiscal policy change. ♦ The impact lag is the time it takes from passing a

fiscal policy change to when the effects on real GDP are felt.

Automatic fiscal policy occurs because some tax receipts and expenditures change whenever real GDP changes. Automatic stabilisers are mechanisms that help stabilise GDP and operate without the need for explicit action. Induced taxes and induced transfer payments are automatic stabilisers. ♦ Induced taxes are taxes that change when GDP

changes. ♦ Induced transfer payments are expenditures that

allow qualified individuals and businesses to receive benefits. Induced transfer payments changes when GDP changes.

Both induced taxes and induced transfer payments decrease the magnitude of the multiplier effects. The smaller the multipliers, the more moderate are expansions and recessions. Induced taxes and induced transfer payments mean that the amount of the budget deficit changes with the business cycle. The deficit automatically increases during a recession as induced taxes fall and induced transfer payments rise. The structural surplus or deficit is the budget balance that would occur if the economy were at full employment and real GDP equalled potential GDP. The cyclical deficit or surplus is the actual deficit or surplus minus the structural deficit or surplus. The cyclical deficit is the part of the deficit is the result of the business cycle.

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The Supply Side: Influencing Potential GDP and Economic Growth

The effects of fiscal policy on employment, potential GDP, and aggregate supply are called supply-side effects. The labour market determines the quantity of labour employed and the production function shows how much real GDP is produced by this amount of employment. When the labour market is in equilibrium, the amount of GDP produced is potential GDP. An income tax decreases the supply of labour, which increases the before-tax wage rate and decreases the after-tax wage rate. The tax creates a tax wedge between the (higher) before-tax wage rate and the (lower) after-tax wage rate. Taxes on consumption expenditure also add to the overall tax wedge because they raise the prices of goods and services and so lower the real wage rate. The tax wedge in Australia is estimated to be quite high, relative, for example, to that in the United States. ♦ An increase in the tax rate increases the tax

wedge. The higher the tax wedge, the lower the supply of labour and so the smaller equilibrium employment and potential GDP.

A tax on interest income drives a wedge between the after-tax interest rate received by savers and the interest rate paid by borrowers. The tax decreases private saving and thereby decreases the supply of loanable funds. The supply of loanable funds curve shifts leftward. The after-tax real interest rate falls and decreases the equilibrium quantity of loanable funds and investment. By decreasing investment, the tax lowers the economic growth rate. ♦ Taxes are levied on the nominal interest rate. The

higher the inflation rate, the higher the nominal interest rate. Hence the higher the inflation rate, the more that is paid as taxes and so the lower the after-tax real interest rate.

The Laffer curve is the relationship between the tax rate and the amount of tax collected. If tax rates are high enough, an increase in the tax rate decreases potential GDP by so much that the total tax revenue collected decreases. It is unlikely that tax rates in Australia is this high, so an increase in taxes would increase total tax revenue.

Intergenerational Aspects of Fiscal Policy

Along with most other developed nations, the Australian economy faces possible problems associated with changing demographics. The proportion of the population of working age is expected to decline in the future, while the proportion of older Australians is expected to increase. The implications for future budgets are two-fold: ♦ A shrinking workforce relative to the total

population means a smaller proportion of the population will be paying income taxes. Currently income taxes comprise the larges proportion of Commonwealth government budget revenue.

♦ A larger proportion of elderly people relative to the total population are likely to put pressure on health related expenditure items in the Commonwealth government budget.

In response to this looming problem, the Commonwealth government commissioned an Intergenerational Report which was published along with the budget papers in 2002/03. This report identified some factors which could decrease future pressures on the budget, such as increasing productivity and decreasing unemployment.

H E L P F U L H I N T S

1. MULTIPLIERS : The expenditure multiplier was discussed two chapters ago. This chapter continues the discussion by introducing additional multipliers, such as the government expenditure multiplier, autonomous tax multiplier, and balanced budget multiplier. All multipliers exist for the same reason: An initial autonomous change that affects people’s disposable income leads them to change their consumption expenditure. In turn, the consumption changes affect other people’s income, which creates yet more induced changes in consumption expenditure. So, for all multipliers, aggregate demand changes because of the initial autonomous change and because of the further induced changes in consumption expenditure.

