Fiscal policy decisions have a widespread effect on the everyday decisions and behaviour of individual households and businesses – hence in this note we consider some of the microeconomic effects of fiscal policy before considering the links between fiscal policy and aggregate demand and key macroeconomic objectives.

The microeconomic effects of fiscal policy

1. Taxation and work incentives

Can changes in income taxes affect the incentive to work? This remains a controversial subject in the economic literature!

Consider the impact of an increase in the basic rate of income tax or an increase in the rate of national insurance contributions. The rise in direct tax has the effect of reducing the post-tax income of those in work because for each hour of work taken the total net income is now lower. This might encourage the individual to work more hours to maintain his/her target income. Conversely, the effect might be to encourage less work since the higher tax might act as a disincentive to work. Of course many workers have little flexibility in the hours that they work. They will be contracted to work a certain number of hours, and changes in direct tax rates will not alter that.

The government has introduced a lower starting rate of income tax for lower income earners. This is designed to provide an incentive for people to work extra hours and keep more of what they earn.

Changes to the tax and benefit system also seek to reduce the risk of the ‘poverty trap’ – where households on low incomes see little net financial benefit from supplying extra hours of their labour. If tax and benefit reforms can improve incentives and lead to an increase in the labour supply, this will help to reduce the equilibrium rate of unemployment (the NAIRU) and thereby increase the economy’s non-inflationary growth rate.

2. Taxation and the Pattern of Demand

Changes to indirect taxes in particular can have an effect on the pattern of demand for goods and services. For example, the rising value of duty on cigarettes and alcohol is designed to cause a substitution effect among consumers and thereby reduce the demand for what are perceived as “de-merit goods”. In contrast, a government financial subsidy to producers has the effect of reducing their costs of production, lowering the market price and encouraging an expansion of demand.

The use of indirect taxation and subsidies is often justified on the grounds of instances of market failure. But there might also be a justification based on achieving a more equitable allocation of resources – e.g. providing basic state health care free at the point of use.

3. Taxation and labour productivity

Some economists argue that taxes can have a significant effect on the intensity with which people work and their overall efficiency and productivity. But there is little substantive empirical evidence to support this view. Many factors contribute to improving productivity – tax changes can play a role - but isolating the impact of tax cuts on productivity is extremely difficult.

4. Taxation and business investment decisions

Lower rates of corporation tax and other business taxes can stimulate an increase in business fixed capital investment spending. If planned investment increases, the nation’s capital stock can rise and the capital stock per worker employed can rise.

The government might also use tax allowances to stimulate increases in research and development and encourage more business start-ups. A favourable tax regime could also be attractive to inflows of foreign direct investment – a stimulus to the economy that might benefit both aggregate demand and supply. The Irish economy is often touted as an example of how substantial cuts in the rate of corporation tax can act as a magnet for large amounts of inward investment. The very low rates of company tax have been influential although it is not the only factor that has underpinned the sensational rates of economic growth enjoyed by the Irish economy over the last fifteen years.

Capital investment should not be seen solely in terms of the purchase of new machines. Changes to the tax system and specific areas of government spending might also be used to stimulate investment in technology, innovation, the skills of the labour force and social infrastructure. A good example of this might be a substantial increase in real spending on the transport infrastructure. Improvements in our transport system would add directly to aggregate demand, but would also provide a boost to productivity and competitiveness. Similarly increases in capital spending in education would have feedback effects in the long term on the supply-side of the economy.

Fiscal Policy and Aggregate Demand

Traditionally fiscal policy has been seen as an instrument of demand management. This means that changes in spending and taxation can be used “counter-cyclically” to help smooth out some of the volatility of real national output particularly when the economy has experienced an external shock.

Discretionary changes in fiscal policy and automatic stabilisers

Discretionary fiscal changes are deliberate changes in direct and indirect taxation and govt spending – for example a decision by the government to increase total capital spending on the road building budget or increase the allocation of resources going direct into the NHS.

