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Fiscal Policy

1. Introduction

The term “fiscal policy” refers to those aspects of government that are broadly concerned with the collection and disbursement of money. These are just fancy words for “taxing” and “spending.” It is important to keep in mind that almost every act of government taxation and spending has a redistributive component to it. This is most obvious in the case of transfer programs (e.g., social assistance). But it also holds true to some extent for other expenditures (e.g., hospitals or bridges that service a local community). Because of this, politics usually plays an important role in shaping the nature offiscal policy.

Fiscal policies are in reality multidimensional objects. Moreover, they are typically implemented at all levels of government; i.e., federal, provincial or state; and municipal. In spite of all this heterogeneity, the common principle remains taxation (the acquisition of resources) and spending (the disbursement of resources); and this shall constitute the focus of this chapter.

This is not a chapter designed to explain why people collectively erect insti- tutions that are called “governments.” To address this difficult question would take an entire textbook. Instead, I focus on the more modest question concern- ing the likely economic effects of differentfiscal policies, without explaining why thesefiscal policies are put in place to begin with. In short, I am going to treat government behavior as exogenous. Needless to say, such a treatment is not entirely satisfactory, but it seems like a good place to start.

2. Accounting and Data

Almost all of governmentincome is collected in the form of taxes. Gov- ernmentspendingcan be broadly classified into two components: purchases

of output; andtransfers. It is important to understand the difference between government purchases and transfers. A government purchaseGinvolves an ex- penditure on output (goods and services). A government transfer A involves no expenditure on output; it simply constitutes a transfer of existing output from one set of agents to another. For this reason, only government purchases are counted as a component of the economy’s total expenditure; recall, from Chapter 1, the income-expenditure identity:

Y ≡C+I+G+N X.

of purchases and transfers). If we let T denote total government income (tax revenue), then government sector saving is defined as:45

SG≡T−A−G.

Here,T denotesgrosstax revenue and(T−A)denotesnettax revenue. Private sector saving is defined as:

SP ≡Y +A−T−C.

Hence, the domestic saving identity is given byS≡SP+SG;or

S _≡Y ₋C₋G;

or, equivalently,

S_≡I+N X.

The key point to note here is that while(T₋A)constitutes net income for the government, it constitutes a net expense for the private sector. In the aggregate, these two quantities cancel each other out; which is why taxes and transfers do not appear in the aggregate income-expenditure identity.

Table 6.1 depicts the Canadian government’s (consolidated across federal, provincial, and municipal levels) income statement for the year 2005.

Table 6.1 Consolidated Government Income Statement

Canada 2005 (millions of dollars)

Income

Direct taxes from persons 164,979

Direct taxes from corporations 49,492 Direct taxes from non-residents 5,478 Contributions to social insurance 65,340 Taxes on production and imports 173,081

Other taxes 10,442

Investment Income 48,446

Total Revenue 517,258

Spending

Goods and services 262,650

Transfers to persons 134,766

Transfers to businesses 16,900

Transfers to non-residents 4,700

Interest on Debt 62,765

Total Expenditure 481,791

Surplus (Deficit) 35,467

Source: CANSIM II 3840004.

4 5_{Technically, government income should include investment income net of interest payments}

on outstanding debt. I also assume that to afirst approximation, all ofGconstitutes spending on consumer goods and services.

To place the numbers in Table 6.1 in context, note that Canada’s GDP for 2005 was 1,375,080 million dollars. Hence, we have the following rough breakdown: ¡_T Y ¢ ³ 517,258 1_,375_,080 ´ 0.38 ¡_G Y ¢ ³ 262,650 1,375,080 ´ 0.19 ¡_A Y ¢ ³ 219,141 1_,375_,080 ´ 0.16 ¡_SG Y ¢ ³ 35,467 1,375,080 ´ 0.03

Thus, almost 40% of all income generated in Canada is taxed away. Out of this tax revenue, roughly 50% is used to purchase output (the bulk of these purchases are provided without charge to the public) and with the remainder distributed as transfers (there was also a small surplus). Figure 6.1 shows how these ratios have evolved over time since 1981.

