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ECON 1010 (256)
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Chapter 29

ECON 1010 - Textbook Notes - Chapter 29.docx

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ECON 1010
Jean Adams

Chapter 29: Fiscal Policy ECON 1010 Textbook Notes • The federal budget is an annual statement of the outlays and revenues of the government of Canada together with the laws and regulation that approve and support those outlays and revenues. • The federal budget pursues the government’s fiscal policy: the use of the federal budget to achieve macroeconomic objectives such as full employment, sustained long-term economic growth and price level stability. • Budget Making o Federal government and Parliament make fiscal policy o Discussions between Minister of finance and department of finance start the process o After all consultations, the projections made by the dept of finance, the minster develops and set of proposals which are eventually compiled as a budget to be debated in parliament • Highlights of 2011 Budget o Revenues  Federal government’s receipts  Come from our sources: • Personal Income Taxes o Largest source o Paid by individuals on their income • Corporate Income Taxes o Smallest source of revenues o Paid by companies on their profit • Indirect and other taxes o Second biggest source o Include taxes like gas tax, HST • Investment income o Income earned from government enterprises and investments o Outlays  Payments made by the government.  Categorized in three categories: • Transfer payments o Largest outlay, by a huge margin o Payment to individuals, business, other governments, rest of world o Includes social welfare, subsidies, aid to developing countries • Expenditures on goods and services o Expenditures on final goods and services such as phones for parliament, government cars • Debt interest o Interest on government debt o Depends on year, sometimes exceeds other categories o Budget balance  Revenues – Outlays  If revenues > outlays, budget surplus  If revenues < outlays, budget deficit • The Budget in Historical Perspective o The government has historically rarely been in surplus o Revenues are usually between 15 and 20% of GDP, while expenses are between 15 and 25% of GDP • Revenues: o Main sources of fluctuations are in personal income taxes o Changes in policy impact the amount of revenue coming in from income taxes • Outlays: o Main source of change is in transfer payments to provincial governments o Especially high in times of crisis e.g.Alberta drought • Deficit and Debt: o Government borrows to finance it deficit; total amount of borrowing is government debt o Apersistent deficit leads to an increase in debt interest because of an increasing amount of debt incurred, the opposite also applies o Also applies to times of war where debt can increase 100% of GDP • Debt and Capital: o When individuals incur debts, they do so to buy capital or major assets o The government is similar in this regard o Some debt is incurred to continue investment; infrastructure, healthcare, public education yield a social rate of return far exceeding the interest rate paid by the government o Government debt > value of public capital stock, therefore some government debt was used to finance public expenditure but not all • Supply-side Effects of Fiscal Policy: o Economists on this side of theory believe effects of taxes to be large o (Pre-Tax) Full Employment and Potential GDP:  At full employment, real wage rate adjusts to make quantity of labour demand equal to quantity of labour supplied; without taxes  The labour equilibrium amount occurs at potential GDP, therefore real GDP equals potential GDP o Effects of Income Tax  Tax on labour incoeme influences potential GDP and aggregate supply by changing the full employment quantit of labour  Income tax weakens incentive to work and drives a wedge between the take-home wage of workers and the cost of labour to firms  Result: smaller equilibrium quantity of labour due to labour supply shifting left and lower potential GDP  Tax wedge: Difference between before-tax and after-tax wage rates  Full employment quantity of labour has decreased therefore, potential GDP has decreased (therefore, aggregate supply also decreases)  Lower tax rate = lower effect on the thing  Reverse is also applicable (tax cut increases supply of labour) o Taxes on Expenditure and the Tax Wedge  Tax wedge is only part of the wedge that affects labour-supply decisions  Taxes on consumption raises prices paid for consumption goods and services and is equivalent to a cut in the real wage  Affects labour because people don’t care about money price of wage, but what they can buy with it o Taxes and the Incentive to Save and Invest  Tax on interest income weaken the 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 a tax on labour income, but more serious because: • Lowers quantity of saving and investment; slowing growth rate of real GDP (versus affecting potential GDP) • True tax rate on interest income is higher because of the way that inflation and taxes on income interact o Effect of Tax Rate on Real Interest Rate:  Real interest rate influences investment and saving plans  Real after-tax interest rate subtracts the income tax rate paid on interest-income from real interest rate  However, taxes depend on nominal interest rate  Therefore, the higher the inflation the higher the true tax on interest income  E.x. if inflation is 6%, nominal interest is 10%, and tax is 4%, then real interest rate = 4%, which means all of that income is taxed o Effect of Income Tax on Saving and Investment:  No effect on DLF  Weakens incentive to save and lend, therefore moving SLF to the left  Savers look at after-tax interest rate when they decide how much to save  When a tax is imposed, tax payable is measured by the difference between the original position of the SLF curve, and its position after the tax is imposed o Tax Revenues and the Laffer Curve  Ahigher tax rate does not always bring in greater tax revenue  Ahigher tax rate brings in more revenue per dollar earned but because it decreases the number of dollars being earned, it may not raise overall tax revenue  Two forces essentially act in opposite directions on the tax revenue collected  Relationship between the tax rate and the amount of tax revenue collected is called the Laffer curve • Named after innovator • Idea originally was that tax cuts could increase tax revenue • Looks like an upside down hill  Tax rate – x axis; Tax revenue – y axis  T* - optimized point on La
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