Public Expenditures and Fiscal Policy

“The only good budget is a balanced budget.”

(Adam Smith)

Structure of lecture

Public expenditures System of public budgets State budget Fiscal policy

Public expenditures

GovernmentExpenditures (G)

Transfers (Tr)

Public Expenditures

Private and Public sectors

Private sector

Public Sector

Consumption (C)

Investment (I)

Gov. Investment (IG)

Gov. consumption (CG)

G

Tr (Transfers)T (Taxes)

Public expenditures classificationPublic expenditures can be split into two

groups: Current expenditures for:

goods and services, interest payments, subsidies, transfers.

Capital expenditures.

Macro-economical aspects of public expenditures Public expenditures are important part of total

incomes and expenses. Public expenditures for goods and services

(G) = an important part of AD. Remember? AD (aggregate Demand)= Agg.Expenditure =C + IG + G + Xn

Trends of G influence employment and production in the economy.

G could work as multiplier▼ in fiscal policy.

Multiplier theory by Keynes in-short Each economic agent has marginal propensity to consume (MPC)

and to save (MPS). Say, Mr. Smith leaves 25% of income in a bar (MPC=0,25), so his MPS=0,75.

Let’s analyse what will happen to the money spent: (1)Mr. Smith’s extra income is 1000CZK

Mr. Smith spends 25% of 1000CZK (=250CZK) in a bar (2)Mr. Black (bar-keeper) receives extra income of 250CZK

Mr. Black spends 25% of 250CZK (=63 CZK) in a neighbour bar (3)Mr. White (neighbour-bar-keeper) receives extra 63CZK

Mr. White spends 25% of 63CZK (=16CZK) in another bar

… (10) Mr. Brown (a drug-store keeper) receives extra 0,005CZK for selling

medicine against all the above gentlemen’s hangover.

Total income generated: 1334,33 CZK

Multiplier theory by Keynes in-short The formula:

In our example:

Multiplier 1,33 means, that 1000CZK of money injection will lead to 1000*1,33=1330CZK of generated income.

So in the same manner the government uses Multiplier Effect to lead to the growth of national income and further growth of consumption, support producers, etc.

MPSMPCMultiplier

1

1

1

33,175,0

1

25,01

1

Multiplier

Empirical fact: Public budgets are growing

„The public sector grows with increasing income per capita“

Alfred Wagner (1835 – 1917)

Factors influencing growth of public expenditures

demographic factors: shift from self-sufficiency on farm with large family to urban mutual dependence, age structure changes, etc.

militant affairs, inflation trends (higher costs for goods and services), technological changes (increased labour productivity), production volumes growth – increase of incoming taxes, increasing consumption, political and social influences, etc.

Demographical factors: Population structure in the CR by age group and sex in 1930

85+80-8475-7970-7465-69

55-5950-5445-4940-4435-3930-3425-2920-2415-1910-145-90-4

200 400 600200400600Population (in 1930)

60-64

menwomen

menwomen

Population structure in the CR by age group and sex in 1990

85+80-8475-7970-7465-69

55-5950-5445-4940-4435-3930-3425-2920-2415-1910-145-90-4

200 400 600200400600Population (in 1990)

60-64

menwomen

menwomen

Size of the public sector as % of GDP

6 000 8 000 10 000 12 000 14 000

%

ITAL. RAK.

U.K.

FR.BELG. SRN

SVED.

USA

NOR.

JAP. AUST.

GDP/cap. USD

CAN.

System of public budgets

State budget, Local budgets (regional, municipal), Special centralized funds (i.e. in CR –

National Property Fund, Land Fund, Environmental Fund etc.)

State budget

Localbudget 1

Localbudget 2

Localbudget N

…

State budget Passes in a Parliament as a law.

The fact of approval law implies confidence in government and its policy.

Budget is being approved for a Fiscal year (= calendar year)

USA: September – September, Japan: March – March, UK: April –April.

Any budget has 2 parts: Revenue side Expenditure side

Income Expenditure

1. Taxes

2. Duties

3. …

100

25

1. Medicare

2. Military

3. ...

13

200

Income side of the State budget Direct taxes:

taxes on persons or property, individual income tax, employee social insurance tax, corporate tax, property tax,

Indirect taxes: taxes on events or transactions, employer payroll tax, sales tax (including excise and value-added).

Other incomes for state budget: Customs duties, loans from abroad, incomes from public offerings of state bonds

Indirect taxes► are imposed by the government on producers - but the burden of

the tax can be passed onto consumers.

Indirect taxes can either be specified as value tax (i.e. as a percentage of the price of a good), as a unit tax (i.e. as a price per unit or per amount).

Indirect taxes consequences: increase in prices, limitation of final consumption.

Indirect taxes are better managed than direct taxes. Trend in many countries: from direct to indirect taxes.

One of the main indirect taxes – value added tax (VAT).

Principles of taxation

Fairness, efficiency, purpose. The benefits principle is the idea that people should pay taxes

based on the benefits they receive from government services. (I.e. gasoline tax: revenues from a gasoline tax are used to finance the highway system).