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Q u e s t i o n s

True/False and Explain

Government Budgets

11. The Cabinet Expenditure Review Committee presents the Budget papers to Parliament.

12. If tax revenues exceed government expenses, the government has a budget deficit.

13. The Commonwealth government has run budget surpluses for most years since the late 1990s.

14. Many nations have a government budget deficit.


5. The autonomous tax multiplier shows that a tax cut decreases aggregate demand.

6. If GDP is less than potential GDP, a tax cut or an increase in government expenditures can return GDP to potential GDP.

7. One factor hindering the use of fiscal policy is the law-making time lag.

8. Induced taxes are an example of an automatic stabiliser.

9. Over a business cycle, the structural deficit rises and falls.


10. Increasing the income tax rate decreases potential GDP.

11. Taxes on expenditure, such as the GST, decrease the tax wedge.

12. Increasing the tax rate always increases tax revenue

13. Increasing the tax rate on interest income decreases saving but increases equilibrium investment.


14. Australia is one of the few developed countries which is expected to have a decreasing labour force in the future.

15. The intergenerational problem was problem associated with conflict between the generation

in the 1960s and 1970s over Australia’s participation in the war in Vietnam.

Multiple Choice

Government Budgets

11. In Australia today, which of the following is the largest source of revenue for the Commonwealth government? a. Corporate income tax b. Personal income tax c. Indirect tax d. Government deficit

12. What is the largest component of Commonwealth government outlays? a. Transfer payments b. Expenditures on goods and services c. International purchases d. Interest on the debt

13. Suppose that the Commonwealth government’s outlays in a year are $2.5 billion, and that its tax revenues for the year are $2.3 billion. The government is running a budget a. surplus of $2.3 billion. b. surplus of $0.2 billion. c. deficit of $0.2 billion. d. deficit of $2.5 billion.

14. Which of the following countries had the largest federal government debt in 2008? a. Germany. b. France. c. Japan. d. The United States.

15. In 2007/08 Australia had a budget ____ and the United States had a budget ____. a. surplus; surplus b. surplus; deficit c. deficit; surplus d. deficit; deficit



6. An increase in income taxes is an example of a. discretionary fiscal policy. b. automatic fiscal policy. c. expansionary fiscal policy. d. a multiplier in action.

7. If government expenditure is increased by $200 billion and simultaneously taxes increase by $200 billion, then a. potential GDP increases. b. aggregate demand does not change. c. aggregate demand increases. d. aggregate demand decreases.

8. If the economy has a recessionary gap, in order to restore full employment an appropriate fiscal policy is a. a tax increase. b. a cut in government expenditures. c. an increase in government expenditures. d. a decrease in the autonomous tax multiplier.

9. Once the multiplier effect is taken into account, which of the following policies decreases aggregate demand the most? a. A $10 billion increase in government

expenditures. b. A $10 billion decrease in government

expenditures. c. A $10 billion tax increase. d. A $10 billion decrease in government

expenditures combined with a $10 billion tax decrease.

10. How do induced taxes, such as the income tax, affect the size of the multiplier effects? a. Induced taxes increase the size of the

multiplier. b. Induced taxes have no effect on the size of the

multiplier. c. Induced taxes reduce the size of the multiplier.d. The answer depends on the presence or

absence of induced transfer payments in the economy in addition to induced taxes.

11.

Which of the following happens automatically when the economy goes into a recession? a. Government expenditures on goods and

services increase. b. Income taxes rise. c. A budget surplus falls. d. Induced transfer payments falls.

12. If the federal government’s budget is in deficit even when the economy is at full employment, the deficit is said to be a. persisting. b. non-cyclical. c. discretionary. d. structural.


13. An increase in the income tax rate a. increases potential GDP. b. can eliminate the income tax wedge. c. increases the demand for labour d. decreases the supply of labour.

14. The tax wedge measures the gap between a. potential GDP and real GDP. b. before-tax and after-tax wage rates. c. the demand for labour and the supply of

labour. d. government spending and tax revenues.

15. An increase in the income tax rate ____ employment and ____ potential GDP. a. increases; increases b. increases; decreases c. decreases; increases d. decreases; decreases

16. Because taxes are imposed on the nominal interest rate, an increase in the inflation rate ____ the after-tax real interest rate. a. raises b. does not change c. lowers d. at first raises and then lowers

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17. An increase in the tax on interest income ____ the supply of saving and ____ the equilibrium amount of investment. a. increases; increases b. increases; decreases c. decreases; increases d. decreases; decreases

18. Most economists believe that in Australia an increase in the tax rate would a. increases total tax revenue. b. not change total tax revenue. c. decreases total tax revenue. d. probably change total tax revenue but the

direction of the change is ambiguous.


