14.

1 The meaning of fiscal policy

Fiscal policy The use of government expenditure and revenue collection to influence the
economy
Fiscal policy is at the heart of economic management and is used to achieve
Sustainable growth
Reallocation of resources
Redistribution of income
Budget The tool used by the government to exercise fiscal policy. It outlines the
governments planned revenues and expenditures over the following financial
year
Revenue refers to all the receipts received by the government over the financial year. Such receipts
include;
Direct tax (personal and company)
Indirect tax (GST, customs duties)
Other revenues (Public enterprises)
Expenditure refers to all the money spent by the government over the financial year. Such spending
includes;
Social welfare
Healthcare
Defense
Public administration
Governments alter economic policy to suit changing economic or political conditions
Governments may make alterations to spending patterns throughout the year with such figures being
factor in to the next budget
14.2 Budget outcomes
Budget outcome The intended result of the governments fiscal policy
There are three possible budget outcomes including;
Fiscal surplus A positive balance that occurs when the commonwealth government
anticipates that total government revenue will exceed total expenditure
Fiscal deficit A negative balance that occurs when the commonwealth government
anticipates that total government expenditure will exceed total revenue
Fiscal balance A zero balance that occurs when the commonwealth government anticipates
that total government revenue will be equal to total expenditure
The main fiscal policy of the government is to achieve fiscal balance over the course of the business
cycle
The budget includes two measures of the budget outcome, which are the result of different accounting
measures;
The fiscal outcome is calculated as total revenue less total expenses less net capital investment. This
method excludes one off factors such as the profits of privatising a firm. This method is considered
the most accurate long term indicator of fiscal policy
The underlying cash outcome is similar to the fiscal outcome, except that it is calculated by using the
cash accounting method. The underlying cash outcome gives the best indicator of the impact of fiscal
policy over the financial year
Both of these methods remove the effect of one off transactions that can distort the budget outcome
(e.g. sale of government assets)
These one off transactions are shown in the headline budget outcome. However this is widely
considered to be a useless measure of fiscal outcomes by economists
This is because such one off transactions rarely generates any extra economic activity in the short
term.
However, privatisation can lead to increased resource efficiency in the long term, which in turn can
lead to benefits for economic activity
14.3 Changes in budget outcomes
Each year the government changes its spending and revenue patterns, thus leading to differing
budget outcomes
Such changes can be divided into two categories; discretionary changes and non-discretionary
changes
Discretionary This involves deliberate changes to fiscal policy, such as reduced spending
and increase revenue to dampen demand. Such changes influence the
structural component of the budget outcome
Non-discretionary Are changes which occur due to cyclical factors. Example the budget deficit
will increase during a recession. Such changes influence the cyclical
component of the budget outcome
Non discretionary changes occur mainly due to automatic stabilisers;
Automatic stabilisers Are instruments which automatically counter current economic trends. In a
boom they decrease economic activity and in a recession they stimulate it.
The most common types are welfare payments and the progressive tax
system
In times of recession unemployment will rise causing an increase in unemployment payments
automatically increase the level of economic growth
In a boom the progressive tax system leads to a rise in taxation which would automatically
decrease the level of economic growth
Counter-cyclical policies Economic policies designed to smooth out fluctuations in the business
cycle. Both fiscal and monetary policy are key examples of this as they
are designed to counter current trends
Impact on economic activity
Expansionary policy An expansionary stance of fiscal policy involves a net increase in government
spending (G > T) through rises in government spending or a fall in taxation
revenue or a combination of the two. This will lead to a larger budget deficit
or a smaller budget surplus than the government previously had. This is done
in times of recession to stimulate the economy.
An expansionary policy will lead to a multiplied increase in consumption and investment, thus
stimulating AD and economic activity
Contractionary policy A contractionary fiscal policy (G < T) occurs when net government spending
is reduced either through higher taxation revenue or reduced government
spending or a combination of the two. This would lead to a lower budget
deficit or a larger surplus than the government previously had. This is done
in times of excessive growth to slow the economy.
A contractionary policy will lead to a multiplied decrease in consumption and investment, thus
dampening AD and economic activity
Neutral policy A balanced budget where G = T (Government spending = Tax revenue).
Government spending is fully funded by tax revenue and overall the budget
outcome has a neutral effect on the level of economic activity.
