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Fiscal Policy and Budget Defcits

Fiscal and monetary policies are the two major tools available to
policy makers to alter total demand, output, and employment. This
feature will focus on fscal policy, what it is and its potential and
limitations as a tool with which to promote economic stability and
strong growth.
What is Fiscal Policy?
When the supply of money is economic constant, government
expenditures must be fnanced by either taxes or borrowing. Fiscal
policy involves the use of the governments spending, taxing and
borrowing policies. The governments budget defcit is used to evaluate
the direction of fscal policy.
When the government increases its spending and!or reduces taxes,
this will shift the government budget toward a defcit. "f the
government runs a defcit, it will have to borrow funds to cover the
excess of its spending relative to revenue. #arger budget defcits and
increased borrowing are indicative of expansionary fscal policy. "n
contrast, if the government reduces its spending and!or increases
taxes, this would shift the budget toward a surplus. The budget surplus
would reduce the governments outstanding debt. $hifts toward budget
surpluses and less borrowing are indicative of restrictive fscal policy.
"t is important to note that a budget defcit is di%erent from the
national debt. & defcit occurs when government spending exceeds
revenue over a year, 'uarter or month. & defcit will increase the si(e
of the national debt. )ut another way, the defcit adds to the
outstanding stock of "*+s issued by the +.$. ,overnment and not yet
repaid. -onversely, a budget surplus will reduce the si(e of the national
debt. & surplus permits the government to pay o% some of the holders
of the federal governments "*+s. These holders are the bondholders
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of +.$. Treasuries .onds, /otes and .ills.
Keynesian View of Fiscal Policy
The 0nglish economist, 1ohn 2aynard 3eynes 4pronounced
5canes67 populari(ed the use of fscal policy as a stabili(ation tool.
Writing during the ,reat 8epression of the 9:;<s, 3eynes argued that
output and employment were well below their potential because there
was insu=cient total demand. "f demand could be increased, output
and employment could be expanded and the economy would return to
its full employment potential. 2oreover, 3eynes believed this could be
achieved with expansionary fscal policy.
8uring a recession, 3eynes argued that, rather than balancing its
budget, the government should increase its spending, reduce taxes,
and shift its budget toward a defcit. &ccording to 3eynes, higher levels
of government spending would directly increase total demand. Further,
lower taxes would increase the after>tax incomes of households and
they would spend most of that additional income, which would also
stimulate total demand. Thus, the 3eynesian prescription to cure a
recession was a larger budget defcit.
"n contrast, if the economy was experiencing a problem with
in?ation during an economic boom, 3eynesian analysis called for
restrictive fscal policy to temper excessive demand. "n this case,
reductions in government spending, higher taxes, and a shift of the
budget toward a surplus would reduce total demand and thereby help
to fght an in?ationary boom.
Thus, 3eynes rejected the view that the governments budget
should be balanced. @e argued that appropriate budgetary policy was
dependent on economic conditions. &ccording to the 3eynesian view,
governments should run budget defcits during recessionary times and
surpluses during periods when in?ation was a problem because of
excessive demand.
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Can Fiscal Policy Be Used to Reduce Economic nsta!ility?
The 3eynesian view of fscal policy swept the economics
profession and, by the 9:A<s, it was also widely accepted by policy
makers. 8uring that era, most economists believed that fscal policy
exerted a powerful impact on the economy and that it could be
instituted in a manner that would smooth the ups and downs of the
business cycle.
@owever, this is more di=cult than was initially perceived. "f
changes in fscal policy are going to exert a stabili(ing impact on the
economy, they must be timed correctly. )roper timing of fscal changes
is di=cult. There will be time lags between when an economy is
dipping into a recession and when the government fgures out what is
happening and what to do. "t will also take time to develop a fscal
package on which the majority will agree and pass it through -ongress.
Finally, there will also be time lags between when additional
government spending is passed, when contracts are extended and the
spending actually occurs. The combination of these time lags is long
and variable, typically 9B to BC months.
,iven these time lags, if fscal policy is going to exert a stabili(ing
in?uence, policy makers need to know what economic conditions are
going to be like 9B to BC months in the future. .ut this is a big
problem. The ability to forecast when the economy is about to dip into
a recession or experience an economic boom is extremely limited.
Therefore, in a world of dynamic change and unpredictable events,
macroeconomic policy>making is a little bit like lobbing a ball at a
target that often moves in unforeseen directions. )redictably, policy>
making errors will occur. $ometimes fscal policy changes will end up
adding stimulus during periods of strong demand and restraint during
periods of recession. -hanges of this type would add to, rather than
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reduce, economic instability.
.ecause of these timing problems, most economists, including
many 3eynesians, now believe that it is a mistake for policy makers to
be constantly changing fscal policy in response to minor changes in
economic conditions. $uch constant changes are likely to be timed
incorrectly and add to the uncertainty with regard to future business
conditions. )ut another way, it is unrealistic to expect that political
decision>makers will alter fscal policy in a manner that will add
stimulus during recessions and restraint during in?ationary booms.
"utomatic #ta!ili$e%s
There are a few fscal programs that tend automatically to apply
demand stimulus during a recession and demand restraint during an
economic boom. )rograms of this type are called automatic stabili(ers.
They are automatic in that, without any new legislative action, they
tend to increase the budget defcit 4or reduce the surplus7 during a
recession and increase the surplus 4or reduce the defcit7 during an
economic boom.
The unemployment compensation system provides an example.