Automatic fiscal changes are changes in tax revenues and government spending arising automatically as the economy moves through different stages of the business cycle. These changes are also known as the automatic stabilisers of fiscal policy

• Tax revenues: When the economy is expanding rapidly the amount of tax revenue increases which takes money out of the circular flow of income and spending
• Welfare spending: A growing economy means that the government does not have to spend as much on means-tested welfare benefits such as income support and unemployment benefits
• Budget balance and the circular flow: A fast-growing economy tends to lead to a net outflow of money from the circular flow. Conversely during a slowdown or a recession, the government normally ends up running a larger budget deficit.

Estimates from economists at the OECD have found that the effects of the automatic stabilisers of fiscal policy can reduce the volatility of the economic cycle by up to 20%. In other words, if the government is prepared to allow the automatic stabilisers to work through fully, the fiscal policy can help to curb the excessive growth of demand during a boom, but also provide an important support for income and demand during an economic downturn.

Measuring the fiscal stance

The fiscal stance is a term that is used to describe whether fiscal policy is being used to actively expand demand and output in the economy (a reflationary or expansionary fiscal stance) or conversely to take demand out of the circular flow (a deflationary fiscal stance).

A neutral fiscal stance might be shown if the government runs with a balanced budget where government spending is equal to tax revenues. Adjusting for where the economy is in the economic cycle, a neutral fiscal stance means that policy has no impact on the level of economic activity
A reflationary fiscal stance happens when the government is running a large deficit budget (i.e. G>T). Loosening the fiscal stance means the government borrows money to inject funds into the economy so as to increase the level of aggregate demand and economic activity.
A deflationary fiscal stance happens when the government runs a budget surplus (i.e. G<T). The government is injecting fewer funds into the economy than it is withdrawing through taxes. The level of aggregate demand and economic activity falls.

The table below summarises the main changes in government spending and tax revenues and government borrowing during recent years.

	Govt Spending	% of GDP	Tax Revenues	% of GDP	Govt Borrowing	% of GDP
1993	277.8	42.6	232.3	35.7	50.8	7.8
1997	318.5	38.8	308.7	37.6	10.2	1.2
2000	363.9	37.9	378.8	39.5	-14.9	-1.5
2004	488.0	41.4	454.0	38.5	34.1	2.9

From 2001-2004 there was a huge fiscal stimulus to the UK economy through substantial increases in government spending on transport, and in particular heavier spending in the twin areas of health and education. The real level of government spending grew from £364 billion in 2000 to £488 billion in 2004 – a rise of 34%. The share of GDP taken up by government spending has also increased from 38% in 2000 to 41.4% in 2004. This significant increase in government spending has helped to maintain Britain’s short-term economic growth at a time when some components of AD (notably export demand and investment) have been weak.

The Keynesian school argues that fiscal policy can have powerful effects on aggregate demand, output and employment when the economy is operating well below full capacity national output, and where there is a need to provide a demand-stimulus to the economy. Keynesians believe that there is a clear and justified role for the government to make active use of fiscal policy measures to manage the level of aggregate demand.

Monetarist economists on the other hand believe that government spending and tax changes can only have a temporary effect on aggregate demand, output and jobs and that monetary policy is a more effective instrument for controlling demand and inflationary pressure. They are much more sceptical about the wisdom of relying on fiscal policy as a means of demand management. We will consider below some of the criticisms of using fiscal policy as a tool of stabilising demand and output in the economy.

The multiplier effects of an expansionary fiscal policy depend on how much spare productive capacity the economy has; how much of any increase in disposable income is spent rather than saved or spent on imports. And also the effects of fiscal policy on variables such as interest rates

Problems with Fiscal Policy as an Instrument of Demand Management

In theory a positive or negative output gap can be relatively easily overcome by the fine-tuning of fiscal policy. However, in reality the situation is complex and many economists argue for ignoring fiscal policy as a tool for managing aggregate demand focusing instead on the role that monetary policy can play in stabilising demand and output.