Impact on resource use
Fiscal policy can alter the allocation of resources either directly or indirectly
The government can directly allocate resources by increasing spending in a particular sector of the
economy e.g. roads
The government indirectly alters the allocation of resources by making a sector of the economy more
attractive for production. E.g. Removal of tax on cigarettes will lead to increased demand for them
thus increasing their production
The government may also allocate resources to certain sectors, if they feel that private firms are
unable or unwilling to provide them. Such goods are known as public goods
Public good Are g/s that private firms unwilling to supply as they are unable to restrict
usage and benefits to those willing to pay for the good. Therefore
governments provide them. Examples include waterways and defence forces
Furthermore, the government may allocate resources to certain areas in emergency situations
(natural disaster etc)
In addition, the government may use fiscal policy to remove resources from undesirable sectors of the
economy. E.g. Tax on cigarettes to discourage their use
Impact on income distribution
The governments progressive tax system enables them to redistribute income from the rich to the
poor
Governmental changes to social welfare and UE benefits are another way that the government can
produce a more equitable distribution of income
However, government spending cuts can increase income inequality as government spending is often
relied upon by low income earners
Impact on savings and CAD
If the budget goes into deficit, this can have a significant impact on the level of savings in an economy
If the budget goes into deficit, the government must fund spending by borrowing from the private
sector. This will hence lead to an increase in public sector debt
This will lead to dis-savings and a reduction on the level of national savings in an economy
This dis-saving will lead to the crowding out effect, which will in turn lead to an increase in foreign
liabilities as the economy looks overseas to fund domestic investment
Hence, this will therefore contribute to a larger deficit on the net income account, thus raising the CAD
However, in recent times, sustained budget surpluses have meant that the majority of Australia's dis-
savings have been from the household sector as opposed to the public sector
In the future however, it is predicted the public sector debt will rise due to the deficit incurred from the
fiscal stimulus activated due to the global GFC
14.4 Methods of financing a deficit
When the budget goes into deficit, the government will have to spend far more then what it receives.
Therefore, it must borrow from a variety of sources
Such sources include
Domestic private sector
RBA
Overseas investors
The government may also fund a deficit by selling off government assets; however, this is fairly rare
as the government often resorts to borrowing
Borrowing from the private sector
This is the main form of deficit financing used by Australian governments
To conduct this operation, the government sells a set amount (usually the size of the deficit) of
treasury bonds to potential buyers.
These potential buyers offer the government a rate of interest. The government then accepts the
offers from the lowest interest rate to the highest
The advantages of this system are twofold. Firstly the government ensures that it can finance the
deficit whilst the market sets the interest rate on the bond
However, this form of deficit financing can lead to a process known as the crowding out effect
Crowding out effect Occurs when government borrowing to fund a deficit from the private sector
leads to a shortage of domestic funds
If the government consistently runs budget deficits and borrows from the public to fund the deficit, it
will drain funds otherwise use to fund domestic investment.
This will therefore cause businesses to look overseas to fund investment, worsening the CAD.
The strength of this effect usually depends on current economic conditions.
If the fiscal deficit occurs during a recession, then the effect wont be as severe, since private sector
activity falls during a recession, a crowd-out is less likely to occur.
However, since the majority of those who buy Australian treasury bonds are overseas residents
(60%), this lowers the crowd out of our domestic private sector
Borrowing from overseas
The government can also borrow from overseas to fund a deficit, especially if it wants to avoid the
crowding out effect
However, this will lead to increased foreign debt which will lead to a worsening CAD.
This is likely to be detrimental to growth in the future, due mainly to the possibility for the passive
accumulation of debt
Borrowing from the RBA (monetary financing)
In previous years, the government borrowed from the RBA to fund the deficit in a process sometimes
referred to as monetising the deficit
This involves the RBA printing money for the government
However since the deregulation of financial markets in 1982, the government has not borrowed from
the RBA to fund the deficit, as to avoid increasing money supply and hence inflation
Selling government assets
The government can sell its assets and use the profits to fund a deficit
This can avoid the other negatives associated with the government borrowing money to fund a fiscal
deficit
However, government assets are scarce, thus limiting their ability to significantly reduce the deficit
Using budget surpluses
Another alternate way to fund a deficit is a surplus. The government can do this by
Depositing the surplus with the RBA
Using it to pay off public sector debt
Placing it in a government owned investment fund
This process can reduce the size of our overall debt, and free up funds for private sector investment,
thus offsetting the contractionary nature of a surplus
Public sector borrowing and debt
In order to view the complete public sector debt from all levels of the economy (state, local,
government owned enterprises etc); we must look at the public sector underlying cash outcome
This shows the borrowing needs or the surplus funds from all levels of government, as well as
government authorities and public trading enterprises.