19. The intergenerational problem refers to the expectation that in the future the working age population will ______ as a percentage of the total population, while the elderly will ________ as a percentage of the total population. a. decrease; increase b. decrease; decrease c. increase; decrease d. increase; increase

20. Factors identified by the Intergenerational Report to ease future pressures on the budget include all the following EXCEPT: a. increasing productivity. b. decreasing healthcare to decrease the

proportion of the population living to old-age. c. decreasing unemployment. d. lowering health care costs.

Short Answer Problems

1. How has the Australian budget surplus and deficit changed over the past four decades?

2. As a percentage of GDP, how has the Commonwealth government debt changed over the same period?

3. Igor has been elected to lead Transylvania. Igor’s first action is to hire a crack team of economists and to ask them what fiscal policy he should propose.

a. If Transylvania has an inflationary gap, what fiscal policies should Igor’s economists propose?

b. If Transylvania has a recessionary gap, what fiscal policies should Igor’s economists propose?

c. Because the legislature decides to meet only at night, it takes a year to get a fiscal policy in place in Transylvania. Suppose that Igor’s economists predict that next year, without any government policy, Transylvania will have a recessionary gap. The government passes a fiscal policy that is designed to correct a recessionary gap. However, the prediction is incorrect and without any government policy Transylvania actually would have had a full employment equilibrium. What happens when the fiscal policy, based on the incorrect prediction, takes effect?

d. As Igor is sent packing back to his old night job, explain to him what other factors might have hindered the success of his fiscal policy.

4. In Figure 27.2, show the effect of an increase in taxes that restores the economy to potential GDP. Assume there is no effect on potential GDP itself from the change in taxes.

5. What is the difference between a cyclical budget

deficit and a structural budget deficit?


6. Explain the effect on potential GDP of an increase in taxes on labour income.

7. What is the tax wedge?

You’re the Teacher

1. “These multipliers are kind of cool, and I’ve studied them until I really understand them. But there’s just one point that still puzzles me: How come the government can’t use its fiscal policy to eliminate fluctuations in GDP brought by changes in investment? I’d think that this policy would be a good one for the government to follow!” Your friend has certainly hit on a good point; now what’s a good answer?

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A n s w e r s

True/False Answers

Government Budgets

11. F The federal Treasurer presents the budget papers to Parliament in a televised address.

12. F A budget deficit occurs when tax revenues fall short of government expenditures.

13. T With the exception of 2001/02, the Commonwealth budget has been in surplus from 1997/08.

14. T Many nations have government budget deficit. For example, the United States federal government budget has been in surplus in only two years between 1980 and 2009.


5. F A tax cut increases aggregate demand and the autonomous tax multiplier shows that the increase in aggregate demand exceeds the initial cut in taxes.

6. T A tax cut or an increase in government expenditures increases aggregate demand and thereby increases real GDP.

7. T The law-making time lag reflects the fact that it usually takes Parliament some time to change taxes or government purchases.

8. T Another automatic stabiliser is induced transfer payments.

9. F The structural deficit shows what the deficit would be if real GDP equalled potential GDP.


10. T Increasing the income tax rate decreases the amount of full employment, which decreases potential GDP.

11. F The tax wedge is the sum of the expenditure and income tax wedges, so a tax on expenditure would increase the tax wedge.

12. F The Laffer curve shows that if the tax rate is high enough, a further tax increase will decrease tax revenue.

13. F Increasing the tax rate on interest income decreases saving, which increases the

equilibrium real interest rate and decreases equilibrium investment.


14. F Australia is one of the few countries expected to have an increasing labour force.

15. F The intergenerational problem is one of changing demographics, whereby the proportion of the population who are elderly is expected to increase, while at the same time, the proportion of the population in the workforce is expected to decrease. The result is an expected increase in government expenditures combined with decreases in revenue.

Multiple Choice Answers

Government Budgets

11. b Personal income taxes are the largest source of revenue.

12. a Transfer payments are the largest component of Commonwealth government outlays.

