Fiscal policy

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Supplements to this article include:  notes on   fiscal stability   and  British and European deficit-limiting rules ,  and   a breakdown of a typical European fiscal stance .

Fiscal policy encompasses public expenditure, taxation and borrowing. Its essential function is the provision of public goods and services. It is also used to influence social conduct and the distribution of wealth, and to promote the growth and stability of economic activity. It can require a compromise between the objective of maintaining investor confidence in the government's bond issue and the longer term objective of preserving and developing the country's economic infrastructure, its human capital and its social capital.

Introduction: the fiscal stance

A government's fiscal stance is the outcome of multiple choices concerning public expenditure and taxation including, in particular, the choice of the fiscal balance, which is the choice that has to be made between financing expenditure by taxation and financing it by borrowing. The fiscal balance choice is concerned with the resolution of the sometimes conflicting objectives of financial stability and economic growth known as the fiscal dilemma.

Among the other choices, the distinction between the pursuit of social and economic objectives is to some extent arbitrary because both are concerned with the allocation of resources for the benefit of the community. Some distinctions are nevertheless essential to an understanding of the options among which choices have to be made. They include:

The variations of fiscal stance that occur over time and between countries are reflections of the fact that they are the outcome, not of single unlimited choices, but of successive incremental choices made within different financial and political constraints.

Policy choices

Structural policy choices

The criterion of fiscal policy choice by a representative government may be presumed to be the expectation of net benefit to the community (although, under a democracy, a dilemma can arise if the majority of voters demand a choice that they mistakenly believe to be beneficial). It is implicit in that criterion that fiscal policy may be employed only if it can be expected to provide a greater net benefit than could be expected from the operation of the market. The obligation to meet that criterion - either by cost-benefit analysis or by informed judgement - applies even to the politically essential items of law and defence. Except in wartime, however, expenditure on those items seldom exceeds 10 percent of national income (see table), and the bulk of expenditure has been devoted to other social welfare objectives. Perceptions of the benefits from such expenditure have been influenced by a range of conflicting concepts of social justice, and there are large international differences in policy, especially in the treatment of income inequality. Social welfare objectives account for most of the expenditure on health, housing, education and social security which in many industrialised countries, cost over 20 per cent of national income , and most of which involve a significant element of redistribution.

Some of the fiscal policy measures that have been attributed to social welfare objectives may also be expected to contribute to supply-side objectives. Studies have shown that several components of social capital and human capital , including education and the maintenance of law, make significant indirect contributions to economic growth[1][2]. The evidence concerning the effect of reducing inequality is mixed, but suggests, on balance, that it tends to increase growth [3]. Policy measures concerned with other supply-side objectives account for a relatively small proportion of national income.

Countercyclical policy choices

According to Keynesian theory, fiscal policy choices concerning the burden of personal and corporate income tax have a major influence upon economic stability because the revenue from such taxes falls when the economy encounters a shock, and that provides a countercyclical fiscal stimulus. The larger is the burden of those taxes and the higher are their marginal tax rates, the greater will be their countercyclical influence. A further, and often smaller, contribution to stability arises from the provision of income support such as unemployment benefit, the expenditure on which rises during a downturn, adding further to the fiscal stimulus. Those two effects are termed automatic stabilisers, and it has been estimated that together they can stabilise the economy to the extent of absorbing 38 per cent of most shocks to the economy in the case of the European Union, and 32 per cent in the case of the United States [4].

It is open to policy-makers to augment the countercyclical effect of the automatic stabilisers with a discretionary fiscal stimulus. Discretionary fiscal policy figured prominantly in economic management in the post war 20th century until the 1980s. A consensus then developed in favour of using monetary policy for countercyclical purposes, and little use was made of countercyclical fiscal action until the crash of 2008, in the aftermath of which there was a general acceptance by the governments of the Group of Twenty industrialised countries of the need to use fiscal policy to augment monetary expansion.

An increase in a country's budget deficit is implicit in countercyclical fiscal action, and in many countries major public debt increases - due mainly to the operation of the automatic stabilisers - occurred in the course of the Great Recession.

Fiscal consolidation

Fiscal policy following a recession is often devoted to the reduction of recession-induced budget deficits. The purpose of such fiscal consolidation is to maintain investors' confidence in the country's fiscal sustainability and thus to avoid having to pay a risk premium on top of the normal rate of interest on further bond issues. The advantage of meeting that purpose may be partially or fully offset by losses of national output brought about by the tax increases and public expenditure reductions needed to reduce the deficit. The intended deficit reduction may also be partially or fully offset by reductions in tax revenue and increases in social security payments brought about by the operation of the economy's automatic stabilisers. The extent of those offsets depend upon the current size of the fiscal multiplier and the intended rate of fiscal consolidation.

