Home > CFA Level 1 > Fiscal policy tools and their advantages/disadvantages

Tools available with governments in implementing fiscal policy include government spending and taxes.

## Government spending

Government spending has different forms including transfer payments, current government spending, and capital expenditure. Transfer payments are welfare payments made by the government to provide a basic income level to low-income households. They may be used to redistribute income in an economy. However, they are not part of the government expenditure component of GDP. Current government spending refers to expenditure on providing regular recurring goods and services such as healthcare, education, etc. Capital expenditures are expenditures on infrastructure and physical capital.

Purpose of government spending include (a) provision of services, such as defense which benefits all citizens equally, (b) create infrastructure necessary for growth, (c) guarantee minimum income by redistributing income and wealth, (d) achieve objectives of sustainable growth and low inflation, and (e) subsidize high-risk innovation.

## Taxation

Government revenues are mainly in the form of direct and indirect taxes. Direct taxes include personal income tax, social insurance tax, corporate tax, capital gains tax, property tax, inheritance tax, etc. Indirect taxes are taxes levied on consumption, such as sales tax, value-added tax. These may have social and environmental considerations.

## Principles of tax policy

Economists believe that tax policy should have the following attributes:

• Simplicity, which means that the final liability should be certain, and compliance should be easy.
• Efficiency, which means that taxation should interfere as little as possible with the choice consumers make. While most economists accept a limited role for taxation in guiding consumer choices, some argue that governments are ill-equipped to decide on objectives.
• Fairness, which means that people in similar situations should pay the same tax (horizontal equity), and that richer people should pay more taxes (vertical equity).
• Revenue sufficiency, which means that revenue should be sufficient, but it may conflict with the objectives of efficiency and fairness.

Indirect taxes can be adjusted as soon as they are announced, and they affect consumer behavior and increase government revenue almost immediately. Similarly, social policies can be changed almost instantly.

Direct taxes and transfer payments can be changed only when a considerable notice is given because individuals and companies need to adjust for the changes. However, the announcement itself may have an effect. Similarly, government spending has a large time lag, i.e. it takes a lot of time in approving and formulating capital spending plans.

Government spending has a bigger impact on aggregate demand than tax cuts. However, if the tax cuts are directed at the poorest of society, those who spend all their income, they are far more effective.

An assessment of whether the fiscal policy tools will be effective can be carried out using the multiplier effect.

## The fiscal multiplier

The fiscal multiplier is the ratio of change in equilibrium output to an exogenous change in spending. When government spending changes by $1, consumers consume an amount c, called the marginal propensity to consume, and saving an amount equal to 1 – c, which is called marginal propensity to consume. The amount c spent by consumers become incomes of some other agents who consume (1 – c)c and save the rest. This way, just like the process of money creation, the initial stimulus of$1 increases total income/output by 1/(1 – c). This is called the multiplier effect. The calculation of multiplier ignores any changes in prices.

Since the household income also depends on taxes, a more comprehensive multiplier also includes the effect of taxes. Disposable income equals (1 – t) × Y, where t is the net tax rate and Y is total income. Hence, a \$1 increase in government spending G would increase disposable income by (1 – t) and if the marginal propensity to consume is c, the change in consumption would be c × (1 – t). Hence, we define fiscal multiplier as per the following expression:

$Fiscal\ Multiplier=\frac{1}{1-c\times(1-t)}$

## Balanced budget multiplier

When a government increases its spending and finance it with an equivalent amount of taxes, it still has a multiplier effect called the balanced budget multiplier. It occurs because when the marginal propensity to consume is less than one, any decrease in disposable income due to higher taxes reduces spending by a lower amount.

However, when a government decreases taxes and increases its deficit, according to the Ricardian equivalence, if people recognize that the government must raise taxes in the future to finance the deficit and they would save for that increased tax. Hence, there would be no change in consumption due to tax cuts.