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EC140 6.docx

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Justin Smith

EC140 March 19 2013 FISCAL POLICY  The government takes our money through taxes  Why do they do this?  Income Redistribution  Spending  Why does the government spend?  What effect does this spending have?  In this section we study the topic of government spending/taxing/transferring, also known as Fiscal Policy Government Budgets  Just like any individual, the government budgets its money  Federal budget: the annual statement of the federal government’s outlays (spending) and tax revenues.  The federal budget has two purposes:  To finance the activities of the federal government  Mostly income redistribution  To achieve macroeconomic objectives  Stabilization of the economy  Fiscal policy is the use of the federal budget to achieve macroeconomic objectives  Maintain full employment, economic growth, price level stability Budget Making • The federal government and Parliament make fiscal policy. • Minister of Finance (Jim Flaherty) presents a budget plan to Parliament. • Parliament debates the plan and enacts the laws necessary to implement it. • Budgets are usually, and unfortunately, very politically driven • So may not always be in the interests of the economy • Prior to the Conservative majority, Liberal governments had been threatening to bring down minority government over the previous 2 budgets • Revenues come from • Personal income taxes (largest component) • Corporate income taxes • Indirect taxes (GST/HST) • Investment income • Outlays are • transfer payments (largest component) • Achieves income redistribution • expenditure on goods and services • debt interest 1 EC140 March 19 2013 Budget Balance  Outlays = spending  Budget balance = revenue – outlays  Budget surplus: revenues > outlays  Budget deficit: outlays > revenues  Balanced budget: revenues = outlays  The budget surplus in 2007 was $15 billion  The budget deficit in 2011 was $26.2 billion  Due to reduced tax revenues, and increases in spending  In 2012, a $22 billion deficit is predicted  In 2015, a small surplus is predicted The Budget in Historical Perspective  Budget balance usually presented as % of GDP  Why % of GDP?  Shows spending relative all income earned in Canada  Adds perspective to the numbers  Deficit increased and peaked at 6.6% of GDP in 1985.  Outlays grew and revenues fell  During the 1990s, spending cuts eliminated the deficit.  In 1997, a budget surplus emerged.  Since 2008, large deficits have returned.  The budget balance is usually presented as a fraction of GDP (better perspective) 2 th EC140 March 19 2013 Annual Budget Balance 20 10 0 19611961965196196919719719751971979198198198519819891991991995199199920020032002002009 -10 -20 Billions of Dollars -30 -40 -50 Year Annual Budget Balance as Fraction of GDP 2 1 0 196119619651961969197197319719719791981983198198719819911991995199199920020020052002009 -1 -2 -3 -4 P-5ent of Nominal GDP -6 -7 -8 Year  Minor deviations in production levels from year to year (more fluctuations) 3 th EC140 March 19 2013 Government Revenues 10 9 8 7 6 Personal Taxes 5 Corporate Taxes 4 Indirect Taxes Percent of Nominal GDP Investment Income 2 1 0 19611964196719701973197619791982198519881991199419972000200320062009 Year Federal Outlays as Fraction of GDP 14 12 10 8 Expenditures 6 Transfer Payments % of Nominal GDP Debt Interest 4 2 0 19611964196719701973197619791982198519881991199419972000200320062009 Year 4 th EC140 March 19 2013 Deficit and Debt • Government Debt: the accumulation of government borrowing. • It is the sum of past deficits minus past surpluses. • Figure shows the federal government’s debt as a percentage of GDP. Gross and Net Federal Government Debt to GDP 90 80 70 60 50 40 Gross Debt % of Nominal GDP Net Debt 30 20 10 0 19611964196719701973197619791982198519881991199419972000200320062009 Year 5 EC140 March 19 2013 Fiscal Policy  The government collects most of its money through our taxes  It then spends that money on various things  What are the consequences of these activities?  Supply Side Effects  Operates through the labour market  Taking part of peoples’ income through taxes reduces income  Introduces a “wedge” between income earned and received  Can have strong effects on incentives to work  Macroeconomic Effects  Taxing and spending by the government has consequences on the business cycle  Can affect GDP through the multiplier process The Supply-Side Effects of Fiscal Policy  Supply-side effects: The Effect of fiscal policy on employment, potential GDP, and aggregate supply  An income tax changes full employment quantity of labour, and therefore potential GDP.  Introduces a “tax wedge”  Basically, reduces the amount of take-home pay of each individual  This may reduce the amount people work  Reduces incentives to work Full Employment and Potential GDP  Figure illustrates the effects of an income tax in the labour market.  The supply of labour decreases because the tax decreases the after-tax wage rate.  The before-tax real wage rate rises but the after-tax real wage rate falls.  Tax wedge: The gap created between the before-tax and after-tax wage rates.  The quantity of labour employed decreases. 6 EC140 March 19 2013  When the quantity of labour employed decreases:  Potential GDP decreases  The supply-side effect of a rise in the income tax decreases potential GDP and decreases aggregate supply.  Less and less additional output as you hire more workers (because they are less productive)  Income taxes shift the supply curve left Taxes on Expenditure and the Tax Wedge • Taxes on consumption (GST/HST) add to the tax wedge. • A tax on consumption raises the prices paid for consumption goods and services • It has effects similar to a cut in the real wage rate. • Decreases the goods you can buy with each dollar • If the income tax rate is 25 percent and the tax rate on consumption expenditure is 10 percent, a dollar earned buys only 65 cents worth of goods and services. • The tax wedge is 35 percent. Taxes and the Incentive to Save • A tax on interest income lowers the quantity of saving and investment and slows the growth rate of real GDP. • It reduces the real after-tax interest rate Real interest rate =
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