Policy, Fiscal
Policy, Fiscal
DIFFICULTIES WITH FISCAL POLICY
Fiscal policy is the use of a government’s spending, taxing, and debt issuance authority for the purpose of influencing economic activity. The origins of fiscal policy are rooted in the worldwide economic depression of the early twentieth century (1929–1939). Prior to that time, there was little in economic theory or practice suggesting the deliberate use of the government’s authority to achieve particular economic ends. Rather, emphasis was placed on the government’s role in creating a favorable environment for private economic activity.
DYNAMIC PRINCIPLES
A tool for understanding fiscal policy is government’s intertemporal budget constraint. This constraint relates the path of government spending to the path of government receipts. It highlights the fact that a government’s budget need not be balanced each time period. However, the present value of current and future government spending must equal the present value of government revenue.
To fix the ideas, let G equal current government spending, Gf equal future government spending, T equal current taxes imposed on the private sector, Tf equal future taxes imposed on the private sector, and r equal the real rate of interest. Further, let D equal the government’s current budget deficit. That is, D = G – T. The government finances the deficit by selling an equal amount of government bonds.
In the future, the government must collect enough taxes to repay the debt (including interest) and to pay for future government purchases. That is, Tf = (1 + r ) D + Gf. Substituting into this latter equation the expression for D and rearranging yields a government’s intertemporal budget constraint:
G + Gf / (1 + r ) = T + Tf / (1 + r )
The left-hand-side of this expression is the present value of government purchases. The right hand side is the present value of government taxes. A fundamental fiscal policy lesson learned from this analysis is that all government spending ultimately must be reconciled with current and/or future government taxes so that the government’s intertemporal budget constraint is satisfied.
Recognition of the government’s budget constraint is crucial for assessing the impact of fiscal policy on long run economic growth. Neoclassical growth theory suggests that fiscal policy’s only impact is on the level of output per capita and the transition dynamics from one per capita output level to another. On the other hand, endogenous growth models suggest that fiscal policy can affect the steady state rate of economic growth. Key to this prediction is the distinction between distortionary and non-distortionary taxation and productive and nonproductive expenditures. Using data from twenty-two Organisation for Economic Co-operation and Development (OECD) member countries, in 1999 Richard Kneller, Michael Bleaney, and Norman Gemmell demonstrated that if appropriate account is taken of the implicit financing of government spending, then the evidence suggests that distortionary taxation (income, profit, property, and payroll taxes) reduces growth and productive government expenditure (education, health, housing, and transportation spending) enhances growth.
STABILIZATION CAPACITIES
Because the government is not constrained to balance its budget period-by-period, it may adopt other objectives for its spending and taxing authority in the short run. One short-run objective that has been adopted is stabilization of the macroeconomy. Discretionary fiscal policy seeks to moderate fluctuations in overall economic activity by adjusting government expenditure or taxes. (Whether there is much scope for effective discretionary fiscal policy is controversial.) Traditional macroeconomic theory suggests that for a closed economy performing below its potential, an increase in government expenditure will stimulate aggregate expenditure. Private business firms respond to the increase in expenditure by raising production and employment. The total rise in production exceeds the increase in government spending because of a chain reaction of private consumption spending induced by the initial government expenditure. This chain reaction of spending is called the multiplier. An alternative, though slightly less potent, way for the government to trigger a chain reaction of spending is to reduce the amount of taxes it collects from the private sector. These policies also work in reverse. Therefore, if the economy is performing above its potential, the government can reduce its expenditures or raise taxes to prevent the economy from overheating.
Empirical evidence from the United States in the post–World War II period suggests that shocks to government spending and taxes effect real gross domestic product (GDP) in a manner that is broadly consistent with the aforementioned description. According to a 2002 study by Olivier Blanchard and Roberto Perotti, increases in government spending raise real GDP contemporaneously and over time. The peak dynamic effect of the increased spending on GDP occurs between one and fifteen quarters in the future. Tax increases, on the other hand, lower real GDP contemporaneously and over time. The peak dynamic effect of tax increases on GDP occurs between five and seven quarters in the future.
