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29. Fiscal.docx

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Rizwan Tahir

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Chapter 29 - Fiscal policy
Government budgets
federal budget: annual statement of the federal government’s outlays and tax revenues, with the
laws and regulations that approve and support those outlays and revenues
1. To finance the activities of the federal government
2. To achieve macroeconomic objectives pursue fiscal policy
Fiscal policy: the use of the federal budget to achieve macroeconomic objectives, such as full
employment, sustained economic growth, and price level stability
Federal government outlays and revenues and total government outlays and revenues fluctuate
similarly, but total > federal so total outlays fluctuate more. Provincial outlays/revenues vary a great
deal across provinces.
Budget making
Federal government and Parliament make fiscal policy
After a process of consultations, the Minister of Finance presents a budget plan to Parliament
Parliament debates the plan and enacts the laws necessary to implement it
Revenue sources
Personal income taxes are the largest revenue source
- payroll taxes, CPP contributions, EI premiums
- Mildly progressive in Canada, as those with high income pay larger proportion than those with
low income increasing marginal tax rate as income increases, move to higher tax bracket
- Payroll taxes are regressive: those with high income pay a smaller proportion of income as tax
than those with low income due to caps on insurable/pensionable earnings
- Taxes on wage income; this accounts for the tax wedge
Second largest source is indirect taxes: Goods and Services Tax (GST) and taxes on gasoline, alcohol
Smallest source is corporate income tax, paid by companies on their profits, and investment income,
from government enterprises and investments.
Largest outlay is transfer payments: to people, businesses, other levels of government, etc. It
includes unemployment cheques and welfare payments, etc.
Expenditures on goods and services (G) include national defense, government cars, highways
Debt interest: interest on the government debt is large because of huge debt
- debt-service payments (i x D) where i is the interest rate and D is the stock of government debt
- letting T = tax revenue (of government), the budget constraint = G + iD T = borrowing
government’s budget constraint is government expenditure = tax revenue + borrowing
- this is true when there is little or no inflation
governments can also finance spending through increase in money supply (inflation)
Budget Balance
Budget balance = revenues outlays
Budget surplus: revenues > outlays budget deficit < 0
Budget deficit: outlays > revenues
- Excess of total government expenditure over total (net) revenue in a given year
- Government’s borrowing = change in government’s stock of debt during the year
- budget deficit =  = G + iD T
Balanced budget: revenues = outlays
Expressing budget balance as percentages of GDP shows how large the government is relative to the
size of the economy, and gives a better sense of the magnitudes of these items.
- represent how many cents of each dollar that Canadians earn are given to the government
Deficit and debt
Debt: total amount that the government is borrowing; sum of past deficits past surpluses
budget deficit increases stock of debt; budget surplus decreases stock of debt
vicious cycle: budget deficit increases borrowing, which leads to larger debt, which leads to larger
interest payments, and then a larger deficit
virtuous cycle: persistent budget surplus creates falling interest, larger surpluses, falling debt
Debt and capital
debts are usually caused by buying capital: assets that yield a return
main point of debt is to enable people to buy assets that will earn a return that
some government expenditure is investment purchase of public capital that yields a return so
governments are like individuals/businesses in this case
Primary deficit
deficit on the non-interest part of the government’s budget
primary budget deficit = total budget deficit debt-service payments
primary budget deficit = (G + iD T) iD = G T
Canadian federal government had many years of primary budget surpluses (tax revenue >
program/non-interest expenditures)
Actual GDP depends on GDP flow
We will develop a kind of analytical structure for comparing the actual deficit with a kind of
ideal/structural deficit
When the economy slows, when there is a recessionary gap, there’s less income (income tax) or
spending (GST) to tax, so revenue to governments falls, and there are more claims on social
programs (Employment insurance, social assistance, etc), so government outlays can rise
Recessions bring government deficits
Supply-side effects of fiscal policy
Fiscal policy has effects on employment, potential GDP, and aggregate supply supply-side effects
Actual: a tax on labour income changes full employment and potential GDP
Potential GDP: when real wage is at equilibrium; the labour market clears
- At full employment, the real wage rate adjusts to make the quantity of labour demanded equal
to the quantity of labour supplied
Income Tax Effects on Labour
The gap created between the before tax and
after tax wage rate is called tax wedge
Effects of an income tax on labour income
supply of labour (and quantity of labour
employed) decreases because the tax
decreases the after-tax wage rate
Income tax weakens incentive to work and
drives wedge between take-home wage of
workers and cost of labour to firms
The before tax real wage rate rises, but the
after tax real wage rate falls
No effect on demand for labour as demand
depends on how productive labour is and
what it costs real wage rate
Because the full-employment quantity of labour decreases, potential GDP decreases too
aggregate supply deceases. The higher the tax rate, the larger the effect.
Tax on labour income means leftward movement along production function
Taxes on expenditure and the tax wedge
Taxes on consumption expenditure add to the tax wedge
tax on consumption raises the prices paid for goods and is equivalent to a cut in the real wage rate
Incentive to supply labour depends on the goods/services that an hour of labour can buy. The higher
the taxes on goods and the lower the after-tax wage rate, the les the inventive.
If the income tax rate is 25% and the tax rate on consumption expenditure is 10%, a dollar earned
buys only 65 cents worth of goods and services tax wedge = 35 %
Taxes and the incentive to save
Tax on interest income weakens incentive to save and drives a wedge between the after-tax interest
rate earned by savers and the interest rate paid by firms effects are analogous to those of a tax
on labour income
a tax on capital income lowers saving and investment and slows the growth rate of real GDP
True tax rate on interest income is much higher than that on labour income because of the way in
which inflation and taxes on interest income interact.
Tax effects on real interest rate
The interest rate that influences saving and investment is the real after-tax interest rate
subtracts the income tax paid on interest income from the real interest
Taxes depend on nominal interest rate, so true tax on interest income depends on the inflation rate
- If inflation rate rises with no change in nominal tax rate, true tax rate rises (on interest income),
interest rises, and equilibrium investment falls