Recognition lags and policy time lags

• Inevitably, it takes time to for government policy-makers to recognise that AD is growing either too quickly or too slowly and a need for some active discretionary changes in spending or taxation
• It then takes time to implement an appropriate policy response – government spending plans are subject to a three year spending review and cannot be changed immediately. Likewise the tax system is highly complex – for example – income tax can only normally be changed once a year at the time of the Budget. Indirect taxes can be changed more quickly but they have less of an effect on the level of aggregate demand
• It then takes time for the change in fiscal policy to work, as the multiplier process on national income, output and employment is not instantaneous.

The importance of the national income multiplier – imperfect information

Suppose a government wanted to eliminate a deflationary gap of £1000m. The increase needed in government expenditure will depend on the size of the multiplier. The problem lies in knowing the exact size of the multiplier. If the multiplier is 2, then government expenditure would have to rise by £500m. However, if the multiplier was 4, a rise of only £250m would be needed. Without knowing the precise value of the national income multiplier it is difficult to fine-tune the economy accurately.

Fiscal Crowding-Out

The “crowding-out hypothesis” became popular in the 1970s and 1980s when free market economists argued against the rising share of national income being taken by the public sector. The essence of the crowding out view is that a rapid growth of government spending leads to a transfer of scarce productive resources from the private sector to the public sector. For example, if the government seeks to reflate AD by reducing taxation, or by increasing government spending, then this may lead to a budget deficit. To finance the deficit the government will have to sell debt to the private sector. Attracting individuals and institutions to purchase the debt may require higher interest rates. A rise in interest rates may crowd out private investment and consumption, offsetting the fiscal stimulus.

This type of crowding out is unlikely to make fiscal policy wholly ineffective – but large budget deficits do require financing and in the long run, this requires a higher burden of taxation. Higher taxes affect both businesses and households – neo-liberal economists believe that higher taxation acts as a drag on business investment, labour market incentives and productivity growth – all of which can have a negative effect on economic growth potential in the long run.

The Keynesian response to the crowding-out hypothesis is that the probability of 100% crowding-out is extremely remote, especially if the economy is operating well below its productive capacity and if there is a plentiful supply of savings available that the government can tap into when it needs to borrow money. There is no automatic relationship between the level of government borrowing and the level of short term and long term interest rates. We can see from the previous chart that there has been a downward trend in long term interest rates over the last tent to twelve years. Indeed in 2003 the yield (rate of interest) on ten year government bonds dipped below 4 per cent – one of the lowest long term interest rates in recent history.

Reaction to Tax Cuts – Rational Expectations

According to a school of economic thought that believes in ‘rational expectations’, when the government sells debt to fund a tax cut or an increase in expenditure, then a rational individual will realise that at some future date he will face higher tax liabilities to pay for the interest repayments. Thus, he should increase his savings as there has been no increase in his permanent income. The implications are clear. Any change in fiscal policy will have no impact on the economy if all individuals are rational. Fiscal policy in these circumstances may become impotent.
Partly because of the limitations of fiscal policy as a tool of demand management, many governments have switched the focus of fiscal policy towards using it to improve aggregate supply as a means of creating the conditions for sustainable economic growth. This is certainly the case with the current government.

Government borrowing

The level of government borrowing is an important part of fiscal policy and management of aggregate demand in any economy. When the government is running a budget deficit, it means that in a given year, total government expenditure exceeds total tax revenue. As a result, the government has to borrow through the issue of debt such as Treasury Bills and long-term government Bonds. The issue of debt is done by the central bank and involves selling debt to the bond and bill markets.