13. c The government’s deficit equals its outlays, $2.5 billion, minus its taxes, $2.3 billion.

14. d The United States runs a consistently large budget deficit, both in absolute terms and as a percentage of GDP.

15. b Australia had a budget surplus, and the United States a budget deficit.


6. a Because the tax increase does not occur automatically, it is a discretionary fiscal policy.

7. c The balanced budget multiplier shows that an increase in government purchased balanced by an identical increase in tax revenue increases aggregate demand.

8. c A recessionary gap needs an expansionary policy to offset it, so an increase in government expenditures is the correct policy.

9. b Both the decrease in government expenditures and the increase in taxes decrease aggregate demand, but the government expenditures multiplier is larger than the autonomous tax multiplier, so the decrease in government


expenditures has a larger effect on aggregate demand.

10. c Induced taxes reduce the change in disposable income that results from a change in GDP. So induced taxes decrease the amount of induced consumption that results from a change in GDP and thereby reduce the size of the multipliers.

11. c During a recession, tax revenues fall and transfer expenditures rise, thereby decreasing a budget surplus.

12. d A structural deficit is a deficit that exists even when the economy is producing at full employment.


13. d The income tax rise decreases the return from work so the supply of labour decreases.

14. b An income tax lowers the after-tax wage rate so that it is less than the before tax-wage rate.

15. d Increasing the income tax rate decreases the supply of labour, which decreases equilibrium employment and potential GDP.

16. a The increase in inflation raises the nominal interest rate, which increases the real interest rate.

17. d The tax on interest income lowers the return from saving, so it decreases the supply of saving and thereby decreases the equilibrium quantity of investment.

18. a Though it is possible for the tax rate to be so high that a further increase would lower tax revenue, most economists think that in Australia the tax rate is not that high.


19. a Answer a describes the intergenerational problem.

20. b Decreasing health care costs are an important aspect of easing future pressure on the budget, but not by denying access to health care to reduce the population.

Answers to Short Answer Problems

1. For 19 of the 39 years from 1969/70 to 2008/09, the budget was in deficit. Measured as a percentage of GDP, the deficit was particularly large in 1977/78 (2 percent), 1983/84 (3.3 percent) and 1992/93 (4.1 percent). With the exception of 2001/02, the government has had a budget surplus, but due to the global economic crisis which originated in the United States in 2007, this situation is expected to change.

2. Measured as a percentage of GDP, the government debt has declined steadily since 1973/74. Strong economic growth which increased revenue in the late 1990s and 2000s also allowed the government to run budget surpluses. Most years, part of the surplus was used to pay down past debt. The decline in the debt therefore accelerated from the mid 1990s on. The global economic crisis may slow or even halt this decline.

3. a. In an inflationary gap, real GDP exceeds potential GDP, so contractionary policies are appropriate. Igor’s economists should suggest a decrease in government expenditures or an increase in taxes.

b. In a recessionary gap, real GDP is less than potential GDP, so expansionary policies are appropriate. Igor’s economists should suggest an increase in government expenditures or a decrease in taxes.

c. Because Igor’s economists predict the presence of a recessionary gap, the policies they suggest are expansionary policies: An increase in government expenditures and/or a tax cut. Both policies increase aggregate demand. But Transylvania is already at full employment when these policies take effect, so the increase in aggregate demand pushes Transylvania into an equilibrium with an inflationary gap. Real GDP exceeds potential GDP and the price level rises.

d. Igor lost his job because of the difficulty of economic forecasting combined with the law-making lag. Other lags that hamper fiscal policy are the recognition lag, which is the time it takes to figure out that fiscal policy actions are needed, and the impact lag, which is the time between when a fiscal policy

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change is passed and when its effects on real GDP are felt. All these lags make implementing fiscal policy difficult.

4. Figure 27.3 shows the effect of an increase in

taxes. The increase in taxes decreases aggregate demand so that the aggregate demand curve shifts from AD0 to AD1. In the figure the price level falls from 120 to 115 and real GDP decreases from $13 trillion so that it becomes equal to potential GDP, $12 trillion.

5. A budget deficit can be divided into a cyclical budget deficit and a structural budget deficit. The structural deficit is the deficit that would exist if the economy were at potential GDP. The cyclical deficit is the deficit that results because the economy is not a full employment. Basically the cyclical deficit is the result of the business cycle.

