Fiscal policy

Overview

Fiscal policy is necessarily concerned with the provision and financing of those public goods and services that have to be collectively funded because they cannot be provided by the market; and it may also be concerned with the provision of other goods and services for which collective funding is deemed to offer advantages over provision by the market. It is not normally concerned with procurement decisions such as the decision whether to obtain goods or services from the public sector or from the private sector. Fiscal policy decisions may be expected to affect the interpersonal distribution of human welfare, and may be tailored to that purpose. They may also be expected to influence social and personal behaviour, and may be tailored to the purpose of promoting the growth of social capital and the purpose of encouraging personal behaviour that is deemed to be beneficial and of discouraging such behaviour that is deemed to be harmful. Fiscal policy may also be expected to affect economic activity, and its decisions may be concerned with the promotion of economic efficiency, economic growth or economic stability.

Policy objectives

The fiscal policy objectives adopted by governments may be influenced by their political views in two major respects. Ideology may influence the importance attributed to welfare-promoting measures which account for the majority of public expenditure and for which there is no expectation of financial return. Ideology may also influence choices concerning the proportion of public expenditure to be paid for by taxation. There have been occasions when political ideology has also determined attitudes to the use of fiscal policy to stabilise the economy, but in most countries there is now something approaching an ideological consensus on that question.

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. There has also been widespread ideological attachment to fiscal conservatism, which favours the statutory limitation or prohibition of budget deficits - especially in the United States, where it has often been associated with libertarianism.

There was a period following the second world war when discretionary fiscal policy was widely used for the purpose of stabilising the economy, but there is now a widespread consensus in favour of the use of monetary policy for that purpose and for using fiscal policy only as a last-resort response to cataclysmic shocks such as wars and economic depressions,

Policy constraints

Fiscal sustainability

Fiscal policy is necessarily constrained by the consideration that if a budget deficit were to be repeated year after year, a point would eventually be reached at which more money would be required for repayment of the accumulated national debt than could conceivably be raised by taxation. 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 substantially exceeded the value of its annual output - but had then been repaid from budget surpluses over a further series of years. However, the 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 its repayment. It is demonstrated on the tutorials subpage of this article that the average level of surplus required, when expressed as fraction of the national debt that has been accumulated, has to amount to a percentage of gdp at least equal to the difference between the interest rate payable and the gdp growth rate. An unstable situation can arise, however, if investors in the debt repeatedly demand increased interest rates to compensate for what they perceive to be a risk that it may never be repaid - and for that reason, the maintenance of investor confidence is a further condition for fiscal sustainability.

Deficit-limiting rules

Overview

National legislatures have sometimes sought to impose arbitrary limits upon government borrowing. Members of the United States Congress have attempted to introduce "balanced budget amendments" that would have the effect of putting a stop to all borrowing, and similar or less stringent have limits have been proposed elsewhere. Those proposals have usually been successfully resisted, but some governments have adopted self-imposed limits in order to promote investor confidence in the integrity of their bonds. Among developing countries, the development of international capital mobility has made the maintenance of investor confidence a policy imperative because panics among investors and anticipations of default by speculators have been a common cause of sovereign default - as explained by Paul Krugman . Paul Krugman explains the International Monetary Fund's apparently perverse interpretation of the Washington Consensus as requiring the avoidance of deficits, even in periods of recession as a confidence-building tactic.

The maintenance of investor confidence is a matter of mutual concern among governments because crises that can lead to sovereign defaults can be contagious, in much the same way that bank runs can generate banking panics. That consideration has prompted currency unions such as the European Monetary Union to set up deficit-limiting rules and monitoring systems.

The UK's Code for Fiscal Stability

In November 1997 the British government announced its adoption of two rules of fiscal conduct:

- a "golden rule":that over the economic cycle, the government would only borrow to invest and not for public consumption, and

- a "sustainable investment rule": that over the economic cycle, the government would ensure the level of public debt as a proportion of national income is held at a stable and prudent level (subsequently interpreted as 40 per cent of gdp);

and an analysis published by the Treasury in 2008 concluded that:

- the average surplus on the current budget over the previous economic cycle was positive, thus meeting the golden rule; and,

- public sector net debt remained below the 40 per cent of GDP limit of the sustainable investment rule over the cycle.

But in November 2008 the government announced the replacement of those rules by a "temporary operating rule" under which it would set policies to improve the cyclically adjusted current budget each year, once the economy emerges from the downturn, so that it would reach balance with debt falling as a proportion of GDP once the global shocks had worked their way through the economy in full.

The EU's Stability and Growth Pact

The Stability and Growth Pact that was introduced as part of the Maastricht Treaty in 1992, set arbitrary limits upon member countries' budget deficits and levels of national debt at 3 per cent and 60 per cent of gdp respectively. Following multiple breaches of those limits, the pact has since been renegotiated to introduce the flexibility necessary to take account of changing economic conditions. Revisions introduced in 2005 relaxed the pact's enforcement procedures by introducing "medium-term budgetary objectives" that are differentiated across countries and can be revised when a major structural reform is implemented; and by providing for abrogation of the procedures during periods of low or negative economic growth .