Explaination of Fiscal Policy, Government Expenses & Taxation

Fiscal policy can be determined as the use of government spending and taxes in order to alter the Gross Domestic Product (GDP). From the macro perspective, the federal budget is a tool that can shift aggregate demand and thereby alter macroeconomic outcomes. Although fiscal policy can be used to pursue any of the economic goals, we need to explore its potential to ensure full employment and observe the impact on inflation. The mix of output and distribution of income will determine the potential of fiscal policy. The objective of fiscal policy is not always to increase aggregate demand. At times, the economy is already expanding too fast and fiscal restraint seems to be more appropriate. This means tax hikes or spending cuts are intended to reduce aggregate demand. In the short term, priorities may reflect the business cycle corresponds to a natural disaster but in the longer term; the drivers can be development levels, demographics, or resource endowments. The desire to reduce poverty might lead a low income country to tilt spending toward primary health care, whereas in an advanced economy, pension reforms might target looming long-term costs related to an aging population.
The main objective of Fiscal Policy is to achieving desirable price level. Economic stability requires the stability of general prices. Fiscal policy should be used to remove the instability in price level so that ideal level is maintained. However, the maintenance of a desirable price level has good effects on production, employment and national income. Besides providing goods and services, fiscal policy objectives vary. In the short term, governments may focus on macroeconomic stabilization. For example, stimulating an ailing economy, combating rising inflation, or helping reduce external vulnerabilities. In the longer term, the aim may be to foster sustainable growth or reduce poverty with actions on the supply side to improve infrastructure or education. Although these objectives are broadly shared across countries, their relative importance differs depending on country circumstances.
Another objective is, to achieving desirable consumption level which is important for political, social and economic consideration. At times, consumption can be affected by expenditure and tax policies of the government. Therefore, fiscal policy should be used to increase welfare of economy. Fiscal policy is created to achieving desirable employment level. This will then determine the living standard of the people. Apart from that, it is necessary for political stability and for maximization of production.
The purpose of fiscal policy is to divert resource and increase capital. Deficiency of capital is the main reason for under-development in the under-developed countries. This is where large amounts are required for industry and economic development. If the market does not self-adjust, then the government may have to get involved in a difficult situation in order to improve it.
According to Robert H. Frank & Ben S. Bernanke (2009), fiscal policy consists of two tools: first is the changes in government purchases and second, the changes in taxes or transfer payments. It can be explained where an increase in government purchases will increase independent expenditure by an equal amount. However, reduction in taxes will increase autonomous expenditure by equal amount. If in case the economy is in recession, increase in government purchases and cut in taxes are helpful in stimulating more spending as well as eliminating recessionary gap.
There are two fiscal policy mechanisms which are discretionary fiscal policy and automatic fiscal policy. Discretionary fiscal policy is used to “fine tune” the economy along with some difficulties. Fine tuning refers to the use of fiscal (and monetary) policy to equalize all fluctuations in private sector’s spending to keep real GDP at or near its potential. According to Williamson (2010), the government can use this type of policy to shift AD curve to the right and close recessionary gap. Yet, many economists still argue that when a recessionary gap is large enough and persist in a long run, gross tuning might be suitable in order to stabilize the economy. Another mechanism policy is automatic stabilizer. Tax system is the most important automatic stabilizer. Personal income taxes vary directly amount with income and in fact, it can rise and fall by greater percentage itself. Big increases and decrease are both lessened by automatic changes in income tax receipts. Because incomes, earning and profits often fall during recession, the government collects less in taxes. These changes automatically can help to encounter business cycle fluctuations.

Government spending can be broken into several categories. Its expenditure consists of combined capital and current spending of federal government which includes debt interest payments to holders of government debt. Governments have responded by aiming to boost activity through two channels: An automatic stabilizers and fiscal stimulus that is either through new discretionary or tax cuts. Stabilizers will go into effect as tax revenues and expenditure levels change and do not depend on specific actions but operate in relation to the business cycle. An example can be taken when an output falls, the amount of taxes collected declines because corporate profits and taxpayers incomes fall.
The size of the government relates to the automatic stabilizer and it will become larger in advanced economies. When the stabilizers are larger, there may be less need for tax cuts, subsidies or public works programs since both approaches help to soften the effects of a downturn. As such, in current crisis, countries with larger stabilizers have tended to resort less to discretionary measures. Meanwhile, stimulus maybe difficult to design and implement effectively and difficult to reverse when conditions pick up. In many low income countries

According to Carlin & Soskice (2006), governments directly and indirectly influence the way resources are used in the economy. The basic equation of national income accounting helps show how this happens:
GDP = C + I + G + NX. On the left side is gross domestic product (GDP), where the value of all final goods and services produced in the economy. Meanwhile on the right side are the sources of aggregate spending or demand which are private consumption (C), private investment (I), purchases of goods and services by the government (G), and exports minus imports (net exports, NX). This equation makes it evident that governments affect economic activity (GDP), controlling G directly and influencing C, I, and NX indirectly, through changes in taxes, transfers, and spending.
Fiscal policy that increases aggregate demand directly through an increase in government spending is typically called expansionary or “loose.” By contrast, fiscal policy is often considered tight if it reduces demand via lower spending.
Understand that the government directly controls what they purchases, but they can also indirectly affect aggregate demand through taxes. For example, an increase in taxes or reduction in transfer payments can reduce disposable income and decrease consumer spending. Similarly, a decrease in taxes can increase disposable income which leads to an increase in consumer spending. The government can also influence investment spending through business taxes. The example from this can be taken when a tax cut for firms may increase investment spending and shift the AD curve to the right. Thus, the government can change AD in many ways.

