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Canada (492,872)
Economics (1,480)
EC140 (397)

chapter 29.doc

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Wilfrid Laurier University
Rizwan Tahir

Chapter 29: Fiscal Policy Wednesday, March 13, 2013 2:37 PM Government Budgets • Federal budget: annual statement of federal government's outlays (spending) and tax revenues • Federal budge has two purposes: • Finance activities of federal government (mostly income redistribution) • Achieve macroeconomic objectives (stabilization of economy) • Fiscal policy: use of federal budget to achieve macroeconomic objectives • Maintain full employment, economic growth, price level stability • Budget making: • Federal government and Parliament make fiscal policy • Minister of Finance presents budget plan to Parliament • Parliament debates plan and enacts laws necessary to implement it • Budgets usually very politically driven  May not always be in interests of economy • Revenues come from: • Personal income taxes (largest component), corporate income taxes, indirect taxes (GST/HST), investment income • Outlays: • Transfer payments largest component)- achieves income redistribution, expenditure on goods/services, debt interest • Budget Balance • Budget balance = revenue - outlays • Budget surplus: revenues > outlays • Budget deficit: outlays > revenues • Balanced budget: revenues = outlays • Budget balance usually presented as percentage of GDP -> shows spending relative all income earned in Canada • Adds perspective to numbers • Government Debt: accumulation of government borrowing • Sum of past deficits minus past surpluses Fiscal Policy • Government collects most of its money through taxes, then spends that money • Supply Side Effects • Operates through labour market • Effect of fiscal policy on employment, potential GDP, aggregate supply • Income tax changes full employment, potential GDP, aggregate supply • Taking part of peoples' income through taxes reduces income • Introduces "wedge" between income earned and received • Can have strong effects on incentives to work  Supply of labour decreases because tax decreases after- tax wage rate  Before-tax real wage rate rises but after-tax real wage rate falls Tax wedge: gap created between before-tax and after-  tax wage rates  Quantity of labour employed decreases • Potential GDP decreases • Supply-side effect of rise in income tax decreases potential GDP, decreases aggregate supply • Taxes on expenditure and tax wedge ♣ Taxes on consumption (GST/HST) add to tax wedge ♣ Tax on consumption raises prices paid for consumption goods and services Has effects similar to cut in real wage rate   Decreases goods you can buy with each dollar  Ex. income tax rate - 25%, tax rate on consumption expenditure- 10%, dollar earned buys only 65 cents worth of goods and services, tax wedge is 35% Taxes and Incentive to Save • ♣ Tax on interest income lowers quantity of saving and investment, slows growth rate of real GDP  Reduces real after-tax interest rate  Real interest rate = nominal rate - inflation rate  Real after-tax rate = nominal rate - inflation rate - (tax rate x nominal rate) • Subtracts income tax paid on interest income from real interest, lowers return you get on savings • Tax Revenues and Laffer Curve • Laffer curve: relationship between tax rate and amount of tax revenue collected • At T*, tax revenue is maximized • Below T*, rise in tax rate increases revenue  People work less, but not enough to reduce total revenues • Above T*, rise in tax rate decreases tax revenue  People work a lot less, decreasing total revenues  Macroeconomic Effects • Taxing and spending by government has consequences on business cycle • Can affect GDP through multiplier process Fiscal Stimulus  Fiscal policy actions that seek to stabilize business cycle work by changing aggregate demand • Discretionary fiscal policy: policy action that is initiated by act of Parliament • Automatic fiscal policy: fiscal policy action triggered by state of economy with no explicit action by government  Occurs automatically given structure of government programs  Some items in government budget change automatically with state of economy  Automatic changes in revenues: • Government legislates tax rates, not dollars • Given tax rate, when income goes up we pay more tax in dollars • Given tax rate, when income goes down we pay less
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