ATW 108 Macroeconomics

Chapter 8:
Fiscal Policy, Deficit, & Debt
DR. TANG CHOR FOON
Centre for Policy Research & International
Studies Universiti Sains Malaysia,
Room: 116, Tel: 04 653 2044
E-mail: tcfoon@usm.my / tcfoon@gmail.com
Announcement

Class & Tutorial on 12 April 2016 are

Cancelled
OUTLINES
Fiscal Policy & AD-AS Model

Built-In / Automatic Stabiliser

Evaluating Fiscal Policy

Problems, Criticisms, & Complications

Public Debt

False Concern & Substantive Issues

Applications
 FISCAL POLICY
What is Fiscal Policy?
Changes in federal government makes decision in taxes and
purchases of goods and services, and transfer payments that are
intended to achieve macroeconomic policy objective.

What Fiscal Policy Is and What It Isnt?

Generally, federal, state & local governments all have
responsibility for taxing and spending. But, economists defines
fiscal policy only to the actions of the federal government.
Although state & local governments sometime change their
taxing & spending, these are not fiscal policy as they are not
intended to affect the national economy.
Not all decisions about taxes and spending of federal
government are referring to fiscal policy because some of them
are not heading toward achieving macroeconomic policy goal.
 FISCAL POLICY
Decision to cut the taxes of people who buy hybrid cars is a
fiscal policy? Yes / No?, Why?

What about increase in spending of the United States federal

government to fund the war on terrorism and the wars in Iraq
and Afghanistan? Is this a fiscal policy?
 FISCAL POLICY
Decision to cut the taxes of people who buy hybrid cars is a
fiscal policy? Yes / No?, Why?
NO, cut taxes of people who buy hybrid cars is an environmental
policy action, not a fiscal policy action.

What about increase in spending of the United States federal

government to fund the war on terrorism and the wars in Iraq
and Afghanistan? Is this a fiscal policy?
NO, it is part of defence and homeland security policy, not fiscal
policy.
DISCRETIONARY FISCAL POLICY VERSUS
AUTOMATIC STABILISERS
It is essential to distinguish between discretionary fiscal
policy and automatic stabilisers (or Built-In Stabilisers).
Discretionary fiscal policy is action taken by the
federal government to change spending and taxes.
Automatic stabiliser refers to some types of
government spending and taxes, which
automatically increase and decrease along with the
business cycle. The word automatic refers to the fact
that changes in this types of spending and taxes
happen without actions by the government.
 DISCRETIONARY FISCAL POLICY VERSUS
AUTOMATIC STABILISERS
Tax and transfer payment are examples of automatic
stabiliser.

Tax: When the economy is expanding and incomes are

rising, the amount of taxes revenue will also increase as
people pay additional taxes on their higher incomes.
Similarly, when recession, tax revenue will fall.

Transfer Payments: When the economy is expanding and

unemployment rate is reducing, government spending on
transfer payment (e.g. unemployment benefit) will reduce.
Likewise, during recession, transfer payment is higher due
to high rate of unemployment.
 FISCAL POLICY, REAL GDP & PRICE LEVEL
Expansionary Fiscal Policy
The economy begins in recession
at point A, with real GDP of $14.2
trillion and a price level of 98.

An expansionary fiscal policy will

cause aggregate demand to
shift to the right, from AD1 to AD2,
increasing real GDP from $14.2
trillion to $14.4 trillion and the
price level from 98 to 100 (point
B).

Expansionary fiscal policy involves increasing government purchases or

decreasing taxes.
Cutting the individual income tax will increase household disposable
income, the income households have available to spend after they
have paid their taxes, and consumption spending.
 FISCAL POLICY, REAL GDP & PRICE LEVEL
Contractionary Fiscal Policy
The economy begins at point A,
with real GDP at $14.6 trillion and
the price level at 102. Because
real GDP is greater than potential
GDP, the economy will experience
rising wages and prices.
A contractionary fiscal policy will
cause aggregate demand to shift
to the left, from AD1 to AD2,
decreasing real GDP from $14.6
trillion to $14.4 trillion and the price
level from 102 to 100 (point B).