In order to detect the impact of discretionary fiscal policy, it is necessary to account for important yet passive changes in spending and taxation by a government. Automatic stabilizers are changes in spending and taxation that occur in response to changes in economic activity. They do not require initiative by a government. Transfer payments such as unemployment insurance and tax payments linked to income are examples of automatic stabilizers. Net tax payments (taxes minus transfers) tend to rise during economic expansions and fall in recessions.
OPEN ECONOMY CONSIDERATIONS
The effectiveness of fiscal policy in economies open to international trade depends on several factors, including whether a country is large or small relative to the size of the world economy, whether capital can flow freely in and out of the country, and whether a country’s exchange rate is fixed or floating.
Consider, for example, the case of a small country with capital mobility and a flexible exchange rate. Such a country takes the world interest rate as given. Further, the domestic interest rate equals the world interest rate plus a risk premium. An increase in government expenditure increases aggregate spending. The rise in spending will cause an incipient rise in the domestic interest rate. Capital from abroad will be attracted to the domestic country causing the country’s exchange rate to appreciate. Net exports will fall in response to the appreciation, thereby choking off the expansion of domestic production. In the end, there will be no expansion of total output. Fiscal policy’s only impact will be to change the composition of the initial level of output. The government sector is larger. The export sector is smaller. The theoretical prediction that fiscal policy is totally ineffective in this case stands in stark contrast to the closed economy case previously discussed.
Canada is a relatively small country whose characteristics closely match those described. The evidence from Canada suggests that the impact of fiscal policy on economic activity at the business cycle frequency is small at best. In 2005 Perotti estimated that the cumulative response of real GDP to positive shocks to government spending is positive but less than one, suggesting that there is no multiplier effect. In fact, in the post-1980 period, the cumulative response of real GDP to positive shocks to government spending is actually estimated to be negative. Tax cuts are estimated to stimulate economic activity in Canada. This finding, however, appears to be particular to Canada as it was not the case in any of the other OECD countries studied by Perotti.
DIFFICULTIES WITH FISCAL POLICY
Several issues make the theory and practice of fiscal policy controversial and difficult. First, there is uncertainty as to how fiscal policy should be measured. A generational accounting approach, such as the one taken by Laurence Kotlikoff, would focus on the lifetime tax burden born by different age cohorts. Second, lags in the recognition of the need for a policy change, the design of a new policy, and the implementation of a new policy may render fiscal policy too ponderous to be timely. Third, private sector expectations may thwart fiscal policy. According to a 2003 article published by Alan Auerbach in Brooking Papers on Economic Activity, tax changes known to be temporary, for example, are likely to have different affects than those that are permanent. Finally, fiscal policy makers may not be able to resist the temptation to renege on tax and spending promises in order to realize short-term gains. According to Edward Prescott’s 2004 work, this time inconsistency problem may cause more damage to the economy in the long run because the private sector may lose confidence in the government.
SEE ALSO Business Cycles, Real; Multiplier, The; Phillips Curve; Policy, Monetary; Shocks; Treasury View, The
BIBLIOGRAPHY
Auerbach, Alan. 2003. Fiscal Policy, Past and Present. Brooking Papers on Economic Activity 34 (1): 75–122.
Blanchard, Olivier and Roberto Perotti. 2002. An Empirical Characterization of the Dynamic Effects of Changes in Government Spending and Taxes on Output. The Quarterly Journal of Economics 117 (4): 1329–1368.
Kneller, Richard, Michael Bleaney, and Norman Gemmell. 1999. Fiscal Policy and Growth: Evidence from OECD Countries. Journal of Public Economics 74 (2): 171–90.
Kotlikoff, Laurence. 1992. Generational Accounting. New York: Free Press.
Perotti, Roberto. 2005. Estimating the Effects of Fiscal Policy in OECD Countries. Center for Economic Policy Research (CEPR) Discussion Papers : 4842.
Prescott, Edward. 2004. The Transformation of Macroeconomic Policy and Research. The Region, 2004 Annual Report. Federal Reserve Bank of Minneapolis. http://minneapolisfed.org/.
Philip N. Jefferson