The University of Sydney Page 1 ECON1002 Introductory Macroeconomics Week 5 Lecture School of Economics Semester 1, 2022 The University of Sydney Page 2 Lecture 5: Fiscal Policy In this lecture, we will study – How taxes and spending affect the economy – Balanced budget multiplier – Fiscal policy and income distribution – Demographic changes and fiscal policy – Limitations of fiscal policy – Australia’s budget and the stance of fiscal policy – Fiscal policy and government debt Reading: Textbook Ch 8. https://www.westpac.com.au/federal-budget/ The University of Sydney Page 3 Using a tax cut to close a contractionary gap Suppose the initial PAE is: PAE = 50 + 0.7Y What is the equilibrium income What is the multiplier Assume that c = 0.8, current tax rate t = 0.1, and m = 0 What is the new multiplier Consider PAE = 50 + 0.7Y. Suppose consumers are pessimistic and cut their spending by 10 unit, PAE = 40 + 0.7Y Setting this planned expenditure equal to GDP implies a new equilibrium at 133.33 and there now exists a contractionary output gap. What’s the size of output gap Can a tax cut be used to eliminate the output gap How much of a tax cut is needed Fiscal Policy for Stabilisation The University of Sydney Page 4 Y PAE Y 450 PAE0 133.33 166.67 A fall in exogeneous spending followed by a tax cut PAE1 PAE2 The University of Sydney Page 5 = + +pPAE C I G Exogenous Changes and Equilibrium Income ( ) (1 )= + + + pPAE C cT I G c t Y Consider a 3-sector economy (i.e., No X and M and hence m = 0). 1 ( ) 1 (1 ) = + + e pY C cT I G c t In terms of changes, 1 ( ) 1 (1 ) = + + e pY C c T I c G t The University of Sydney Page 6 What happens if government cuts lump sum taxes, (i.e., cut in the exogenous component of the tax function, ) and purchases ) by the same amount Suppose there is an equal change in government purchases and net taxes, such that, G = T. Govt budget remains unchanged. Balanced Budget Multipliers T G The University of Sydney Page 7 The change in the equilibrium income is Balanced Budget Multipliers 1 ( ) 1 (1 ) = + eY c c t T G Since G = T, 1 ( ) 1 (1 ) = + eY c c t G G 1 (1 ) 1 (1 ) = eY c c G t 1 1 (1 ) = e GcY c t The University of Sydney Page 8 The balanced budget multiplier is Balanced Budget Multipliers 1 1 (1 ) = eY c c tG 1 ( ) 1 (1 ) = + + e pY C c T I G c t From We can see 1 , 1 (1 ) = ≡ e G Y k cG t , 1 (1 ) = ≡ e T Y c k c tT Govt spending multiplier Tax multiplier Hence, 1 1 (1 ) = ≡ = + e BB G T Y k G c k k c t The University of Sydney Page 9 Quiz: What if G and T are both cut by the same amount, $5m Exercise: Assume c = 0.8 and t = 0.1. If G and T both rise by 5, What’s the change in Y ( )1 0.8(5) (5) 1 0.72 = + eY ( )( )3.57 4 5 3.57 = + =eY Balanced Budget Multipliers The University of Sydney Page 10 Y PAE Y 450 PAEold A simultaneous cut in G and T by $5m (e.g. a baby bonus financed by a cut in G) PAEnew The University of Sydney Page 11 In the Keynesian model, fiscal policy affects the demand side (PAE) of the economy. But, there are other issues……. – Fiscal policy can affect the supply side of the economy too (how ). That is, potential output (y*) can be affected. – Budget deficits need to be financed somehow. It matters how budget deficits are financed. S and I can be affected. A higher government borrowing can ‘crowd out’ private investment! – Not always flexible enough for stabilisation (‘inside lag’: takes time from policy discussion to implementation). May be inadequate as a short-term stabilisation tool. Fiscal policy as a stabilisation tool The University of Sydney Page 12 Fiscal policy is less effective than the above model suggests. In Australia, Fiscal policy has medium term objectives. Government follows balanced budget rule. But, fiscal policy is still an important stabilising force. Why The presence of automatic stabilisers (taxes fall and transfers rise when GDP falls and vice versa) Fiscal policy is better suited when there is a prolonged period of recession (e.g., the Great Depression, the Lost Decade in Japan, GFC in 2007-8) Fiscal policy as a stabilisation tool The University of Sydney Page 13 Fiscal policy has distributional consequences. Taxation system matters: Progressive, regressive or flat GST may improve efficiency but worsens equity. Demographic changes affect fiscal policy. Ageing population and low birth rates affect participation rate and labour force. See Intergenerational Report 2015 (https://treasury.gov.au/publication/2015-intergenerational-report/) . Who should pay for the elderly and retired PAYG (Pay-as-you-go) or Fully funded pension system What is the best retirement income support system Australia has The Future Fund (http://www.futurefund.gov.au/), a sovereign wealth fund. Contemporary Issues in Fiscal policy The University of Sydney Page 14 Managing demographic change The University of Sydney Page 15 Fiscal policy and the public debt Governments have three major ways they can finance their spending: 1. They can raise taxes. What constrains this 2. They can borrow (issue securities or debt, e.g., government bonds). They have to pay interest r