The ability-to-pay principle is the idea that taxes should be levied on a person according to how well that person can shoulder the burden: Vertical equity (progressive and regressive system). Horizontal equity (equal conditions).

State budget expenditures► are the transfers and purchases of goods and services.Transfers = financial flows from state budget to individual

subjects (firms and households). Transfers to households: Social insurance, childern

allowances, unemployment allowances etc. Transfers to firms: Capital and non-capital subsidies.Govermental purchases of goods and services: capital and

non-capital.

Interes t expenditure; 34; 3%

Subs idies ; 59; 5%Capital form ation;

138; 11%

Other; 45; 4%

Collective consum ption; 311;

25%

Social trans fers ; 639; 52%

State budget expenditures items by cascade

1. social expenditures

2. education

3. administration (civil service)

4. highway

5. local governments

6. defence expenditures

7. security

8. housing

9. health service

10. support of agriculture and forest

11. personal railage

12. governmental reserve

13. culture

14. subsidies on heating

State budget: Result of the fiscal year Balanced budget Surplus budget Deficit budget

Example: CZ budget for 2004

Components Year 2004Total revenue 1145

Total expenditure 1228

Deficit -83

Deficit budget

Two types of deficits exist: Cyclical deficit – related to the business cycle. Structural (active) deficit – related to the measures of the

economic policy (taxation, volume of expenditures…).

State budget deficit compensation measures: State bonds sale, Loans from abroad.

Historical Developments which changed the Role of Fiscal Policy

Development stages that bolstered the use of fiscal policy

Influence of the General Theory by John Maynard Keynes.

World War II--Evidence of positive effects of increased aggregate demand.

Fiscal Policy: Objectives and Tools  Main objectives:

Balancing the budget (Pre-Great Depression) Promoting full employment with price stability

(Post Keynes and WWII) Eliminating critical points of economic cycles Economical growth promotion

General tools: Discretionary Fiscal Policy Automatic Stabilizers

Expansive or Restrictive?

Expansive Fiscal policy – supports Aggregate Demand growth and therefore the growth of total output.

Restrictive Fiscal policy – is aimed to lessen the inflation rate by the means of limiting both the Aggregate demand and supply.

1. Tools of Discretionary Fiscal Policy General tools:

Government purchases Transfer payments Taxes and Borrowing

Given a price level, what changes will increase the level of real GDP? Other things being equal.

An increase in government purchases? An increase in transfer payments?

Fiscal Policy basics

AD = C + I + G + (Ex-Im)Fiscal policy points of AD influence:

G … governmental expenditures, T … net taxes (they influence C).

Fiscal expansion – supporting the Aggregate Demand growth. directly – by increasing G, indirectly – by increasing C (lessen the tax burden).

The main issue of the expansive fiscal policy implementing is the budget deficit.

The same instruments are used by restrictive fiscal policy.

How does an increase in government purchases increase real GDP? The Multiplier Effect in action

►The government increases its purchases. The aggregate expenditure function shifts up.

► Increased government purchases increase real GDP. ► Increased real GDP increases disposable income. ► Increased disposable income increases consumption

(According to the marginal propensity to consume).► Increased consumption increases real GDP (The cycle

continues).

How does expansionary fiscal policy actually work?

► Shifts the AD curve up and to the right.

► At the given price level P1, demand exceeds supply. Excess quantity demanded forces the price level to rise.

► As the price level rises, producers will produce more and consumers will demand less - quantity supplied increases, quantity demanded decreases

► Price level rises until QD3 = QS3

► Output equals potential level and economy is at both short-run and long-run equilibrium

Q

P

AS1

AD1

AD2

P2

P1

QD1 QD2QD3

2. Automatic Stabilizers

Automatic Stabilizers stimulate AD during periods of recession and dampen AD during periods of expansion.

They do not require yearly congressional action to operate.

Examples of automatic stabilizers: progressive income tax with its increasing marginal income

tax rates, unemployment insurance, welfare spending.

Concerns about effectiveness of Fiscal Policy1. Stagflation Situation: Economy is characterized by high inflation and high

unemployment rates that resulted from a decrease in aggregate supply.

Question: Why Was Fiscal Policy Not an Option in Eliminating Stagflation? An increase in aggregate demand (Expansionary fiscal

policy) would force inflation. A decrease in aggregate demand (Contractionary fiscal

policy) would force unemployment.

2. The difficulty of estimating the natural rate of unemployment

Concerns about effectiveness of Fiscal Policy3. The time lags involved in implementing fiscal policy may

weaken fiscal policy as a tool of economic stabilization. In the case of an oncoming recession, it may take time to recognize the coming recession, implement the policy and let the policy have its impact.

4. Both automatic stabilizers and discretionary fiscal policy may affect individual incentives to work, spend, save and invest. Examples: effect of unemployment benefits on job search, effect of changes in income taxes on labor supply, effects of tax incentives on the types of investments.