Fiscal Policy and Economics of
Taxation
Chapter 17
Fiscal Policy 3 main options of fiscal policy
Changes in govt spending & tax government should adopt to stimulate
collections designed 2 achieve full- eco:
employment & non-inflationary 1. Increase govt spending.
domestic output; also called 2. Reduce taxes.
discretionary (active – by govt) fiscal 3. Combination of 2.
policy. If budget = balanced @ outset,
Fiscal Policy and the AD- expansionary fiscal policy = create
govt budget deficit (amount by which
AS Model expenditures of govt exceed revenues
Expansionary fiscal policy: in any year)
increase in govt purchases of g/s, Read p194 details.
decrease in net taxes, / some Contractionary fiscal policy:
combination of 2 for purpose of Decrease in govt purchases 4 g/s,
increasing AD & expanding real output. increase in net taxes, / some
(w/e recession occurs). combination of 2, 4 purpose of
decreasing AD & controlling inflation.
(w/e demand pull inflation occurs)
, When economy faces demand pull • Operational lag. Occurs between
inflation fiscal policy should move time fiscal action = taken & time
towards govt budget surplus (amount action affects outputs, employment
by which revenues of govt exceed / price level. Although changes in
expenditures in any year.) tax rates can be put in2 effect
Policy options: G / T relatively quickly, govt spending on
Which = preferable eliminating public works require long planning
recession/inflation - govt spending periods & even longer periods of
/taxes ? construction. Such spending = of
Answer depends largely on view as to questionable use in offsetting
where the government is too large or short periods of recession.
too small. Discretionary fiscal policy has
• Economists who believe many unmet increasingly relied on tax changes
social & infrastructural needs rather than on changes in spending.
usually recommend govt spending Political Considerations:
be increased during recessions. In • @ extreme elected officials &
demand pull inflation usually political parties might collectively
recommend tax increases. Both ‘hijack’ fiscal policy 4 political
actions neither expand/preserve purposes & cause inappropriate
size of the govt. changes in AD & eco fluctuations.
• Economists who think govt = 2 May stimulate eco using
large & inefficient usually advocate expansionary fiscal policy b4
tax cuts during recessions & cuts in elections & contractionary fiscal
govt spending during demand pull policy 2 dampen excessive AD
inflation. Both actions either after elections.
restrict growth of govt / reduce • Political business cycle: alleged
size. tendency of parliament 2
Problems, Criticisms, & Complications destabilize economy by reducing
Problems of Timing: taxes 7 increasing govt
• Recognition lag. Time between expenditures b4 elections & raise
beginning of recession or inflation taxes & lower expenditures after
& certain awareness that elections.
happening. Arises bcz of difficulty Future policy reversals:
predicting future course of eco • May fail 2 achieve intended
activity. Forecasting tools (index objective if households expect
of leading indicators) provide clues future reversal of policy.
2 direction of eco, may be 4-6 • Example: if taxpayers believe tax
months in2 recession/inflation b4 reduction = temporary, may save
fact appears in relevant statistics large portion of their tax savings,
& acknowledged. reasoning = rates will return 2
• Administrative lag. Wheels of previous level in future.
democratic govt turn slowly. • Called consumption smoothing &
Typically be significant lag between fiscal policy lose some of its
time when need 4 fiscal action = strength.
recognized & time action taken.
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