Policy constraints

Financial constraints

Fiscal policy is necessarily constrained by the consideration that. if the annual interest payments on the public debt continue to rise faster than the national income, they will eventually exceed the feasible revenue from taxation - a situation that has been termed the debt trap. The need to avoid such an outcome does not, however, place an absolute limit upon the budget deficit in any particular year. In fact there have been instances when a country's budget deficits had continued until its national debt had exceeded double the value of its annual output[5] - but had then been repaid from budget surpluses over a further series of years. However, the larger is the accumulated debt and the greater the interest rate that has to be paid on it, the larger will be the budget surpluses required for fiscal sustainability, and those factors are subject to fiscal influences. Moreover, an unstable situation can arise if investors lose confidence in the issuer of the debt and demand increased interest rates to compensate for what they perceive to be a risk that it may not be repaid (a condition that is termed sovereign default). Once started, that can lead to a herding panic similar to a run on a bank. For that reason, the maintenance of investor confidence is a condition for fiscal sustainability that can outweigh more objective considerations.

Policy concerning the rate of fiscal consolidation is necessarily constrained by the need to avoid the self-defeating outcome that would occur if the intended consolidation were offset by deficit increases brought about by the economy's automatic stabilisers

Several countries have adopted fiscal rules[6] in order to promote investor confidence in the integrity of their bonds [7]. Examples include the European Union's Stability and Growth Pact, its proposed Fiscal Compact and the United Kingdom's Code for Fiscal Stability. Their credibility is limited, however, by investor awareness of the time inconsistency problem that suggests that they may be relaxed if they come under pressure. The appointment of independent fiscal agencies has been put forward as a solution to that problem.

The concept of a structural deficit is often used in connection with fiscal stability, but its estimation requires the exercise of judgement to distinguish between government expenditure that increases the long-term national debt, and that which is self-financing in the long term[8].

Political constraints

Ideological attitudes to welfare-promoting measures have ranged from socialism which is the advocacy of public control of all forms of socially-important expenditure to libertarianism which is opposed to any public expenditure that is not necessary for the maintenance of law and order or national defence.

Ideology may also have influenced attitudes to debt and for the extent to which public expenditure has been constrained by arbitrary limits on borrowing. Some communities have sought the statutory prohibition of all budget deficits - especially in the United States, where it has often been associated with libertarianism - and others have sought to impose arbitrary limits upon the level of government borrowing. Members of the United States Congress have several times attempted to introduce "balanced budget amendments" that would have the effect of putting a stop to all borrowing - and similar, or less stringent, limits have been proposed elsewhere. Those proposals have usually been successfully resisted, but popular fears that debt might somehow get out of control have continued to exert a political influence.

Policy trends

There have been substantial increases in the burden of taxation as a share of GDP in the OECD countries since the 1970s, and in composition of taxation, with substantial reductions in the shares of consumption taxes and personal income tax in tax revenues, being offset by increases in the shares of corporate income tax and social security contributions. Corporate income tax rates and the higher rates of personal income tax have generally been reduced. Further trends during the second decade of the 21st century are expected to be influenced on the one hand by the need to maintain the confidence of voters and investors, and on the other, to avoid economically damaging and politically unpopular public service cuts and tax increases.

Notes and references

  1. Robert Barro: Determinants of Economic Growth: A Cross-Country Empirical Study, (Lionel Robbins Lectures) MIT Press, 1997
  2. Rob A. Wilson and Geoff Briscoe: The Impact of Human Capital on Economic Growth: a review., Office for Official Publications of the European Communities, 2004
  3. Elhanan Helpman: The Mystery of Economic Growth, Chapter 6 "Inequality", Harvard University Press
  4. Mathias Dolls, Clemens Fuest, and Andreas Peichl: Automatic Stabilizers and Economic Crisis: US vs. Europe, CESifo Working Paper Series No. 2878, December 2009
  5. Tom Clark and Andrew Dilnot Measuring the UK Fiscal Stance since the Second World War, Fig 3, page 5, Institute of Fiscal Studies,2002
  6. Numerical fiscal rules in the EU Member States, European Commission
  7. Fiscal Rules—Anchoring Expectations for Sustainable Public Finances, International Monetary Fund, December 16, 2009
  8. The measurement problems that also have to be tackled have been described in an IMF staff note by Daniel Kanda [1]