9. fiscal policy

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9. Fiscal Policy

Definition: Fiscal policy

The word fiscal comes from the Latin word fiscus, which means treasury or

purse. Fiscal policy is budgetary policy. It involves the use of taxation andgovernment expenditure contained in a government budget, to achieve

policy objectives. Changes to government expenditure !"and taxation T"affect the level of economic activity.

Objectives of Fiscal Policy

The overall aim of fiscal policy is non inflationary economic growth withfull employment and external balance.

#conomic growth is measured by the percentage change in !$%. TheFederal !overnment needs to &eep !$% growing at around '( to achieveother economic objectives li&e full employment. Changes to fiscal policyand changes to the level of government expenditure and taxation alter thee)uilibrium level of income and the level of economic growth.

*igher growth rates often cause inflation. Inflation occurs when the generallevel of prices increase. If economic growth is unsustainable and demand isexcessive an inflationary gap will develop. Fiscal policy can be used toreduce the level of aggregate demand and prevent inflation.

Lower rates of economic growth are often associated with unemployment.+here the level of aggregate demand is deficient a deflation gap will occur.This is often associated with a recessionary period and higher levels ofunemployment. Fiscal policy can be used to increase the level of aggregatedemand to reduce unemployment.

#xternal balance means that the economy has a sustainable position inregard to trade and borrowing with the overseas sector. Fiscal policy affectsgovernment borrowing and foreign debt. dverse changes in these factorscan act as a constraint on fiscal policy.

The Federal Budget

budget is a plan of taxation T" and expenditure !" for the year ahead. Inustralia there are three levels of government each of which have a budgetor plan of income and expenditure. +e have a Federal government, -tate


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government and local government. The tables below give a brief overviewof the budget of the Federal !overnment. The Federal !overnment is thenational government and being the largest government it sets economic

policy.

FEDERAL GOVERNMENT

REVENUE EXPENDITURE

TAXATION Defense

Income Tax Education

Provisional Tax Health

Company Tax Social Security

Goods & Services Tax Culture & Recreation

Excise DutyHousin & CommunityServices

Customs Duty Economic Services

Capital Gains Tax !ssistance to the States

"rine #enefits Tax Pu$lic De$t Interest

%ithholdin Tax

NON TAX REVENUE

Immiration "ees

Sales Goods & Services

Interest Received

Dividends G#E's

"ees & Chares

The Federal /udget is presented each year in 0ay. The budget documentsets out the current economic conditions as well as the government1s policy

response to theseconditions and identifies all expenditure and taxationchanges. 0ore details on the latest budget figures can be found in the 0id2ear #conomic 3 Fiscal 4utloo& statement at www.budget.gov.au

Budget Outcomes

There are three possible budget outcomes./udget -urplus5 Taxation 6 !overnment #xpenditure/alanced /udget5 Taxation 7 !overnment #xpenditure/udget $eficit5 Taxation 8 !overnment #xpenditure

Budget mpact

It is not the budget outcome that is important but the changes to ! and T thata budget creates. budget will either have an expansionary orcontractionary impact on the economy. +e &now from our study of9eynesian income and expenditure analysis that the economy will expand ifgovernment expenditure is increased or if taxation is reduced. Conversely

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the economy will contract if taxation is increased or government expenditureis reduced.

Therefore it is the change to budget outcomes that is important rather thanthe budget outcome itself. !oing from a large budget surplus to a small

budget surplus is expansionary. To achieve this government would have toreduce taxation or increase expenditure. #)ually to go from a small deficit toa larger deficit would be expansionary. This is called expansionary fiscal

policy.

!oing from a large budget deficit to a small budget deficit is contractionary.To achieve this, the government would have to reduce governmentexpenditure or increase taxation. #ither measure is contractionary. #)ually togo from a small budget surplus to a large surplus would be contractionary.

These changes are called contractionary fiscal policy.

!hanges in Budget Outcomes". #on$discretionary changes in fiscal policy

The budget outcome can be the result of changes in automatic stabilisers.utomatic stabilisers are variables that affect the budget outcome andchange automatically with the level of economic activity. They are alsocalled cyclical componentsof the budget outcome because they varyaccording to the business cycle. In fact they often play an important counter

cyclical roleby ma&ing the extreme periods in the business cycle less severe.