It is the most comprehensive view of the impact of the budget to the public sector. It is usually
measured as a percentage of GDP
A negative outcome means that there is an overall public sector deficit, the opposite is true
Over time, constant public deficit can lead to the accumulation of debt, owed both domestically and
internationally
Over the last 20 years public sector deficit has slowly decreased, however, in recent years it has
sharply risen. This is due centrally to the recent GFC and the subsequent budgetary deficits
Public sector debt can be divided into domestic and overseas categories. Overseas debt is of greater
detriment to the economy as it adds to our foreign debt, thus worsening the CAD
WARNING DO NOT CONFUSE PUBLIC SECTOR DEBT AND NET FOREIGN DEBT. NET
FOEIGN DEBT INCLUDES BOTH PUBLIC AND PRIVATE DEBTS OVERSEAS
Thus, whilst there is little correlation between the fiscal outcome and the CAD in the short term, there
is in the long term
It is important to note that maintaining a low CAD is not a primary fiscal objective of governments
14.5 The current stance of fiscal policy
As such, fiscal policy has played key role in Australias escape from recession during the GFC
The fiscal outcome of the 09-10 budget reflects both cyclical and structural factors, with the budget
moving into an underlying deficit of 4.9% of GPD
Cyclical Factors
The automatic stabilisers have contributed significantly to the fall in government revenues and their
increase in spending
Tax revenue has fallen mainly due to our progressive tax system. As the GFC led to a downturn in
growth, this led to higher U/E and lower wage levels, thus lowering the taxable income of the
population has been
Tax revenue forecast to decline by 210 billion over the next few years
Furthermore, the increase in U/E resulting from the GFC has led to an increase in welfare benefits,
thus increasing overall government expenditure
U/E benefits have risen from 5.2 billion to 9.4 billion in the past two years
Structural Change
As a result of the stimulus, many areas of the economy have experienced significant injections of
funds
The government has allocated $22 billion for infrastructure programs, $16 billion to increase aged
care benefits, $81.7 billion for jobs and education along with $731 million for the paid parenthood
scheme
Such measures were complicated by the governments 10.4 billion economic security package along
with the $42 billion nation building and jobs plan
Such measures have been forecasted to boost our GPD by 2.75% over 2009-10
The government sought to offset this by saving elsewhere in the budget
The government has cut expenditure in superannuation, family tax along with raising the retirement
age to 67 by 2023. Such measures are aimed at offsetting the larger deficit accrued in the 08-09
budget
During the Howard government years, priority was placed on maintaining budget surpluses
Such priorities led to a decrease in government spending along with a shift from direct tax to indirect
tax, primarily through the GST
Such fiscal stance over this government was due mainly to sustained growth across their leadership
In the early years, the Rudd government maintained such surpluses however; they used such
surpluses to establish three governmental investment funds
Such funds were utilised during the GFC to finance some of its short term stimulus measures
However, the GFC forced the Rudd government to enact an expansionary policy which led to a deficit
for the first time in years
Despite this, however, the Rudd government had aimed to maintain fiscal sustainability by moving the
budget back into surplus ASAP
14.6 The impact of a recent fiscal policy
In the short term fiscal policy centrally influences growth, U/E and inflation
In the long term, fiscal policy mainly influences external stability, environmental outcomes and income
distribution
To a lesser extent, it can also influence long-term labour market outcomes
During the periods of sustained growth in Australia, fiscal policy played a less significant role in
influencing the level of economic activity
When accessing the budget/fiscal outcomes, it is important to view the political considerations that go
into them as of times the best possible economic outcomes for a budget are sacrificed for political
outcomes
Economic growth
During the periods of sustained growth, monetary policy as opposed to fiscal policy has played a role
in influencing growth
However, in the GFC, the budget has played a more prominent role in stimulating growth in Australia
In the long term however, it can be seen that the budget can have a significant effect on growth
Tighter fiscal policy in the short term can lead to increased growth in the long-term as interest rates
drop, improving business costs and making domestic funds available for investment. Henceforth, this
would lead to a reversal of the crowding out effect
Conversely it is important to note, that the crowding-out effect is not as prevalent during times of
economic decline, due to the low investment demand which exists in the economy
Changes in fiscal policy can lead to changes in monetary policy which can also effect growth
Eg, As a result of fiscal stimulus in 08-0 and the subsequent growth in our economy, the RBA lifted
interest to restrict growth-which is unusual considering the state of the global economy at that point
U/E and LFPR
In the stimulating AD, an expansionary fiscal policy will lead to an increase in labour demand thus
decreasing U/E
Thus fiscal policy directly altars cyclical U/E depending on its stance
However, the governments spending habits in the budget can reduce U/E and altar LFPR. Some
examples include:
The 2005 welfare to work, which boosted LFPR by shifting individuals off welfare
The 2007 changes to superannuation aimed to increase LFPR by encouraging people to work
beyond retirement age
The 2008 low income tax offset was increased, thus providing a greater incentre to work for
welfare recipients and low income earners
The 2009 jobs and training compact boosted training programs aimed at reducing structural
U/E
2009 JOB SERVICES Australia initiate aimed at lowering long term U/E by providing businesses
incentives to higher the long term U/E
2009 paid parental leave scheme aimed at increasing LFPR to encourage women to return to work
after maternity leave
National savings and the CAD
One of the main goals of fiscal policy is to increase national savings and reduce the CAD
However, in recent years, this goal has gained far less attention as governments have focused more
on sustaining our growth
There is little overall evidence to suggest that Australias increased public savings from the 90s to the
late 2000s had any effect on the CAD
This can however be explained by the fact that while national savings have grown over this period,
investment has not
Distribution of income
The budget can have a significant impact on income distribution
The current budget has acted to reduce the increased inequality which has occurred due to the GFC
Such actions include; increased UE benefits, training programs, pensioner benefits and investment in
public housing
In addition, the general fiscal stimulus should decrease inequality by stimulating the economy, thus
raising wages and lowering UE.
Furthermore the budgets tax cuts should also alleviate the large tax burden placed on low income
earners