on the borrowings. What constrains this 3. They can simply borrow money from the central bank to finance their spending. What is the issue with this The University of Sydney Page 16 Benefits of low public debt Low levels of public debt are desirable to reduce crowding out, which occurs where government borrowing increases interest rates and therefore decreases investment. Borrowing because of deficit budgets can’t be sustained forever, and eventually surpluses would be required to reduce debt. Intergenerational equity refers to the concept that the current generation should not impose an unfair burden on future generations. The University of Sydney Page 17 Benefits of having some (non-zero) public debt Public debt can also have a net benefit for the economy, even when allowing for crowding out and intergenerational equity effects. This is when important infrastructure projects are financed through public debt. Such projects have been estimated to add 0.4% p.a. to productivity for every 1% increase in public spending. Having some positive public debt is useful as it allows bond markets to stay afloat and investment instruments to households. The University of Sydney Page 18 Understanding Australia’s Government Budget Budget timeline: Budget 2021-22 MEYFO 2021-22 Budget 2022-23 May Jan Mar 29 2021 2022 2022 – MYEFO (Mid-Year Economic & Fiscal Outlook) released in January of each year. Provides an update on economic and budget forecasts. – 2020-21 Budget delayed until October due to Covid-19. The University of Sydney Page 19 Understanding Federal Budget: Big Picture Prime Minister and Treasurer, Source: The Australian The University of Sydney Page 20 Fiscal Balance vs GDP Source: 2021-22 Budget and PBO analysis. Underlying cash balance The University of Sydney Page 21 Measures of Government Debt Gross Debt = Face value of Commonwealth Government Securities on issue Net Debt ≈ Gross Debt less (selected) financial asset (all at ‘fair value’). Allow for the fact that government may hold financial assets. Note: Net interest payments are equal to total interest payments less interest receipts. Source: 2019-20, 2020-21 and 2021-22 Budget and PBO analysis. The University of Sydney Page 22 The official (announced) measure of the budget deficit is incorrect. (Why ) Is it a good measure of the stance of fiscal policy The “structural” deficit is often a better measure. Requires 2 basic adjustments: 1. Inflation adjustments (i) Fiscal drag: Nominal GDP rises and hence tax collection, exerting a potentially depressing effect on the economy (ii) Bracket creep: As nominal income is higher due to inflation, they are automatically moved into higher tax brackets (see Lecture 2 on the effects of inflation) MEASUREMENT OF THE BUDGET DEFICIT The University of Sydney Page 23 2. Business cycle (cyclical) adjustment According to Keynesian models, Fiscal policy business cycle Budget deficit Why In recessions tax receipts fall and expenditure on unemployment benefits rises (automatic stabilisers) so the budget deficit increases. It does not necessarily reflect any deliberate change in policy MEASUREMENT OF THE BUDGET DEFICIT The University of Sydney Page 24 Debt and Deficits: Dynamics of Government budget constraint – Let Bt-1 be the stock of securities the government has owing at the end of the previous period. Any new borrowing in the period t means that Bt – Bt 1 > 0. This also means the government has to pay interest on its stock of debt, rBt 1, where r is the real rate of interest. – Therefore, the spending that needs to be undertaken in the period by the government, which needs to be financed by some method, is: Gt + rBt–1 = Tt + (Bt – Bt–1) Gt = Government expenditure during year t, Tt = Tax revenue (net of transfer payments) during t. Bt – Bt 1 = New Borrowing during year t, rt = Real interest rate during year t, The University of Sydney Page 25 Define budget deficit as Bt – Bt–1 = rBt–1 + Gt – Tt When the government runs a deficit budget, the left- hand side is positive (why ) and we will be adding to the stock of public debt, Bt – Bt 1 > 0 When the government runs a surplus budget, the left- hand side is negative, and the stock of debt will fall, Bt – Bt 1 < 0 Dynamics of Government budget constraint The University of Sydney Page 26 Bt – Bt-1 = rBt-1 + (Gt – Tt) Change in debt Interest payments Primary deficit Government budget constraint 1 1 t t t t B B Y Y = 1 1 ( ) t t Br g Y + t t t G T Y Re-arrange it as Bt = (1+r)Bt-1 + (Gt – Tt) Dividing it through by Yt and re-arranging it, we can write it as follows. Change in public debt is now in terms of the ratios of GDP, where g is the growth rate of GDP. The University of Sydney Page 27 Public debt is rising, ceteris paribus, if (1) Primary surplus is falling. (2) The real interest rate is rising N.B. Real interest rate = Nominal interest rate – Inflation (3) Growth rate of output is falling. 1 1 t t t t B B Y Y = 1 1 ( ) t t Br g Y + t t t G T Y Government budget constraint and Public debt Quiz: What would happen to public debt when inflation is rising, ceteris paribus
