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KK: the effect of automatic and discretionary changes in the budget on the budget outcome

and government (public) debt

KK: the effect of automatic stabilisers on AD and the business cycle.

Automatic stabilisers: are the changes to the budget that occur automatically with changes in the level of economic activity. Also referred to as the ‘cyclical’

component of the budget. Automatic stabilisers are policies that are built into the budget e.g. income tax, transfer payments

Discretionary stabilisers: are deliberate policy decisions designed to change receipts or expenditure in an effort to influence economic activity. Also referred to

as the ‘structural’ component of the budget.

**NOTE: IT IS SO ESSENTIAL YOU UNDERSTAND THESE TWO CONCEPTS FOR THE EXAM

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4. Effect of automatic and discretionary stabilisers on the business cycle and the

budget outcome

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Understanding Automatic StabilisersSo, remember what the budget is: it is an estimate of the incoming receipts and outgoing

expenditure for the Commonwealth Government for the year ahead. The key word here is

estimate. Do they know exactly how much income they are going to receive? No. Do they know

exactly how much they are going to spend? No. Because some of this is dictated by a rise or fall

in economy activity (hence why they are also called the cyclical component of the budget i.e. the

business cycle).

For example, the estimated underlying budget outcome for 2018-19 is -14.5B, but what happens

if economic activity slows down to below what the government are expecting? If this happens

then not only will the Government receive less income and company tax receipts, but more

people are likely to qualify for transfer payments (welfare), automatically increasing government

expenditure and therefore the budget outcome will automatically turn into a much larger deficit

than anticipated.

The impact of Automatic Stabilisers on recent budget outcome

Example: the estimated budget outcome for 2017-18 was a deficit of $29.1B, but in the Mid-Year

Economic and Fiscal Outlook (MYEFO) that the government released in December 2016, the

deficit was estimated to actually be 18.2B because they received more income tax than they

originally thought they would.

Why is an automatic stabiliser called a ‘stabiliser’?

Because thinking about the business cycle, if we are in a boom period with very high economic

activity more people are likely to move to a higher tax bracket and pay more tax, reducing their

disposable income. On the other side of this, during a recession more people will qualify for

transfer payments like Newstart and this will stimulate AD to some extent (SEE NEXT PAGE)

Automatic Stabilisers and the impact on government (public) debt

Automatic stabilisers is the result of changes in economic activity during a fiscal year that can

alter the budget outcome. For example, increases in economic activity (associated with

increased consumer and business confidence and overseas economic growth) should result in

an increase in direct taxation in the form of increased sales tax (GST) and possibility of

increased levels of income tax (associated with increased levels of employment). As such, this

should result in a decrease in welfare dependency and a decrease in expenditure.

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Main types of automatic stabilisers

Progressive income taxes

In the upswing of the business cycle, as real GDP and incomes rise, government tax

revenues automatically increase, causing after-tax (disposable) income to be lower than it

would otherwise be. The downward pressure on disposable incomes acts to dampen

aggregate demand, and this tends to counteract the economic expansion, or make it smaller

than it would otherwise be.

In a recession, the opposite occurs. With real GDP and incomes falling, government tax

revenues automatically decline, causing after-tax (disposable) income to be higher than it

would otherwise be, exerting an upward pressure on aggregate demand, which reduces the

severity of the recession.

The more progressive an income tax system, the greater the stabilising effect on economic

activity.

Unemployment benefits

In a recession, as real GDP falls and unemployment increases, unemployment benefits rise

as they are offered to more unemployed workers. If there were no unemployment benefits,

unemployed workers’ spending would fall quite dramatically, putting a strong downward

pressure on consumption spending and aggregate demand.

However, the presence of unemployment benefits means that as workers become

unemployed, their consumption will be maintained to some extent as their benefits partially

replace their lost income, thus lessening the downward pressure on aggregate demand. In

an expansion, unemployment benefits are reduced as unemployment falls; therefore,

consumption increases less than it would in the absence of unemployment benefits.

It is important to bear in mind that a progressive tax system and unemployment benefits cannot by themselves stabilise the economy and eliminate inflationary and recessionary gaps on their own. They can only help reduce the severity of economic fluctuations.

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Bracket Creep

Bracket creep or ‘fiscal drag’ is when, in a progressive tax system like Australia, higher

incomes as a result of high economic activity lead to households moving up to a higher tax

bracket (so they are being taxed more).

This has two main effects:

it increases the tax revenue collected by the government

it possibly decreases household real disposable income and reduces purchasing

power

Q: Explain the impact that bracket creep would have on the budget outcome

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Q: Explain the impact that bracket creep would have on the business cycle and AD

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Q: Explain how bracket creep can lead to a disincentive to work harder (which may decrease

productivity).

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Q: Explain the role of automatic stabilisers in stabilising economic activity. In your answer,

refer to the business cycle.

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Understanding Discretionary Stabilisers

Discretionary stabilisers are deliberate policy decisions on how to change receipts and

outlays. For example, a decision to cut spending from a particular department is a

discretionary decision. Similarly, a decision to increase spending on roads is another

discretionary policy. These policies are used to try and influence the level of economic

activity either now or in the future.

Impact of discretionary stabilisers on government debt and the budget outcome

The impact of discretionary stabilisers on the budget outcome is a lot more straight forward.