%utomatic &tabilisers

There are two main automatic stabilisers5

;nemployment /enefits5 +hen the economy moves into recession the levelof economic activity falls causing a rise in unemployment. n increase inunemployment boosts government expenditure on unemployment benefits.This tends to increase government expenditure in a recession which isexpansionary and will lessen the effects of the recession. ;nemployment

benefits tend to fall in a boom, which tends to decrease governmentexpenditure. This is contractionary and lessens the problems experienced ina boom period li&e inflation.

%rogressive Taxation5 progressive tax is one in which higher incomeearners pay a greater proportion of their income in tax. s the level ofeconomic activity increases wor&ers tend to wor& overtime and receive a


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bonus which means that they earn higher incomes. In addition, theunemployed usually find wor& and start to pay tax. *igher incomes result in

proportionally higher tax payments. Income taxes increase pushing thebudget towards smaller deficits or larger surpluses. This is contractionaryand reduces the severity of the boom period. s economic activity declinesthe government receives less taxation from income. decrease in taxation isexpansionary and lessens the severity of the recession.

'. Discretionary changes in fiscal policy

$iscretionary changes are deliberate changes to a budget as a result ofgovernment policy. deliberate increase in expenditure or a reduction intaxation to stimulate demand is an example of a discretionary change. -uchchanges are also called structural componentsof the budget outcome. Thesestructural components are used by economists to determine the intent of

government fiscal policy.

$iscretionary changes are re)uired to offset trends in the business cycle.=on>discretionary changes are insufficient to achieve significant changes inthe business cycle. They influence the business cycle and limit the severityof the extremes but they are insufficient to alter the trend in economicactivity. !overnments use discretionary fiscal policyto change the directionof economic activityand to alter the business cycle where possible, to avoidunfavourable economic conditions.

+hen trying to determine the stance of fiscal policyit is important toconsider the structural components or deliberate taxation and expenditurechanges of the budget. Fiscal stancerefers to whether policy is expansionaryor contractionary in impact.

The main macroeconomic goal of fiscal policy is to provide stabilisation.This means to control variations in the business cycle. Fiscal policy can also

be used to achieve certain microeconomic objectives.

(icroeconomic mpact of Fiscal Policy%llocation of )esources

Fiscal policy can change prices and demand and this will affect the

pattern of resource usein the economy.

!overnment can promote the production of some goods by offering

subsidiesto producers.

!overnment can limit social costsie. taxing polluters.

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!overnments providepublic goodsand collective goods.

0erit goodsare often provided at low prices to promote their usage.

Distribution of ncome

!overnments provide for welfare spending and social securityas well asother types of social expenditure in their budgets.

=umerous organisations and charitiesdepend of government for their

funding. Charities provided incomes and assistance to desperateindividuals in the community.

0any government programsthat provide training or assistance to the

needy are funded in government budgets.

Changes to taxation can affect disposable incomes.

Taxes can have regressive, progressive or proportional effects on the

distribution of income.

#xam ?uestions0ultiple Choice ?uestions. #xpansionary fiscal policy occurs when5a" Taxation increases by more than government spending.

b" n increase in taxation is offset by a corresponding increase ingovernment spending.c" !overnment spending increases by more than taxation.d" /oth b" and c" above.

:. Contractionary fiscal policy occurs when government moves from5a" large budget deficit to a small budget surplus.

b" small budget surplus to a large budget surplus.c" large budget deficit to a small budget deficit.d" ll of the above.


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'. #ducation is a good example of a5a" Collective good.

b" %ublic good.c" 0erit good.d" ll of the above.

B. %ollution that is not taxed or compensated is a good example of a5a" -ocial cost.

b" =egative externality.c" 0ar&et failure.d" ll of the above.

. +hich of the following will act as an automatic stabiliDer in a recession@a" %rogressive tax rates.

b" %ensions.c" %ayments made to the unemployed.d" /usiness subsidies.

E. change to Federal tax rates is an example of5a" structural change to the Federal budget.

b" cyclical change to the Federal budget.c" -tabilisation policy.d" utomatic stabilisers.