6. An increase in taxes on labour income decreases potential GDP. An increase in these taxes decreases the supply of labour. As a result, the full-employment equilibrium quantity of labour decreases, which decreases potential GDP.

7. The tax wedge is the difference between the before-tax wage rate and the after-tax wage rate. A tax on labour income increases the before-tax wage rate but decreases the after-tax wage rate, thereby creating the tax wedge. In addition, taxes

on consumption expenditure also increase the tax wedge because these taxes raise the prices of goods and services and thereby further decrease the after-tax real wage.

You’re the Teacher

1. “Yeah, I think the multipliers are cool, too. I didn’t have the foggiest idea about them until we started studying them in class.

“But look, let’s talk about your question. I think the main deal here is that it’s hard for the government to respond in a timely and appropriate fashion. One problem is the time required for the government to enact fiscal policy changes. As the text points out, the federal budget is proposed by the Treasurer in May, but the laws to enact the proposed spending and revenue raising actions are only enacted after the budget has been debated in Parliament. This means there is a delay between the proposed budget and its enactment. I bet that one reason for the delay is the complexity of the budget and the budgeting process. Another reason is politics. You know how we disagree about who to vote for! Well, the political parties might agree that, say, tax cuts are needed, but disagree on precisely which taxes should be cut and by how much.

“Also, it can’t be real easy to know what the correct policy to pursue is. Some observers might think that we are headed for a recession, and others believe that a strong expansion will occur over the next year or so. And who knows what potential GDP really is? I mean, it’s a great concept for us to learn because it helps us get a lot of ideas straight, but in the real world it’s got to be hard to know what potential GDP equals. So again I can see political parties squabbling — one thinking that we are below potential GDP and need expansionary policies to lower unemployment and the other thinking we are above potential GDP and need contractionary policies to limit inflation. “So, I guess there are probably some reasons why the government doesn’t use its fiscal policy to eliminate business cycles even though it would be great if the government could do so.”

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C h a p t e r Q u i z

11. A balanced budget occurs when the government’s a. outlays exceed its tax revenues. b. outlays equal its tax revenues. c. outlays are less than its tax revenues. d. total debt equals zero.

12. As a fraction of GDP, the Australian public debt a. has risen each year for the past 50 years. b. has fallen each year for the past 50 years. c. has fallen over the past decade. d. has increased rapidly over the past decade..

13. Which of the following is a problem with using fiscal policy to stabilise the economy? a. Implementing fiscal policy can be slow, so that

the requirements of the economy have changed by the time the policy has an impact.

b. The Parliament can act too quickly and so the policy might be inappropriate.

c. Government expenditures have only an indirect effect on aggregate demand.

d. The Reserve Bank must determine whether the policy is correct.

14. An increase in government expenditure shifts the a. LAS curve rightward. b. SAS curve leftward. c. AD curve rightward. d. AD curve leftward.

15. If taxes on labour income are cut, then a. the AD curve shifts leftward. b. the tax wedge shrinks in size. c. potential GDP decreases. d. employment decreases because people no

longer need to work as long to pay their taxes.

16. The presence of income taxes ____ the magnitude of the government expenditure multiplier and ____ the magnitude of the autonomous tax multiplier. a. increases; increases b. increases; does not change c. decreases; does not change d. decreases; decreases

17. Income taxes and induced transfer payments a. act like economic shock absorbers and stabilise

fluctuations in income. b. prevent the economy from moving toward

equilibrium. c. increase the impact of changes in investment

and net exports. d. increase the economy’s growth rate.

18. If the government increases its expenditure by $10 billion and increases its taxes by $10 billion, the AD curve a. shifts rightward. b. does not shift. c. shifts leftward. d. might shift depending on whether the tax hike

increases or decreases aggregate demand.

19. By definition, a discretionary fiscal policy a. requires action by the government. b. is triggered by the state of the economy. c. must involve changes in government

expenditure. d. must involve changes in taxes.

10. If a tax cut has large effects on the supply of capital and labour, then it a. increases potential GDP. b. does not change potential GDP. c. decreases potential GDP. d. might change potential GDP, but the direction

of the change is uncertain.

The answers for this Chapter Quiz are on pages 256-257.

Mctaggart Econ 6e Esg Ch27

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