0.0 0.2 0.4 0.6 0.8 1.0 82 84 86 88 90 92 94 96 98 00 02 04 Tax Revenue Purchases Transfers Saving FIGURE 6.1

Government Revenue and Expenditure Canada 1981 - 2005 R at io of G D P

As you can see, there is really nothing very exciting happening in Canada with respect tofiscal policy over the last couple of decades. I suppose that this is a good thing—assuming that you like boring countries. There is some evidence of a modest contraction in the relative size of the public sector (as measured by the sum of purchases and transfers) beginning some time in the mid 1990s. More recently, we have seen a modest decline in the (gross) tax rate and a move from a deficit to surplus position. A part of this might be explained by a general political climate amenable to the idea that cutting taxes and paying down government debt is likely to stimulate economic activity.

Perhaps a better idea of the relationship between economic activity and the size of government can be gleaned by examining a cross section of countries. For this purpose, I make reference to the Penn World Tables, which provides various data for a large set of countries.46 _{In Figure 6.2, I plot for several countries in} 2005 the country’s real GDP (measured relative to U.S. GDP) and government purchases as a ratio of GDP.47 In this figure, I limit attention to the set of countries that have a GDP that is at least 50% that of the U.S.

FIGURE 6.2 0 20 40 60 80 100 120 140 160 0 5 10 15 20 25 30 35

Government Purchases as Ratio of GDP

R e a l GDP R e la tiv e to U .S.

The relationship in Figure 6.2 is not perfect, but the data does suggest a negative relationship between the level of GDP and the size of government (the country at 140% of U.S. GDP is Luxembourg). In the next section, I develop a simple economic model that might be used to interpret this relationship.

4 6_{Alan Heston, Robert Summers and Bettina Aten, Penn World Table Version 6.2, Center}

for International Comparisons of Production, Income and Prices at the University of Penn- sylvania, September 2006.

4 7_{For Canada, the ratio of government purchases to GDP is recorded as 0.13, so I presume}

3. Government Spending and Taxation

The model I have in mind here is an extension of the simple static model developed in Chapter 2. Since there is no saving in this model,SP =SG= 0.

Let us begin by assuming that the government sector ‘demands’ g units of output, where g is exogenous (and takes the form of consumer goods and services). There are two ways of viewing the production of output destined for the government sector. The first way is to suppose that all output y is produced by the private sector and that the government sector purchases the output it desiresgfrom the private sector. The second way is to suppose that the government produces the output it needs by employing workers (public sector workers). If the government has access to the same production technology as the private sector, then either approach will yield identical results.

Since government purchases (or production) of output are typically distrib- uted in some manner across households, we need to address the question of how individuals in the household sector value g. The answer to this question will depend on the nature of the purchases made by the government. In reality, the government allocatesgto a wide variety of uses, ranging from outright waste to the delivery of an assortment of valuable goods and services. In what follows, I am going to assume that household preferences can be represented by a utility function of the following form:

u(c, l) +v(g), (29) wherev is an increasing and concave function.

The question that concerns us here is the following: How does an exoge- nous increase in government spending (anexpansionary fiscal policy) affect output and employment? As it turns out, the answer to this question depends critically on the nature of the tax instrument used tofinance the expansion in government purchases. In what follows, I consider two such instruments. The

first is a lump-sum tax (also referred to as a head-tax). Because lump-sum taxes are rarely used in practice, this case is primarily hypothetical; nevertheless, it serves as a useful benchmark since lump-sum taxes work exclusively through their effect on household wealth (a force that is likely to be present in any type of tax). The second is anincome-tax. Studying this type of tax is interesting because it is realistic and has additional interesting effects on incentives.

3.1 Expansionary Fiscal Policy: Lump-Sum Tax

Imagine that government spending isfinanced with a lump-sumtax τ on households. The key feature of a lump-sum tax is that the amount of tax paid by the household in no way depends on household behavior. What this means is that the household has no incentive to change its behavior in an attempt to escape its tax burden. Since a lump-sum tax does not distort incentives, it is

callednon-distortionary.