Unlike automatic stabilisers, the receipts/outlays from discretionary policies can be planned

and estimated with much greater accuracy. However, discretionary policies often still need to

be approved by the Senate and if they do not get approved then this will impact the budget

outcome. For example, in 2014-15 the Government want to introduce a policy where

previously bulk-billed (free) medical appointments would have to pay a $7 fee for a Doctor’s

visit. This was an extremely unpopular policy and was not approved by the Senate, therefore

all the estimated receipts the Government were hoping to get from that policy was now gone.

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Q: The estimated underlying budget outcome for 2018-19 is a deficit of $14.5B (or -14.5B).

In reference to automatic stabilisers, explain one type of government revenue and one type

of government expenditure that would lead to the deficit being larger than expected.

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Q: Explain one discretionary and one automatic stabiliser that could cause the budget deficit

to decrease and the impact that this is likely to have on the level of net public debt.

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Q: Explain why the level of public debt will decrease during a boom in economic activity

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Q: Explain the impact that a recession will have on the budget outcome. In your answer,

refer to automatic stabilisers.

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Question 1Which of the following is most correct? A budget deficit (such as occurred between 2008–09 and

2016–17) is where:

a.  the total value of government receipts is more than the total value of government expenses.

b.  the total value of government expenses is less than the total value of receipts.

c.  the total value of government asset sales and taxes is more than the total value of government

consumption (G1) and government investment (G2) spending.

d.  the total value of government receipts is less than the total value of government expenses.

Question 2 The main difference between the headline budget balance and underlying budget balance is that:

a.  the underlying balance excludes one-off volatile items like asset sales and interest repayments by

state governments.

b.  the headline balance excludes transfers like welfare outlays, which vary from year to year.

c.  the underlying balance removes the effect of automatic stabilisers.

d.  the underlying balance removes the impact of inflation on the values of receipts and outlays.

Question 3 Concerning budgetary policy, which statement is generally false?

a.  A deficit budget may be financed by foreign and/or local borrowing.

b.  A larger deficit budget as a ratio to GDP may stimulate domestic economic activity and, if the

economy is already at its capacity, this may cause demand inflation.

c.  A deficit budget in a recession financed by local borrowing from the financial sector may

unintentionally tend to drive up domestic interest rates, causing a possible degree of conflict with RBA

efforts to run an expansionary monetary policy with lower interest rates.

d.  In itself, the shift towards a bigger surplus budget or a smaller deficit is generally regarded as

expansionary, and should help to lower unemployment and accelerate economic growth.

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Question 4 Between 2014–15 and 2019–20, the federal government initially planned to convert a headline de cit

of $48.5 billion into a small surplus. Theoretically, this could be achieved using:

a.  increased asset sales, automatic increases in tax collections and bracket creep, and the

introduction of discretionary new taxes.

b.  a discretionary reduction in government consumption (G1) and government investment (G2)

spending.

c.  automatic and discretionary cuts in welfare outlays and other transfer payments.

d. all of the above.

Question 5What factor(s) might theoretically help to explain why the small budget surplus that the treasurer

predicted would be achieved by 2019–20 ended up as a budget deficit; or why the actual deficit ended

up being nearly twice as big as that projected; or why the predicted surplus finished as a budget

deficit?

a.  More rapid inflation and faster economic growth than initially expected

b.  Lower unemployment than initially expected

c.  An unexpected boom among our trading partners overseas

d.  Lower terms of trade, along with slower levels of domestic economic activity and higher rates of

unemployment than initially expected.

Question 6 Which statement is correct? An increase in G2 spending on public health, education, housing and

transport will normally tend to:

a. decrease cyclical unemployment.

b. decrease job vacancies.

c. decrease demand inflation in the short term.

d. decrease the rate of economic growth by slowing AD.

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Key Knowledge covered:

the stance of budgetary policy: expansionary or contractionary

The stance of budgetary policy: expansionary or contractionary

An expansionary budgetary or fiscal policy stance. Budgets that seek to stimulate AD

and economic activity (because there is a slowdown in the economy) are said to be

expansionary budgets. They typically include reductions in receipts and/or rises in outlays.

Hence, expansionary budgets generally involve either one of the following:

an increase in the size of the budget deficit against the previous year (such as a rise in the

deficit from $30 billion to $50 billion)

 a cut in the size of the budget surplus against the previous year (such as a decrease in the

surplus from $20 billion to $5 billion).

A contractionary budgetary or fiscal policy stance. Budgets that seek to slow the growth

of AD and economic activity (because there is an inflationary threat) are said to be

contractionary budgets. They typically include rises in revenue relative to expenses.

Therefore, contractionary budgets generally involve either one of the following:

a reduction in the size of the budget deficit against the previous year (such as a cut in

the deficit from $30 billion to $10 billion)

a rise in the size of the budget surplus against the previous year (such as a rise in

the surplus from $10 billion to $20 billion).

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The stance of budgetary policy: expansionary or contractionary

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The stance of the 2018-19 Budget

For example, this year the deficit is $14.5B which seems expansionary, but if you compare

this year’s outcome to the 2017-18 budget which was a deficit of $18.2B, we see that this

year’s deficit is less, and therefore will have a mildly contractionary effect on the economy

(as there is approximately $4B less being injected into the economy than last year).

So, in the exam this year if you were required to discuss the budget stance for this year’s

budget you would say it is a mildly contractionary stance (or less expansionary is fine too).

Q: Referring to the data provided in the table above, outline the stance of the 2017-18 Budget

and the stance of the 2018-19 budget.

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Q: Explain the impact that the stance of the 2018-19 budget would have on Aggregate Demand

and the economy, ceteris paribus.

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