This system levies a payroll tax on employment and uses the revenues
to provide benefts to workers who are unemployed. When an economy
begins to dip into a recession, the government will pay out more
money in unemployment benefts as the number of laid>o% and
unemployed workers expands. $imultaneously, the revenues derived
from the employment tax will decline because fewer workers are
paying into the system. Therefore, this program will automatically run
a defcit during a recession. "n contrast, during an economic boom, the
tax receipts from the program will increase because more people are
now working, and the amount paid out in benefts will decline because
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fewer people are unemployed. &s a result, the program will
automatically tend to run a surplus during good times. Thus, without
any legislative action, the unemployment compensation system will
tend to shift the budget toward a defcit during a recession and toward
a surplus during a boom.
The corporate income tax and progressive nature of the personal
income tax also tend to act as automatic stabili(ers. &utomatic
stabili(ers minimi(e the problem of appropriate timing. They help keep
the economy on track even without any legislative action. They are
important because they shift the budget toward defcit during
recessions and surplus during booms without having to depend on
politicians to time a policy change in an appropriate manner.
Cu%%ent De!ate "!out the Potency of Fiscal Policy
Will increases in government spending, reductions in taxes, and
large budget defcits stimulate output and employmentD Fifty years
ago during the heyday of 3eynesian economics, most all economists
believed that expansionary fscal policy exerted a strong impact on
total demand and output. .ut this is no longer the case. Today, many
economists argue that there are important incentive and secondary
e%ects that largely erode the potency of expansionary fscal policy.
There are two major reasons why 3eynesian critics believe that
expansionary fscal policy is not very potent. First, there is the interest
rate e%ect. .udget defcits will have to be fnanced by increased
borrowing. .ut when the government borrows more in the loanable
funds market, this will increase interest rates. "n turn, the higher
interest rates will 5crowd out6 private investment and consumption
and this reduction in private spending will largely, if not entirely, o%set
the stimulus e%ects of the increase in government spending. $econd,
other non>3eynesians stress that the budget defcits will result in a
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larger government debt and higher taxes to cover the interest costs.
These economists believe that the expectation of the higher future
taxes will dampen private spending and thereby o%set the stimulus
e%ects of defcit spending.
The potency of expansionary fscal policy is a hot topic of current
debate among economists. 0ven though they recogni(e that it is
extremely di=cult to time fscal changes correctly, modern 3eynesians
believe that increased government spending and enlarged budget
defcits will help promote recovery from a serious recession like that of
B<<E>B<<:. *n the other hand, many non>3eynesians argue that higher
interest rates and expected future taxes accompanying the higher
levels of government borrowing will largely o%set the expansionary
impact of the budget defcits. 0ven if the government is able to borrow
at low interest rates during a recession, as was the case during B<<E>
B<<:, some combination of higher interest rates and higher taxes will
be re'uired for the fnancing and re>fnancing of the larger debt as the
economy recovers. /on>3eynesians believe that these higher interest
rates and tax rates will reduce private investment, weaken the
recovery, and lead to a slower rate of long>term growth.
We are in the midst of a 5great experiment6 that will yield some
light on who is right. 8uring B<<: and B<9<, the +nited $tates ran
budget defcits of approximately F9.G trillion, 9< percent of ,8), levels
only achieved in the midst of World War "". "f the 3eynesians are
correct, this should lead to a strong recovery. .ut, if there are
important secondary e%ects of these large defcits, the recovery is
likely to be both slow in coming and relatively weak. "t will be
interesting and informative to observe this experiment in the years
immediately ahead.
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&a' Cuts Ve%sus #(ending nc%eases
When using expansionary fscal policy to promote recovery from a
recession, would it be better to reduce tax rates or increase
government spendingD There are at least four reasons why a tax cut is
likely to be more e%ective than a spending increase as a tool with
which to promote recovery and long>term growth.
First, a tax cut will generally stimulate aggregate demand
more rapidly. &s recent experience illustrates, the federal
government is able to get checks to people in just two or three months.
0ven if a substantial portion of the funds is not spent 'uickly, there will
be an immediate positive impact on the fnancial position of
households. "n contrast, spending projects are often a lengthy process
spread over several years. For example, the -ongressional .udget
*=ce estimated that only 9G percent of the spending funded by the
stimulus package passed in February B<<: would occur during the
initial year while nearly half 4CE percent7 would not be spent until B<99
and beyond.
Second, compared to an increase in government spending, a
tax cut is less likely to increase structural unemployment and
reduce the productivity of resources. /ew government spending
programs generally change the structure of total demand more than a
tax cut. *ther things constant, larger changes in the composition of
demand will mean more unemployment, at least in the short run.
2oreover, the additional government spending is likely to be less
productive. ,overnment has a tendency to become heavily involved in
allocating scarce resources through spending programs that favor
sectors, businesses, and interest groups. .y contrast, households will
tend to purchase items that are valued more than the cost of
producing them when their spending increases as the result of lower
taxes.
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Third, a tax cut will be easier to reverse once the economy
has recovered. *nce started, the interests undertaking a government
project and benefting from it will lobby for its continuation. Therefore
spending projects started during a crisis are likely to continue long
after the crisis is history.
Fourth, a reduction in tax rates will increase the incentive to
earn, invest, engage in business activity, and employ others.
From a supply>side view, the marginal tax rate imposed on income is
particularly important. The marginal tax rate determines the
breakdown of a persons additional income between tax payments on
the one hand and personal income on the other. #ower marginal tax
rates mean that individuals get to keep a larger share of their
additional earnings. This incentive e%ect will encourage more
productive activity and help speed a recessionary economy toward
recovery.