-hort nswer. $efine the following terms5 budget, budget surplus, budget deficit,cyclical components, structural components, automatic stabilisers, fiscalstance, and stabilisation.


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:. +hat are automatic stabilisers and how do they wor&@

Principles of Ta*ationDefinitions

Tax /ase5The economic variable on which the taxation is based.

Income or consumption are popular bases for taxation. /roadening thetax base means to increase the activities that are subject to taxation.

$irect Tax5 tax that is levied directly on a taxpayer and is unable tobe passed on to another party.

Indirect Tax5 ny tax the burden of which may be passed on in whole

or in part by the person who actually ma&e the payment to thegovernment.

d>valorem $uty5 tax that is levied according to the value of the

base.

-pecific $uty5 tax that is charged according to the )uantity of

product sold or imported.

Gero Tax Threshold5 That level of income at which a person first startspaying tax.

Tax voidance5 The legal minimiDation of tax liability. eg Income

splitting using trust accounts.

Tax #vasion5 The illegal minimiDation of tax liability. eg Failing to

declare some income.

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mpact of Ta*ation Progressive Ta*5 tax where a greater proportionof income is paid

in tax as the level of income rises. The following table and graph is anexample of a progressive tax.

Progressive Ta*

Monthly Income Tax Payable Tax as % o Income

( ( )

*+++ + +

,+++ ,-+ *,.-

/+++ *-++ 01.-

2+++ /+++ 22.1

Proportional Ta*5 tax where all income earnerspay the same

proportion of income in tax. The following table and graph is anexample of a proportional tax.

Proportional Ta*


( ( )

*+++ *++ *+

,+++ ,++ *+

/+++ /++ *+

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2+++ 2++ *+

)egressive Ta*5 tax where lower income earners pay a higher

proportion of their income in tax. The following table and graph is anexample of a regressive tax.

)egressive Ta*


( ( )

*+++ /++ /+,+++ /++ ,+

/+++ /++ *+

2+++ /++ 2.1


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Fringe Benefits Ta*: fringe benefit includes any benefit that an

employee gains from employment. #mployee benefits may includecompany cars, overseas travel, entertainment allowances, clothes etc.This tax re)uires employers to treat these benefits as income for

employees. &tamp Duty: tax paid on the transfer of property or the lodging of

legal documents. -tamp duty is paid on the transfer of property, carsand the registering of documents li&e mortgages.

0and Ta*: tax on the land value of investment properties.

Payroll Ta*: tax on business payrolls.

!ouncil )ates: tax on property owners that is used to pay for the

services provided by local councils which include, garbage, sewerage,water supply, street cleaning etc.

!alculating ncome Ta*

To calculate income tax it is important to remember the followingdefinitions5

Gero Tax Threshold5 Income tax has a Dero tax threshold which is the

level of income needed before a person starts to pay income tax.

0arginal Aate of Tax5 The tax paid on the last dollar of income. This

varies with the tax rates for each income brac&et.

verage Aate of Tax5 Tax paid divided by income earned.

%n /*ample of !alculating ncome Ta*

;se the following table to calculate the income tax, marginal rate of tax andaverage rate of tax for an income earner on KJJ,JJJ.

Income!"ac#et Rate

TaxPa$

+ 2+++ + +

2++* ,++++ *-) ,*++

,+++* /++++ ,-) -+++

/+++* 3++++ /+) *2+++3+++* a$ove -+) *++++

%ns1er5 The taxpayer pays no tax on the first KJJJ dollars of income. Thisis called the Dero tax threshold and all taxpayers benefit from this. For everydollar of income earned between KJJJ and K:JJJJ B( is paid in tax. 4urtaxpayer earns K'JJJ in this brac&et and pays K:JJ in tax. For every


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dollar of income earned between K:JJJJ and K'JJJJ :B( is paid in tax. 4urtaxpayer earns K:JJJJ in this brac&et and pays KBJJJ in tax. For everydollar of income earned between 'JJJJ and HJJJJ 'J( is paid in tax. 4urtaxpayer earns K'JJJJ in this brac&et and pays KJJJ in tax. For everydollar of income earned above KHJJJJ BJ( is paid in tax. 4ur taxpayerearns K:JJJJ in this brac&et and pays KJJJJ in tax.

