FISCAL POLICY IMPACT ON ECONOMY

TOOLS

• Governments influence the economy:1. Changing the level and types of taxes, 2. Changing the extent and composition of spending, and 3. Changing the degree and form of borrowing.• Governments directly and indirectly influence the way resources are

used in the economy.

A BASIC EQUATIONA national income accounting that measures the output of an economy gross domestic product (GDP)—according to expenditures:

GDP = C + I + G + NX.

• GDP—the value of all final goods and services produced in the economy. • private consumption (C), • private investment (I), purchases of goods and services by the

government (G), and • exports minus imports (net exports, NX).

EXPLANATION

• Governments directly affect economic activity (GDP): controlling G directly and influencing C, I, and NX • Governments indirectly affect economic activity (GDP): changes in taxes, transfers, and spending. Fiscal policy : • increases aggregate demand directly (an increase in government

spending) expansionary or “loose.” • reduces demand via lower spending contractionary or “tight”.

FISCAL POLICIES (SHORT-TERM OBJECTIVES)• Macroeconomic stabilization:1. Expanding spending or cutting taxes to stimulate an ailing economy, 2. Slashing spending or raising taxes rising inflation/reducing external

vulnerabilities. • priorities may reflect the business cycle or response to a natural

disaster or a spike in global food or fuel prices.

FISCAL POLICIES (LONG-TERM OBJECTIVES)• To address change or trend in social-economic development levels,

demographics, or natural resource endowments. • The aim may be to foster sustainable growth or reduce poverty with

actions on the supply side to improve infrastructure or education. • To reduce poverty:1. a low-income country to tilt spending toward primary health care, 2. an advanced economy, pension reforms might target looming long-

term costs related to an aging population.

FISCAL POLICIES (LONG-TERM OBJECTIVES)In an oil-producing country: • to better align fiscal policy with broader macroeconomic

developments moderating procyclical spending (by limiting boom of spending when oil prices rise and by refraining cut of spending when they drop).

RESPONSE TO THE GLOBAL CRISIS

• The global crisis 2007 initiated by the U.S. mortgage market. • The crisis hurt economies around the globe, with financial sector

difficulties and flagging confidence hitting C, I and NX. • Governments responded by trying to boost activity through two

channels: 1. automatic stabilizers and 2. fiscal stimulus—that is, new discretionary spending or tax cuts.

RESPONSE TO THE GLOBAL CRISISStabilizers: tax revenues and expenditure levels change the business cycle:• output slows or falls, the amount of taxes collected declines

corporate profits and taxpayers’ incomes fall, particularly under progressive tax structures where higher-income earners fall into higher-tax-rate brackets. • Unemployment benefits? and other social spending are also designed

to rise during a downturn. These cyclical changes make fiscal policy automatically expansionary during downturns and contractionary during upturns.

RESPONSE TO THE GLOBAL CRISIS

• Automatic stabilizers are linked to the size of the government, and tend to be larger in advanced economies. • Countries with larger stabilizers tended to resort less to discretionary

measures. • Automatic stabilizers are not subject to implementation lags (to

design, get approval for, and implement new road projects) • Automatic stabilizers—and their effects—are automatically

withdrawn as conditions improve.

RESPONSE TO THE GLOBAL CRISIS

• In many low-income and emerging market countries, however, institutional limitations and narrow tax bases mean stabilizers are relatively weak. • Discretionary measures can be tailored to stabilization needs

subject to implementation lags

RESPONSE TO THE GLOBAL CRISIS

Economic stimulus—tax cuts, subsidies, or public works programs. • Where stabilizers are larger, there may be less need for stimulus• Stimulus may be difficult to design and implement effectively and

difficult to reverse when conditions pick up. • Even in countries with larger stabilizers, there may be a pressing need

to compensate for the loss of economic activity and compelling reasons to target the government’s crisis response to those most directly in need.

FISCAL ABILITY TO RESPOND

• The exact response:the fiscal space a government has available for new spending initiatives or tax cuts its access to additional financing at a reasonable cost or its ability to reorder its existing expenditures.