Recent trends in UK government borrowing

Government finances have moved from surplus in the late 1990s to a deficit of over 2.5 % of GDP in 2003-04. The emergence of a rising budget deficit has been due to a weaker economy and the effects of substantial increases in government spending on priority areas such as health, education, transport and defence. Both current and capital spending are rising sharply in real terms. Critics of Gordon Brown argue that he risks losing control of the budget deficit if tax revenues continue to come in below forecast whilst public sector spending remains high. Gordon Brown’s reputation of fiscal prudence has come under pressure both before and after the most recent election.

Does a budget deficit matter?

There is a consensus that a persistently large budget deficit can be a problem for the government and the economy. Three of the reasons for this are as follows:

• Financing a deficit: A budget deficit has to be financed and day-today, the issue of new government debt to domestic or overseas investors can do this. In a world where financial capital flows freely between countries, it can be relatively easy to finance a deficit. But it may be that if the budget deficit rises to a high level, in the medium term the government may have to offer higher interest rates to attract sufficient buyers of government debt. This in turn will have a negative effect on economic growth
• A government debt mountain? In the long run, government borrowing adds to the accumulated National Debt. This means that the Government has to spend more each year in debt-interest payments to holders of government bonds and other securities. There is an opportunity cost involved here because this money might be used in more productive ways, for example an increase in spending on health services or extra investment in education. It also represents a transfer of income from people and businesses that pay taxes to those who hold government debt and cause a redistribution of income and wealth in the economy
• Crowding-out - the need for higher interest rates and higher taxes. Eventually the budget deficit has to be reduced. This can be achieved by either by cutting back on public sector spending or by raising the burden of taxation. If a larger budget deficit leads to higher interest rates and taxation in the medium term and thereby has a negative effect on growth in consumption and investment spending, then a process of ‘fiscal crowding-out’ is said to be occurring.
• Wasteful public spending: Neo-liberal economists are naturally opposed to a high level of government spending. They believe that a rising share of GDP taken by the state sector has a negative effect on the growth of the private sector of the economy. They are sceptical about the benefits of higher spending believing that the scale of waste in the public sector is high – money that would be better off being used by the private sector.

Potential benefits of a budget deficit

What are the main economic and social justifications for a higher level of government spending and borrowing? Two main arguments stand out

1. Government borrowing can benefit economic growth: A budget deficit can have positive macroeconomic effects in the long run if it is used to finance extra capital spending that leads to an increase in the stock of national assets. For example, spending on the transport infrastructure improves the supply-side capacity of the economy. And increased investment in health and education can bring positive effects on productivity and employment.
2. The budget deficit as a tool of demand management: Keynesian economists would support the use of changing the level of government borrowing as a legitimate instrument of managing aggregate demand. An increase in borrowing can be a useful stimulus to demand when other sectors of the economy are suffering from weak or falling spending. The fiscal stimulus given to the British economy during 2002-2004 has been important in stabilizing demand and output at a time of global economic uncertainty. Perhaps Keynesian fiscal demand management has once more come back into fashion! The argument is that the government can and should use fiscal policy to keep real national output closer to potential GDP so that we avoid a large negative output gap.

The current situation

• Government borrowing in the UK has shot up to 3.4 percent of GDP in the last fiscal year, in excess of the 3.0 percent limit set by Europe's Stability and Growth Pact. But as the UK is not participating in the single currency, the UK is not bound by the terms of the fiscal stability pact and this gives it more flexibility in terms of how much the UK government can borrow
• The government has allowed the automatic stabilisers to work during the current cycle. In other words, it has allowed an increase in government borrowing brought about by a slowdown in domestic demand and output.
• Gordon Brown has introduced his own fiscal rules – including the golden rule that government spending on currently provided goods and services should be financed by taxation over the course of the economic cycle. Government capital spending (public sector investment) can be financed by borrowing because it results in the accumulation of capital which has long term economic benefits for the country