4ur taxpayer pays a total tax bill of K


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social costs are also important. /ut not all tax changes improve theallocation of resources. Taxation efficiency is needed to achieve anoptimal allocation of resources.

&implicity5 This covers several criteria that appeared in the firsteconomics boo& called the +ealth of =ations which was written bydam -mith in the EJJ1s. In the boo& -mith referred to the cannonsof taxation. These cannons included5

#conomy5 The cost of collecting the tax is less than the revenue

that it raises.

Convenience5 The cost of record &eeping and compliance is not

an unreasonable burden on the community and does not createdisproportionate costs compared to the revenue raised.

Certainty5 tax should be simple and easy to apply and the tax

liability should be able to be calculated exactly.ll taxes should be exact, simple to understand and worth collecting.

Performance of %ustralian Ta*es on the !riteria

ncome Ta*: Income tax is progressive so it achieves vertical e)uity.

Tax avoidance creates some problems with horiDontal e)uity. The selfemployed have greater access to measures to reduce tax and %2#taxpayers pay a greater proportion of this tax. Income tax law has

become very complex and is constantly trying to &eep pace with thetax avoidance industry. This means that the tax fails on convenience.

+oods , &ervices Ta* -+&T:The !-T is an indirect tax and is

therefore regressive. This means that is fails on e)uity. The !-T has aconstant rate for all industries and is therefore efficient. The !-T hasa significant increase in record &eeping and would fail onconvenience. It does raise significant amounts of money and therefore

passes on economy.

!apital +ains Ta*:This tax was introduced to increase the e)uity of

the tax system. %rior to its introduction in HB households earningincome from capital gains paid no tax whilst wage earners paidincome tax. This was seen as a failure of horiDontal e)uity.

Fringe Benefits Ta*:This was another measure to improve e)uity in

the tax system. /efore this was introduced many executive were beingpaid with generous fringe benefits and paying no tax on them.


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0and Ta*:This is a &ind of wealth tax and affects rich property

owners. It is seen as progressive and introduces some vertical e)uity.

/*cise Duty:This is a user pays tax that deliberately reallocates

resources. It scores well on efficiency. #xcise duty li&e all indirect

taxes is regressive and scores badly on e)uity. Payroll Ta*:This is a tax on employment and reduces the willingness

of firms to employ wor&ers. It fails on efficiency because it distortsthe factor mar&ets.

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#xam ?uestions0ultiple Choice ?uestions. +hat would be the impact on personal incomes of an increase in the taxrate for the !oods 3 -ervices Tax@a" %rogressive.

b" %roportional.c" Aegressive.d" Flat.

:. +hat would be the impact on personal incomes of a broadening of the taxbase for Capital !ains Tax@a" %rogressive.

b" %roportional.c" Aegressive.

d" Flat.


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-hort nswer. $efine the following terms5 tax base, tax threshold, tax avoidance, taxevasion, proportional tax, progressive tax, regressive tax, marginal rate oftax, and average rate of tax.

:. +ith the use of diagrams explain the difference between a progressive anda proportional tax.


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(ethods of Financing a Budget Deficit

+hen the government budgets for a deficit it is planning to spend more thanit receives in revenue over the current financial year. This means thatrevenue is not sufficient to cover expenditure and the government needsadditional funds to meet its expenditure. There are various ways in which thegovernment can source these funds.

Borro1ing from the domestic private sector

!overnment -ecurities5 Treasury bonds are sold using a tender system.

treasury bond is a long>term debt security issued by a government. tender system means that the amount borrowed is determined first andthen mar&et participants are as&ed to ma&e offers for the securities arevarious interest rates. The A/ selects the lowest bids interest rates"first and so on until the tender is filled.

Tender -iDe5 The siDe of the budget deficit determines the siDe of thetender.

Crowding 4ut5 The disadvantage of this approach is that it can lead to

crowding out during periods of strong demand for funds by the privatesector. !overnment borrowing will increase interest rates and result inless investment proceeding. If it is done in a recession when investmentis low then it will create Ocrowding inP and help stimulate the economy"

=ational $ebt5 nother disadvantage is that past deficits add to the

=ational $ebt debt owed by the public sector". This burdens future

governments with higher interest payments on outstanding debt. This iso& in a recession as long as the budget surpluses in the boom years areused to reduce the =ational $ebt".