The key restriction on government behavior is given by the government budget constraint(GBC). That is, if the government desiresgunits of output, it must levy a net taxτ on the household sector sufficient to cover its desired expenditure. Mathematically, what this implies is:

τ =g. (30)

Now, let’s consider a representative household. The household takes as given the prevailing wage rate w, non-labor incomed, and the level of taxesτ . The household’s budget constraint is given by:

c=w(1−l) +d−τ;

where labor supply is given byn= 1₋l.Hence, the choice problem facing the representative household can be stated formally as:

Choose(c, l)to maximizeu(c, l) +v(g)

subject to: c= (1₋l)w+d₋τ .

The solution to this choice problem is a pair of demand functions: cD_{(w, d, τ)}

and lD_{(w, d, τ). Once the demand for leisure is known, one can compute the}

supply of labornS_{(w, d, τ) = 1−l}D_{(w, d, τ).}

Mathematically, the choice(cD_{, l}D_{)is the solution to:}

M RS(cD_{, l}D_{) = w;}

cD = (1−lD)w+d−τ .

This should look very familiar to you.

Exercise 6.1: Depict the solution(cD_{, l}D_{, n}S_{)on a diagram and show how n}S _is

predicted to respond to an increase inτ .

Having characterized optimal behavior on the part of households, the next step involves examining the behavior of the business sector. As it turns out, there is not much work to do here since the choice problem for a representative

firm remains exactly the same as in Chapter 2. In fact, one can use the reasoning developed there to conclude—in this simple model, at least—that thisfiscal policy will have no effect on the equilibrium real wage or profits (verify this fact as an exercise).48 _{Accordingly, we can conclude that(w}∗_{, d}∗_{) = (z,0).}

4 8_{This will not be the case for the more general model studied in Appendix 2.1. Nevertheless,}

the general conclusions arrived at here (regarding the effects of government spending on output and employment) continue to hold in even the more general model.

Thefinal step is to invoke the government budget constraint, which in this case is simplyτ =g.Now let us combine all of these restrictions to determine the equilibrium allocation(c∗, l∗) :

M RS(c∗, l∗) = z; (31)

c∗+g = z(1₋l∗).

The equilibrium level of employment can then be calculated asn∗_{= 1−l}∗_;with the equilibrium level of GDP given byc∗_+g=y∗_=zn∗_{.Notice that the model} studied in Chapter 2 is just the special case for whichg= 0.

Exercise 6.2: Given preferences such thatM RS(c, l) = c/l,use (31) to solve for

(y∗, n∗)as a function ofg.

Since g is a parameter (an exogenous variable), the equilibrium level of output and employment (y∗_{, n}∗_{) will, in general, depend on g. One way to} investigate this dependence is through the use of algebra, as in Exercise 6.2. This approach requires us to specify an explicit mathematical form for the MRS. But we can also investigate this dependence by way of a diagram (exploiting the fact that both consumption and leisure are normal goods). To see how this can be done, consider the following.

Imagine that initially,g= 0.Then point A in Figure 6.3 depicts the equilib- rium allocation. Notice that, as in Chapter 2, theequilibriumbudget line in this case corresponds to the economy’s production possibilities frontier (PPF).49 Suppose now that the government embarks on an expansionary fiscal policy by increasing spending to some positive level g > 0. Because the government spending program requires a tax on households, the budget constraint moves downward in aparallelmanner (leaving the PPF in its original position).50 _If consumption and leisure are normal goods, then the new equilibrium is given by point B in Figure 6.3.

Thus, according to this theory, an expansionaryfiscal policyfinanced by a lump-sum tax induces an increase in output and employment. However, note that the policy also induces a decline in consumer spending. From the income-expenditure identity, we know thatc∗_+g≡y∗ _{in this model economy} (there is no investment and no foreign sector). While an increase ing results in an increase iny∗_{,it also appears to partiallycrowd outprivate sector spending} (so thatc∗_{falls, but by less than the increase in public sector spending,g).}

The basic force at work here is a pure wealth effect (there is no sub- stitution effect here because the real wage remains unchanged). In particular, because theafter-tax wealth of households declines, they naturally demand

4 9_{Again, note that this will generally not be the case; i.e., see Appendix 2.1.}

