Metodología de Enseñanza – Aprendizaje

In economics and political science, fiscal policy is the use of government expenditure and revenue collection (taxation) to influence the economy (Sullivan and Steven, 2003). Fiscal policy is carried out by governments to influence the level of aggregate demand in the economy, with an effort to achieve economic objectives - price stability, full employment, and economic growth

79

(Keynes, 1936; Rittenberg and Tregarthen, 2011). According to Weil (2008) fiscal policy is the use of governments’ spending and taxation to influence the economy. When the government decides on the goods and services it purchases, the transfer payments it distributes, or the taxes it collects, it is engaging in fiscal policy. The term “fiscal policy” is usually used to describe the effect on the aggregate economy of the overall levels of spending and taxation, and more particularly, the gap between them (see Weil, 2008).

Fiscal policy is based on the theories of Keynes (1936), also known as Keynesian economics. According to Keynesian economics increasing government spending and decreasing tax rates are the best ways to stimulate aggregate demand (Fisher, 1988). This can be used in times of recession or low economic activity as an essential tool for rebuilding the framework for strong economic growth and working towards full employment (Rittenberg and Tregarthen, 2011). For example, before the Great Depression of the US, the government's approach to the economy was laissez-faire, fundamentals macroeconomic thought of Classical Economics (Snowdon and Vane, 2005). But the economic situation following the Second World War, determined that the government had to take a proactive role to regulate unemployment, growth, inflation and the cost of money (Snowdon and Vane, 2005). Indeed, government and monetary authority can control the economic phenomenon by using a mixture of both monetary and fiscal policies. However, this is also depending on the political manifesto and the philosophies of the political party that is in power (Fatas and Mihov, 2004).

Governments use fiscal policy primarily to control local and national economy (Tobin, 2001). According to Keynesian Economics fiscal policy promotes higher growth, employment and stabilization into the economy by changing the aggregate demand (Tobin, 2001; Weil, 2008). From the macroeconomic perspective fiscal policy instruments mainly fall into two categories: government expenditures or expenditure policy and taxation or revenue generation policy (Peston, 1982; Vane and Thompson, 1985; and Fisher, 1988). For example, an increase in government expenditure will increase aggregate demand and reduce the level of unemployment. Conversely a reduction in government expenditure will reduce the level of aggregate demand and hence employment. Yet, in fact it is not very easy to manipulate government expenditure in such a way to fine-tune the economy. Many government programmes take a long time to complete. Thus, variations in government expenditure are undertaken in the context of a much longer time horizon than that envisaged for short-run stabilization policies.

Unlike government expenditure, tax revenue can be varied quickly and has therefore been the main instrument of fiscal short-run stabilization policies. Taxes are two of types: direct taxes and

80

indirect taxes. Direct taxes are taxes paid to the appropriate revenue department by the economic unit assessed, for example – income tax paid by individuals. On the other hand, indirect taxes are mainly expenditure taxes and in this case the tax is paid by the manufacturers or providers of the service who in turn attempts to pass the tax on to their customers by making the necessary adjustments to the prices charged by him, for example – value added tax (VAT). Similar to monetary policy, fiscal policy can be contractionary and expansionary. In theory expansionary fiscal policy is defined as an increase in government expenditures and/or a decrease in taxes that causes the government's budget deficit to increase or its budget surplus to decrease (Gravelle and Hungerford, 2011; Ahtiala and Kanto, 2000). On the other hand, contractionary fiscal policy is defined as a decrease in government expenditures and/or an increase in taxes that causes the government's budget deficit to decrease or its budget surplus to increase.

The general effect of expansionary fiscal policy is to increase aggregate demand (Gravelle and Hungerford, 2011). However, the changes in taxation and spending have different multiplier effects on the level of economic activity (Vane and Thompson, 1985). Barro and Redlick, (2011) assert that an increase in government expenditure will have a greater impact on the economy than a rise in tax payments of the same amount. This is because, higher government expenditure should increase disposable income of citizen which further increases aggregate demand (Vane and Thompson, 1985). This is called balanced budget multiplier or simply, multiplier (Vane and Thompson, 1985; Gravelle and Hungerford, 2011). In addition, Vane and Thomson (1985) note that tax rates can be varied quickly and therefore have been an important instrument for government to stabilize the economy in short-run.

Weil (2008) stresses that in an open economy fiscal policy can affect the interest rate, exchange rate and the trade balance. For example, during a deficit, government can meet some of its expenses by issuing bonds into the market (Vane and Thompson, 1985; Fisher, 1988;). In doing so, government basically compete with private borrowers, thus, holding other things constant, fiscal expansion will increase the interest rate and crowd out some private investment, reducing the fraction of output composed of private investment (Vane and Thompson, 1985; Fisher, 1988; Gravelle and Hungerford, 2011). On the other hand, higher interest rate during expansionary fiscal period can positively attract foreign investment (Darrat and Suliman 1991; Weil, 2008) and increase the demand of local currency. Furthermore, strong local currency makes foreign products cheap and affects the trade balance negatively as import increases and export decreases (Vane and Thompson, 1985; Weil, 2008;).

81

To the extent fiscal policy impacts the economy through changing aggregate demand, it also has a direct effect on stock markets (Tobin, 1969; Blanchard, 1981). Broadly speaking, both government spending and taxation influence the movement of this asset market (Blanchard, 1981; Shah 1984). Shah (1984) states that the long-run effects of fiscal policy ought not to neglect the interrelationship between investment, stock market, and fiscal policy.

In case of expansionary fiscal policy, governments increase spending and reduce taxation (Gravelle and Hungerford, 2011). This higher spending immediately can affect the firm performance in five different ways (Vane and Thompson, 1985) and thus the stock market. An increase in government expenditure financed by net open market sales of government bonds will put upward pressure on interest rates (see Geske and Roll, 1983 as well). The rise in interest rates will in turn cause a reduction in the level of private investment as firms will cancel investment projects they had planned to finance by borrowing before interest rates increased. Moreover, increased sales of government bonds will lead to a significant reduction in the quantity of finance available to private firms.

Vane and Thompson (1985) claim that even if the higher government expenditure is financed by taxes rather than borrowing, still it could affect the firm and the stock market. They refer to balance budget multiplier effects and explain that as income rises the transactions demand for money will increase and with a fixed money supply cause interest rates to rise. This in turn will cause some reduction in the level of private investment. Indeed, government tax policy such as corporate tax, personal tax, capital gain tax, investment tax credit etc. can directly or indirectly affect the stock market growth. Personal tax rate can also be a determinant of stock market return (Poterba, 1987; Dammon et al., 1989). Under the expansionary fiscal policy governments generally reduce tax rates, for example, the personal tax rate. A low personal tax rate increases the disposable income of individuals and thus people have more savings to invest in capital markets. Furthermore, this lower rate also increases investors’ returns from cash and stock dividends. Tax law related to how the dividends and capital gains are taxed also affect the capital markets (see, Golob, 1995).

Investment tax credit is another mechanism that affects firm performance by increasing investment. As Feldstein (2009) states, experience confirms that some form of investment tax credit could stimulate business investment, especially if it is not recaptured later. He further adds, a larger R&D tax credit could help to offset the currently predicted decline in private R&D spending. Firms can also earn higher return by enjoying tax incentive on depreciation and interest. Government can also indirectly intervene into the capital market by offering different

82

stimulus packages to change the business cycle and subsequent effects will be on stock market. For example, during the financial catastrophe of 2008 the US government had declared a total of $152 billion stimulus package (US Budget Report, 2008).