Borro1ing from Overseas

4verseas -ales5 ustralian government securities can be sold overseas in

international debt mar&ets. The A/ sells government securities in returnfor foreign currencies. The A/ holds the foreign currencies in itsreserves and credits the ;$ e)uivalent to the !overnment1s accounts.

=o Crowding 4ut5 International borrowing avoids the domestic crowdingout effect and there is no increase in domestic interest rates.

Lower /orrowing Costs5 International interest rates may be lower than

domestic rates and this could reduce the cost of borrowing to theustralian government.

#xchange Aate Ais&5 International debt is usually written in the debtor

currency and therefore carries an exchange rate ris&. Changes in the value

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of the exchange rate of the lender country can cause significant changesin the value of the debt.

Foreign $ebt5 Foreign borrowing adds to foreign debt and increases

interest payments, which tends to worsen the net incomes balance on the

current account. Foreign debt includes all sums of money that ustralianconsumers, firms and governments owe to similar parties overseas.

International Crowding 4ut5 Foreign borrowing will increase capital

inflow and this will cause the exchange rate to rise. *igher exchangerates will ma&e exports more expensive and imports cheaper. Lessexports will be sold and more imports will be purchased. This is calledinternational crowding out.

Borro1ing from the )eserve Ban3

0onetising the $eficit5 +hen the !overnment borrows from the A/ to

finance a deficit this is called monetising the deficit. This effectivelymeans that the A/ prints money to pay for the deficit.

Inflation5 This increases the money supply and decreases the relative

scarcity of money which inevitably results in inflation.

$ebt and Aates5 This creates no change to interest rates or =ational $ebt

because it eliminates the need to issue government securities.

%sset &ales

!overnments can sell assets to finance their expenditure. Large asset

sales are a )uic& way to pay for large expenditure items. sset -ales5 sset sales include privitisation of government business

enterprises and the sale of government property.

4ne>4ff Impact5 sset sales create a one>off impact on the budget and

may result in the loss of government revenue in future years.

4sing Budget &urpluses

If revenue is greater than expenditure then the government then theygovernment will create a surplus of money. If this continues for several years

the government will accumulate a significant holding of money. Thegovernment can use a budget surplus in three ways5

Deposit the money 1ith the )eserve Ban3

Lower Circulation5 deposit with the A/ would re)uire money to be

ta&en out of circulation.

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0oney -upply 3 Aates5 This would reduce the money supply and

increase interest rates.

)etire public sector debt

Cancel $ebt5 The government has the ability to purchase bac& and cancelgovernment securities, which are always sold with repurchaseagreements.

=ational 3 Foreign $ebt5 This reduces government or =ational $ebt as

well as foreign debt.

Interest /urden5 Aeducing debt will reduce the interest rate burden on the

government and improve the C$.

0oney -upply5 Aetiring domestic debt will not change the money supply

because the increase in deposits will offset by the taxation and spending

changes used by the government to achieve the surplus.

%ccumulate the &urplus

Future -pending5 *old the surplus funds and increase spending in future

years. ie tax cuts before an election.

%ublic 4wnership5 Increase public ownership of infrastructure and public

assets.

)ecent Fiscal Policy in %ustralia

It is important for students to be aware of the current fiscal policy position ofthe ustralian government as exam )uestions on economic policy mayre)uire this information. This information is constantly changing as new

budgets are released each year. The study guide will provide recentinformation. For the latest figures see the following web site5www.budget.gov.au

nternet )esearch

For your own information research the following )uestions5. +hat was the planned budget outcome for the recent Federal budget@

:. *ow does this compare with recent years@


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#xam ?uestions0ultiple Choice ?uestions. +hich of the following is not a method of financing a budget deficit@a" -elling government securities.

b" 4verseas borrowing.c" sset sales.d" %rinting money.

:. 4ne of the advantages of overseas borrowing is5a" Lower interest rates.

b" =o crowding out.c" Lower foreign debt.d" -table exchange rates.

-hort nswer. $efine the following terms5 tender system, crowding out, crowding in,

national debt, and foreign debt.

:. *ow can government finance a budget deficit@

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9. fiscal policy

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