The government can stimulate AD to reduce unemployment by using the Expansionary Fiscal Policy to close the recessionary gap. From Figure A on the right below, the initial equilibrium is at E1 which is a recession scenario, with real output below potential RGDP. Starts at this point and moving along the short run AS curve, and increase in government purchases would increase the size of budget deficit and lead to increase in AD, ideally from AD1 to AD2. The change occurred with result in increase in price level, from P1 to P2 while increase from RGDP to RGDP1. The recessionary gap is then closed. If change policy is the right magnitude and at an appropriate time, expansionary fiscal policy can pull the economy out from recession and encourage full employment.

Government purchase change may affect AD directly. Figure B below shows how government reduction of AD can reduce inflation. This is called Contractionary Fiscal Policy. Reduction in government purchases will shift AD curve leftward from AD1 to AD2. This will lowers the price level from P1 to P2 and brings back RGDP back to full employment level which results in new short and long run equilibrium at E2 and inflationary gap is closed.
In this section, I will further explain how taxes can help in developing better economic growth, boost employment and reduce inflation. According to McConnell (2008) & Brue (2008), a Benefit Received Principle can help to improve growth. This happens when the individuals receiving the benefits are those who pay for them. For instance for gasoline tax, the more a person drives on highway the more miles and more gasoline used and this means more taxes collected. This principle may work for some private goods, especially for those who pay for such public spending.

Based on the Wall Street Journal by Alan Auerbach (2005), a consumption tax could raise the same amount of revenue as the current tax system and increase GDP by 9% in the long run, as production increases with increased saving and capital formation. Tax consumption is based on amount earned means that public are taxed based on what they take out of the economy. Understand that consumers will not spend every penny of tax cut, but they will definitely save some of the cut and spend the rest. The lesser simulative power of tax cuts is explained by consumer saving.

As according to figure 1 below, tax cut is used to increase both consumption and saving (as per the Marginal Propensity Consume). Just a brief explanation of MPC, it is Hence, the initial spending injection is less than size of the tax cut. By contrast, every dollar of government purchases goes directly into the circular flow. But based on the figure below, it does not mean the AD can’t be closed with tax cut. It just means that desired tax cut must be larger than required stimulus.

Figure 1: The Tax Cut Multiplier

Based on the source from Time which was published in 2001 by Decision Economics, the cuts add up have increased the GDP from 1.8% in 2001 to 3.4% in 2002. Besides that, the data shows that unemployment rate have decreased from 5.0% to 4.9% in 2001 and 5.3% dropped to 5.0% in 2002. Tax cuts also has increased the personal spending from $6.45 to 6.48 (2001) and $6.6 to $6.7 in 2002. As a result this Bush tax cuts were a form of fiscal stimulus that boosted consumption, increased real Gross Domestic Product growth and reduced unemployment. Refer Figure 2 below for clearer data explanation.

Source: Time, May 28, 2001.

Although injections of government spending can close a GDP gap, increased purchases are not the only way to get there. The increased demand required to raise output and employment levels from Q1 to Q2 could emerge from increases in autonomous consumption or investment as well as from increased government spending. It could also come from abroad, in the form of increased demand for exports. In other words, big spender will help, whether from public sector or private sector.

3.0 Comparison between the two fiscal tools

The comparison of both government spending and tax cuts clearly defines their respective power. In 2.0 and 3.0, I have explained that a dollar of tax cuts is less simulative than a dollar of government purchases. This does not mean that tax cuts are undesirable, but they need to be larger that desired injection of spending. The news from Heritage Foundation (refer to references at last page for web page) indicates that 2001 tax cuts have boosted both consumer spending and as a result, real GDP growth.

There are some advantages of taxation in developing the economic. I understand that if there are no taxes, then government will not earn any income from taxation and civilians do not spend any time worrying about how to evade taxes. Government tax revenue does not necessarily increase as the tax rate increase. Working people will decide to work less if the tax rate increase and this results in productivity declines. Therefore, the higher tax rate, the more time people spend evading taxes and the less time they spend on more productive activity. So the lower the tax rate, the higher value and quality of goods produced.

Government expenditure occurred especially on civil administration, defence forces, public health and education, maintenance of government machinery. Most of the capital expenditure incurred on building durable assets such as highways, multipurpose dams, irrigation projects, purchasing machinery and equipment. These expenditures are expected to improve the productive capacity of Malaysian economy.
The impact of government expenditure plays huge role in improving the economy. Government spending may become a burden at some point, but as large as a government is, the more spending will boost economic growth in protecting property, developing infrastructure. In other words, government spending is necessary for the successful operation of the law rules.

4.0 Summary

Nearly every society in the world has been interested in major economic goals. One of it is to maintain the employment of human resources at high levels means that job opportunities are huge while financial suffering from lack of work and income is relatively uncommon. Another goal is to stabilize the prices at stable levels so that consumers and producers can make better decisions. As i have explained in the above comparison of both tools, fiscal policy contains many tools to managing aggregate demand. When the economy is in a slump, government can stimulate it by purchasing more and cut taxes. When the economy is overheat, government can reduce inflationary pressures by reducing its purchasing and raising taxes.