ECON1102 Lecture Notes - Lecture 5: Government Budget Balance, Tax Rate, Fiscal Multiplier
18 May 2018
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5 – Government Sector and Fiscal Policy
Instruments of fiscal policy
• Government expenditure – current goods & services, investment and infrastructure
• Taxes; direct and indirect – income taxes, consumption taxes (GST)
• Transfer payments – unemployment benefits, pensions
Fiscal policy in income-expenditure model – affecting level of output:
• PAE = C + IP + G → government expenditure directly affects PAE
• C = C0 + c (Y – T) → taxes indirectly affect output via consumption
Tax function
• What determines the level of tax revenue? Role for GDP
• T = T0 + tY
Autonomous component, T0
Induced component that depends on Y
t = marginal tax rate (assume 0 < t < 1)
• ∆T / ∆Y = t
Gives the change in tax receipts for a change in national income
Consumption function and tax function
• C = C0 – cT0 + cY (1 – t)
Equilibrium in three-sector model
• PAE = [C0 – cT0 + I0 + G0] + cY (1 –t)
• Ye = 1 / [1 – c (1 – t)] * [C0 – cT0 + I0 + G0]
Fiscal multipliers in three-sector model
• ∆Ye = 1 / [1 – c (1 – t] * [∆C0 – ∆T0 + ∆I0 + ∆G0]
• Change in G: ∆Ye / ∆G0 = 1 / [1 – c (1 – t)] > 0
• Change in T: ∆Ye / ∆T0 = –c / [1 – c (1 – t)] < 0
What has the larger effect on GDP?
• Government spending multiplier larger than tax/transfer multiplier
Government purchases of goods and services are a component of PAE
Direct effect on PAE and consequently on Y
• Taxes and transfer payments affect the level of disposable income (Y – T) received by
private sector
Exogenous changes only have an indirect effect on PAE
Weighted by marginal propensity to consume (c)
Budget balance multiplier
• Government budget balance: BB = T – G
Equates to: ∆Ye = (1 – c) / [1 – c (1 – t] * ∆G0
(a) Set ∆C0 = ∆I0 = 0
(b) Set ∆T0 = ∆G0
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2
• In three-sector model, BBM is positive, but less than 1
Can increase Y, such that initial level of budget balance is unchanged
Fiscal policy and output gaps
• Income-expenditure model implies that exogenous changes in G and T can be used
to close output gaps, i.e. to ensure Y = Y*
Role of fiscal policy in stabilizing the economy
• Automatic stabilisers
Tendency for a system of taxes and transfers which are related to the level of
income to automatically reduce the size of GDP fluctuations
T = T0 + tY
As GDP declines, level of taxes paid falls and level of transfer payments (e.g.
unemployment benefits) increases
BB = (T – G), so a fall in T, other things equal, implies BB declines
• Discretionary fiscal policy
Deliberate changes in the level of government spending, transfer payments or in
tax rates (e.g. one-off cash payments)
Seen as flexible and less timely than monetary policy:
(a) Recognition lag – recognize need for some form of policy action
(b) Decision lag – decide on an appropriate policy action
(c) Implementation lag – generally requires legislation (needs to be approved by
parliament)
(d) Effect lag – time required to have significant effect on economy
Ideally, macroeconomic policy should be forward-looking, with fiscal policy
changes designed to influence future (forecast) levels of output
GFC
• Falls in GDP were preceded by a financial/ credit crisis (provided warning for
governments)
• Many countries have had relatively large and persistent falls in GDP (not Australia)
• Concerns about ability of monetary policy to provide sufficient stimulus to
economies
Policy interest rates at zero lower bound in some countries
• Provided greater scope for governments to use fiscal policy in a timely manner
Budget deficits and public debt
• Budget balance (BB) = T – G
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Document Summary
Instruments of fiscal policy: government expenditure current goods & services, investment and infrastructure, taxes; direct and indirect income taxes, consumption taxes (gst, transfer payments unemployment benefits, pensions. Fiscal policy in income-expenditure model affecting level of output: pae = c + ip + g government expenditure directly affects pae, c = c0 + c (y t) taxes indirectly affect output via consumption. Role for gdp: t = t0 + ty. T = marginal tax rate (assume 0 < t < 1: t / y = t. Gives the change in tax receipts for a change in national income. Consumption function and tax function: c = c0 ct0 + cy (1 t) Equilibrium in three-sector model: pae = [c0 ct0 + i0 + g0] + cy (1 t, ye = 1 / [1 c (1 t)] * [c0 ct0 + i0 + g0] What has the larger effect on gdp: government spending multiplier larger than tax/transfer multiplier.