• Although government borrowing is currently high, there is little upward pressure on long-term interest rates (indeed they are low). Financing the budget deficit is not a major problem for the UK as it seems able to attract inflows of financial capital from overseas – and foreign investors are happy to purchase new issues of government debt. This reduces the risk of the crowding out effect taking place
• Total government debt as a percentage of GDP remains low by historical standards (less than 40% of GDP). And with interest rates remaining low, the government is not facing up to a huge cost of servicing this debt
• It is difficult to forecast government borrowing with great accuracy. Firstly this is because government tax revenue and spending is sensitive to changes in the economic cycle. Secondly, we are dealing with huge numbers! Total government spending in 2003-04 is forecast to be £459 billion and total tax receipts £422 billion (giving a forecast budget deficit of £37 billion). It only takes government spending and tax revenues to be 1% or 2% different from current forecasts for the budget deficit to change significantly

Inter-relationships between Fiscal & Monetary Policy

For most of the last thirty years, the operation of fiscal and monetary policy was in the hands of just one person – the Chancellor of the Exchequer. However the degree of coordination the two policies often left a lot to be desired. Even though the BoE has independence that allows it to set interest rates, the decisions of the MPC are taken in full knowledge of the Government’s fiscal policy stance. Indeed the Treasury has a non-voting representative at MPC meetings. The government lets the MPC know of fiscal policy decisions that will appear in the budget.

Impact of fiscal policy on the composition of output

Monetary policy is often seen as something of a ‘blunt policy instrument’ – affecting all sectors of the economy although in different ways and with a variable impact. Fiscal policy changes can to a degree be targeted to affect certain groups (e.g. increases in means-tested benefits for low income households, reductions in the rate of corporation tax for small-medium sized enterprises and more generous investment allowances for businesses in certain regions)

Consider the effects of using either monetary or fiscal policy to achieve a given increase in national income because actual GDP lies below potential GDP (i.e. there is a negative output gap)

• Monetary policy expansion: Lower interest rates will (ceteris paribus) lead to an increase in both consumer and business capital spending both of which increases equilibrium national income. Since investment spending results in a larger capital stock, then incomes in the future will also be higher through the impact on LRAS.
• Fiscal policy expansion: An expansionary fiscal policy (i.e. an increase in government spending or lower taxes) adds directly to AD but if this is financed by higher borrowing, this may result in higher interest rates and lower investment. The net result (by adjusting the increase in G) is the same increase in current income. However, since investment spending is lower, the capital stock is lower than it would have been, so that future incomes are lower.

Effectiveness of Monetary and Fiscal Policies

When the economy is in a recession, monetary policy may be ineffective in increasing spending and income. In this case, fiscal policy might be more effective in stimulating demand. Other economists disagree – they argue that changes in monetary policy can impact quite quickly and strongly on consumer and business behaviour.

However, there may be factors which make fiscal policy ineffective aside from the usual crowding out phenomena. Future-oriented consumption theories based round the concept of rational expectations hold that individuals ‘undo’ government fiscal policy through changes in their own behaviour – for example, if government spending and borrowing rises, people may expect an increase in the tax burden in future years, and therefore increase their current savings in anticipation of this

Differences in the Lags of Monetary and Fiscal Policies

Monetary and fiscal policies differ in the speed with which each takes effect the time lags are variable

Monetary policy in the UK is flexible since interest rates can be changed by the Bank of England each month and emergency rate changes can be made in between meetings of the MPC, whereas changes in taxation take longer to organize and implement.

Because capital investment requires planning for the future, it may take some time before decreases in interest rates are translated into increased investment spending. Typically it takes six months – twelve months or more before the effects of changes in UK monetary policy are felt. The impact of increased government spending is felt as soon as the spending takes place and cuts in direct and indirect taxation feed through into the economy pretty quickly. However, considerable time may pass between the decision to adopt a government spending programme and its implementation. In recent years, the government has undershot on its planned spending, partly because of problems in attracting sufficient extra staff into key public services such as transport, education and health.