Contractionary fiscal policy involves decreasing government purchases

or increasing taxes.
Policymakers use contractionary fiscal policy to reduce the increase in
AD that seem likely to lead to inflation.
 EXERCISE
Given that the MPS = 0.20 and the
govt. wish to use expansionary
fiscal policy to reach the full-
employment GDP.

How much of changes of the

lump-sum tax is required to reach
the level?

What above if via govt. spending?

If govt. only spend 25% of total

amount and the balance will
cover by tax reduction stimulus
package. What is the lump-sum
tax amount to be changed?
Suggested Answers 1

GDP 14.4 14.2

1 1 0.2
C
T MPS 0.2 5
0.04
0.05
MPC MPC 0.8 0.80 0.8

OR

GDP MPS 14.4 14.2 0.2 0.04

T 0.05
MPC 0.8 0.8
Suggested Answers 2
GDP 14.4 14.2 0.2
G 0.04
1 1 5

MPS 0.2

OR

G GDP MPS 14.4 14.2 0.2 0.04

Suggested Answers 3
G 0.01 which is 25% of 0.04
1 1
GDPG G 0.01 0.05
MPS 0.2

GDPP GDPG 0.2 0.05 0.15

T 0.0375
MPC 0.8 4
MPS 0.2
OR

T
GDPP GDPG MPS 0.2 0.05 0.2 0.03
0.0375
MPC 0.8 0.8
Suggested Answers 3

G 0.01 which is 25% of 0.04

1 1
GDPG G 0.01 0.05
MPS 0.2

GDPP GDPG 0.2 0.05 0.15

T 0.0375
MPC 0.8 4
MPS 0.2
 AUTOMATIC STABILISERS
This is also known as Built-In Stabiliser.

Income tax and transfer payments are two commons

instrument of automatic stabiliser?

Why income tax considered as a built-in stabiliser?

Because tax revenues change with the level of output.
As the economy expands, more taxes are collected,
slowdown the expansion to reduce the inflationary problem
As the economy contract or recess, tax receipts
automatically fall, then cushioning the contraction.

Progressive tax, Proportional tax & Regressive tax

 Proportional tax a tax which is imposed at the same rate for all
income levels. The average tax rate remains constant regardless
of whether income increase or decreases. Flat tax.
Income 500 1000 1500 2000 2500
Total Tax revenue 25 50 75 100 125
Tax rate 5% 5% 5% 5% 5%

Progressive tax a tax which is goes on increasing with income.

Income 500 1000 1500 2000 2500
Total Tax revenue 25 80 150 240 375
Tax rate 5% 8% 10% 12% 15%

Regressive tax a tax which is FALL with an increase in income.

Is also known as lump-sum tax.
Income 500 1000 1500 2000 2500
Total Tax revenue 50 80 90 80 50
Tax rate 10% 8% 6% 4% 2%
 Proportional tax E.g. Corporate income tax is same for all level
of income, 35%.

Progressive tax E.g. Income Tax, Property Tax, etc..

Regressive tax E.g. sales tax, import tax, GST. As these tax are
fixed in tax rate, when it links to income, then it tend to low when
income increase. 500/1000, 500/2000, 500/4000???
 AUTOMATIC STABILISERS
Tax revenues (T) is function of
GDP, while government
spending is assumed to be
exogenous or independent of
GDP

As GDP falls (recession),

deficits occur automatically
to alleviate recession

As GDP rises (expansion),

surpluses occur also occur
automatically to off-set the
possibility of high inflation
rate.
 AUTOMATIC STABILISERS

Automatic stabiliser will help to reduce the swing or fluctuation

of GDP (business cycle). In other words, it help to stabilise the
economy and heading toward potential GDP (line trend).
EVALUATING FISCAL POLICY
We have studied what is the so-called expansionary,
contractionary and neutral fiscal policy.
T < G = Budget Deficit = Expansionary fiscal policy
T > G = Budget Surplus = Contractionary fiscal policy
T = G = Balanced budget = Neutral fiscal policy
Budget deficit = Cyclical Adjusted Deficit +
Effect of automatic stabilisers