FISCAL ABILITY TO RESPONDSome governments were not in a position to respond with stimulus:• potential creditors believed additional spending and borrowing would put too

much pressure on inflation, foreign exchange reserves, the exchange rate, delay recovery by taking too many resources from the local private sector (crowding out). • Creditors doubt governments’ ability:1. to spend wisely, 2. to reverse stimulus once put in place, or 3. to address long-standing concerns with underlying structural weaknesses in

public finances (chronically low tax revenues due to a poor tax structure or evasion, weak control over the finances of local governments or state-owned enterprises, or rising health costs and aging populations).

FISCAL ABILITY TO RESPOND

• More severe financing constraints have necessitated spending cuts as revenues decline (stabilizers functioning). • In countries with high inflation or external current account deficits,

fiscal stimulus is likely to be ineffective, and even undesirable.

FISCAL ABILITY TO RESPOND (The size of stimulus matter)• Tailoring the size of stimulus measures to their estimates of the size of

the output gap expected output and real output at the full capacity economy. • A measure of the effectiveness of the stimulus how it affects the

growth of output (the multiplier). • Multipliers tend to be larger if there is less leakage (import),

accommodative monetary conditions (interest rates), and the sustainable country’s fiscal position after the stimulus.

FISCAL ABILITY TO RESPOND (size)

• Small or negative multipliers the expansion raises concerns about sustainability or in the longer term the private sector would likely increasing savings or even moving money offshore ><investing or consuming. • Multipliers: 1. spending measures 2. tax cuts or transfers3. small, open economies (the extent of leakages).

FISCAL ABILITY TO RESPOND (size)

• a trade-off in deciding:1. targeting stimulus to the poor the likelihood of full spending and a

strong economic effect is higher; 2. funding capital investments create jobs and help bolster longer-

term growth; 3. providing tax cuts firms to take on more workers or buy new

capital equipment. In practice, governments have taken a “balanced” approach with measures in all of these areas.

FISCAL ABILITY TO RESPOND (timing and duration of stimulus)• to implement spending measures (program or project design,

procurement, execution), • the measures may be in effect longer than needed. • if the downturn is expected to be prolonged (crisis), concerns over

lags may be less pressing: governments stressed the implementation of “shovel-ready” projects that were already vetted and ready to go. • stimulus measures should be timely, targeted, and temporary—

quickly reversed once conditions improve.

FISCAL ABILITY TO RESPOND

• the responsiveness and scope of stabilizers can be enhanced a more progressive tax system. • Transfer payments linked to economic conditions (unemployment rates or

other labor market triggers). • fiscal rules aim to limit the growth of spending during boom times (natural

resources). • formal review or expiration (“sunset”) mechanisms for programs help to

ensure that new initiatives do not outlive their initial purpose. • medium-term frameworks with comprehensive coverage and assessment

of revenues, expenditures, assets and liabilities, and risks help improve policymaking over the business cycle.

BIG DEFICITS AND RISING PUBLIC DEBT• Fiscal deficits and public debt ratios (the ratio of debt to GDP) have

expanded sharply:1. the effects of the crisis on GDP, 2. tax revenues and 3. the cost of the fiscal response to the crisis. • Support and guarantees to financial and industrial sectors the

financial health of governments.

BIG DEFICITS AND RISING PUBLIC DEBT• Advanced economy: moderate fiscal deficits for extended periods:domestic and international financial markets and international and bilateral partners convinced of their ability to meet present and future obligations. • Deficits that grow too large? and linger too long? may undermine that

confidence.

BIG DEFICITS AND RISING PUBLIC DEBT• the IMF in late 2008 and early 2009 called on governments to

establish a four-pronged fiscal policy strategy to help ensure solvency: 1. stimulus should not have permanent effects on deficits; 2. medium-term frameworks should include commitment to fiscal

correction once conditions improve; 3. structural reforms should be identified and implemented to

enhance growth; 4. countries facing medium- and long-term demographic pressures

should firmly commit to clear strategies for health care and pension reform.