5 0_{The PPF remains in its original position because government spending does not affect the}

less consumption and leisure (assuming that these are both normal goods). To put things another way, the tax on households compels them to work harder so that they might mitigate (but not eliminate) the impending decline in dispos- able income. This increase in the supply of labor is what leads to the expansion in GDP. 0 l 1.0 - g A B c* y* l* PPF: y = (1 - l)z Budget Line: c = (1 - l)z - g FIGURE 6.3 Expansionary Fiscal Policy Financed with Lump-Sum Tax

g

Note that while this expansionaryfiscal policy causes GDP and employment to rise, it is not immediately clear how welfare is affected. Recall that welfare here can be measured byu(c∗_{, l}∗_{)+v(g).On the one hand, the decline in personal} consumption and leisure suggests that welfare will decline. On the other hand, to the extent that households value government purchases, welfare will increase. The net effect on welfare will depend on which of these two effects is stronger. In any case, it is once again useful to stress the following:

Do not confuse GDP with economic welfare!

3.2 Expansionary Fiscal Policy: Income Tax

One might be inclined to think that the result described above could have been derived much more easily by simply examining the income-expenditure

identity for this simple economy: y_≡c+g.Does it not follow from this identity that an increase ingmust lead to an increase iny?The answer isno.

To see this, let us now consider a more realistic case where government taxation isdistortionary. An important example of a distortionary tax is an income tax. Consider an economy where the income tax rate is 20%. What this means is that for every dollar that is earned in income, 20 cents must be paid to the government. The more income you make, the more you pay (unlike a lump-sum tax). An income tax effectively reduces theafter-tax return to market activity. In the present model, itdistortsthe relative return between consumption and leisure. These types of distortions alter economic incentives; and people can be expected to act accordingly.

Let us return to the model developed above. We can already guess that

(w∗_{, d}∗_{) = (z,0) as before, so let me impose this here. One important differ-} ence, however, is thatw∗_{=z now represents thegross(pre-tax) wage. If the} government imposes an income tax rate0_≤θ_≤1,then the household’s budget constraint is given by:

c= (1−θ)z(1−l).

Here,(1₋θ)z denotes theafter-tax wage(or return to labor). Note that, as far as the household is concerned, an increase in the tax rateθwill have much the same effect as a decrease in the real wagez.

Exercise 6.3: On a suitable diagram, depict the economy’s PPF and the repre- sentative household’s budget constraint. Verify that the slope of the budget constraint is equal to₋(1₋θ)z.Demonstrate that maximizing utility implies that the indifference curve is tangent to the budget line (not the PPF). From the exercise above, we know that the solution to the household’s choice problem is now characterized by:

M RS(cD, lD) = (1₋θ)z;

cD = (1−θ)z(1−lD).

The revenue collected by the government is now given byτ=θz(1₋lD_).Hence,

the government budget constraint implies that:

θz(1₋lD) =g.

All three of these conditions must hold in equilibrium. Therefore, for a given (exogenous)g,we can think of these three equations as determining the three unknowns(c∗_{, l}∗_{, θ}∗_);i.e.,

M RS(c∗, l∗) = (1−θ∗)z; (32) and

c∗ = (1₋θ∗)z(1₋l∗); (33)

We can combine the last two equations to form:

c∗+g=z(1₋l∗) =y∗.

Hence, we haveθ∗ =g/y∗_{. In terms of a diagram, the equilibrium is depicted} as point B in Figure 6.4. 0 A B y* c* g n* l PPF Budget Line: c = (1- )z(1-l)θ∗ FIGURE 6.4

Expansionary Fiscal Policy Financed with Income Tax

Equilibrium (g=0)

In Figure 6.4, an equilibrium is depicted for the case in which g = 0. The experiment is then to ask what happens when we increase g and finance the spending with an income tax. There are two effects at work here.

1. Wealth Effect: An increase in taxes reduces household wealth (as in the lump-sum tax). The demand for all normal goods falls. That is, private consumer demand falls and the demand for leisure falls (labor supply rises); and

2. Substitution Effect: An increase in the tax rate reduces the return on