Thus, the budget deficits or surpluses cannot tell us

whether the government current discretionary fiscal
policy is fundamentally expansionary, contractionary
or neutral.
 Cyclical Adjusted Budget
Full employment (GDP1), both T
and G = $500 billion as indicate
by the intersection point a. At
this point, the cyclical adjusted
deficit = 0.
Let say recession occur, so GDP
fall from GDP1 to GDP2 & no
discretionary action from govt.,
so the line of T & G remain
constant. But, tax revenues
automatically drop to $450
(point c) at GDP2.
Clearly, there is $50 billion
budget deficit. Is this implies that
govt. is engaging in an
expansionary fiscal policy?
 Cyclical Adjusted Budget
Full employment (GDP3), both T
and G = $500 billion as indicate by
the intersection point d. Then,
cyclical adjusted deficit = 0.
Let say GDP fall from GDP3 to
GDP4, & govt. reduce tax rates, so
T1 shift downward to T2 & G
remain constant.
What is the size of cyclical
adjusted deficit now? At year 4,
G = $500 & T = $475 if the econ.
achieved its full-emp. GDP. Thus,
cyclically adjusted deficit = (e h)
= (500 475) = $25 at year 4.
Expansionary fiscal policy is used.
Cyclical Adjusted Budget Deficit
So, one cannot simply conclude the direction of fiscal
policy by just looking at the current budget figure.
 PROBLEMS, CRITICISMS & COMPLICATIONS
Although fiscal policy can affect national economy,
there are also number of disadvantage of using it.
Problem of Timing
Recognition Lag take time to ensure actual problem
Administrative Lag take time to approve a policy
Operational Lag take time to take effect because building
highways and other construction take time.

Political Consideration
Misuse of fiscal policy as a tool to win a seat / competition.
During election period, expansionary policy tend to be
implemented regardless of economic condition.
This is also known as political business cycle and it tend to
destabilise the economy.
 PROBLEMS, CRITICISMS & COMPLICATIONS
Future Policy Reversals
If taxpayers believe that the tax reduction is transitory, they may
save a large portion of their tax cut because later the rates will
back to the previous level.
If taxpayers believe that the tax increase in temporary, they will
decrease current savings to pay the tax and maintaining the
consumption because they can restore savings when tax rate fall
back again.
Therefore, if taxpayers expected that change in tax in
temporary, the fiscal policy can be less effective.

Off-setting State and Local Finance

If federal govt. implement different policy it will off-set the
implication of fiscal policy.
Top-Down different policy. Local govt. spending during
prosperity, but spending when recession. What problem do you
see?
 PROBLEMS, CRITICISMS & COMPLICATIONS
Crowding-Out Effect
Crowding-out effect may occur with gov.t budget deficit spending.
When the govt. runs a budget deficit, it must sell bonds (i.e. it must
borrow) to finance that deficit. To get people buy and hold the
bonds, govt. must make them lucrative (i.e. high interest rate), thus
push up the level of interest rate, then reduce private investment
which reduce AD, thus cancel the stimulus package of fiscal policy.
Increased govt. spending crowds out private spending. Demand
for loanable fund increase due to budget deficit (borrowing), shift
the Md upward => increase interest rate.
G => AD =>Y , (T<G) => Md => r => I => AD => Y

Current Thinking of Fiscal Policy

Preferences of economists
Fiscal policy is more suitable during recession when the economy fail
to re-act itself because it cant fine-tune to the achieve the actual
goal.
PUBLIC DEBT
If the collected tax revenue is less than govt.
spending, this is call budget deficit. The deficit can
be financed by two source, i.e. Internal or external.
Malaysian Federal Government Debts (%), 1970-2014
90

80

70

60
% of Debt / GDP

50

40

30

20

10

0
1970 1975 1980 1985 1990 1995 2000 2005 2010 2011 2012 2013 2014

Domestic External Total

International Comparison of Public Debt
Is Malaysia a high public
debt country?

In 2005:
Total Debt = 42.1%
Internal = 36.5%
External = 5.6%

In 2014:
Total Debt = 53.1%
Internal = 51.6%
External = 1.5%
 FALSE CONCERN
Can Malaysia Go Bankrupt? Malaysian Federal Govt. Debts

Yes, If the increasing trend of public

1200000

debt continue 1000000

But, debt must be judge based on 800000

RM Million
the ability to repay the principal & 600000
interest of the debt.
400000
Look at the debt/GDP ratio, it is
declining since late 80s. In 1985, the
200000

public debt is 82.5% of GDP, while drop 0

to 35.2% in 2000 and fluctuate around

1970 1975 1980 1985 1990 1995 2000 2005 2010 2011 2012 2013 2014

50% from 2010-2014. Domestic Debt External Debt Total

The govt. can pay manage the debt by refinancing by issuing new gov.t
securities such as treasury bill. Alternatively, imposing tax to gain extra revenue.
However, impose / increase tax rate may demotivate and weaken incentive to
work and invest. Thus, taxation is less likely to be used.
FALSE CONCERN
Can Malaysia Go Bankrupt?

Malaysian Federal Government Debts (%), 1970-2014

90

80

70

60
% of Debt / GDP

50

40

30

20

10

0
1970 1975 1980 1985 1990 1995 2000 2005 2010 2011 2012 2013 2014

Domestic External Total

 FALSE CONCERN
Are We Passing the Debt Burden to Our Children?

Not really, based upon the Malaysian data we see from the graph,
the bulk of the public debt is domestic debt which is the portion of
debt own to local people (citizen). Domestic debt is only about
transferring money between Malaysian. In other words, it is re-
distribution of income from upper-income individuals to others.
Therefore, the overall purchasing power in Malaysia remain
unchanged.

However, only 1-2% of the public debt, i.e. external debt may have
negative impact on Malaysian purchasing power.

Although public debt may burdening future generation, in the

context of Malaysian economy, the burden is very small.
 SUSTANTIVE ISSUES
Inequality of Income Distribution
Bonds are usually hold by wealthier groups and only them
will receive interest payment. But, the burden of tax
increase for repayment imposed by the govt. will be the
same for all. Thus, public debt cause the transfer of wealth
to wealthier groups which probably increases income
inequality.
The poor group didnt enjoy the interest payment but force
to share the tax burden imposed by the govt. for re-
payment the debt, this increases income inequality.

Incentives
Since interest must be paid out of govt. revenues, a large
debt and high interest can increase the tax burden and
may decrease incentives to work, save and invest for
taxpayers.
 SUSTANTIVE ISSUES
Foreign-Owned Public Debt
A higher proportion of the debt is owed to foreigners
(about 2%) than in the past, and this can increase the
burden since payments leave the country. But Malaysian
also own foreign bonds and this off-sets the concern.
Crowding-Out Effect
Some economists believe that public borrowing crowds out
private investment, but the extent of this effect is not clear.
See the next slide for the graph.
There are some positive aspects of borrowing even with
crowding-out. If borrowing is for public investment that
causes the economy to grow more in the future, the
burden on future generations will be less than if the
government had not borrowed for this purpose. Public
investment makes private investment more attractive. For
example, new federal buildings generate private business;
good highways help private shipping, etc.
 Crowding-Out Effect
If the investment demand curve
(ID1) is fixed, the increase in the
interest rate from 6% to 10% caused
by financing a large public debt
will move the economy from a to
b, crowding out $10 billion of
private investment, and
decreasing the size of the capital
stock inherited by future
generations.

However, if the public goods

enabled by the debt improve the
investment prospects of businesses,
the private investment demand
curve will shift rightward, as from ID1
to ID2. That shift may off-set the
crowding-out effect wholly or in
part. In this case, it moves the
economy from a to c.
Thank You