Fiscal Policy

Fiscal Policy
Most people nowadays seem to think that fiscal policy cannot be used to influence economic activity, and they are supported in this view by the majority of professional macroeconomists. Students are taught that output and employment are determined by the demands and supplies of individuals interacting in a gigantic market and that governments cannot alter the outcome of this process except temporarily and destructively. The Congressional Budget Office (cbo) bases its projections of the federal budget on assumptions about output that are largely independent of fiscal policy. An increase in federal expenditure, the cbo assumes, will have no positive effect at all on real output; rather, it will have a negative effect, since it may cause a rise in interest rates and thus a fall in private, interest-sensitive spending. More generally, there is a public perception that a budget deficit is just a way for the present generation to steal from the next. As a leading politician recently put it, ?The deficit is a big black dog eating the luncheon packets of our children.?
This article argues that an expansionary fiscal policy is a necessary condition for growth in the long term, reasserting an old Keynesian principle that sustained expansion requires continuously growing exogenous injections to the flow of income. It is true that the present expansion, which has now lasted for more than six years, has been accompanied by a tightening of the fiscal stance, but this has been possible only because there has simultaneously been a long and sustained expansion of private expenditure financed by borrowing. The article concludes that the expansion of net lending cannot continue for much longer without making debt-income levels impossibly high; therefore, in contradiction to the political consensus of the moment, fiscal policy will have to be expanded substantially and progressively compared with what the cbo is now projecting if a prolonged recession is to be avoided.

The Theory Behind It

We assume that an addition to government expenditure increases the gross domestic product (gdp) directly while a cut in the tax rate adds to private disposable income, thereby increasing gdp indirectly. We maintain that the overall impact of the government?s fiscal operations on the economy can be measured by combining these two policy instruments into a single constructed variable ? the total flow of government expenditure divided by the average tax rate, which we call ?the fiscal stance,? the definition of which implies that it would exactly equal gdp if the budget were balanced.(1) The budget deficit, measured ex-post facto, is a bad measure of the impact of fiscal policy because it notoriously fails to distinguish the effect of the budget on the economy from the effect of the economy on the budget.

This concept of fiscal stance is not new. It is thirty years since Carl Christ, of Johns Hopkins University, had the brilliant insight that should an economy ever reach stationary equilibrium, all stock variables as well as all flow variables would be constant; and that if all stock variables, including government debt, were constant, government receipts would have to equal government payments. It would then follow that if the economy were moving toward stock-flow equilibrium and if taxes were levied as a proportion of income, the gdp of a (closed) economy would always be tracking, perhaps with a long lag, government outlays divided by the average tax rate ? the very same concept that we call fiscal stance. Therefore, a necessary condition for the expansion of the economy, at least in the long term, is that the fiscal stance should rise: Government expenditure must rise relative to the average tax rate. If the tax rate were held constant, government expenditure would have to rise absolutely for output to grow; if government expenditure were held constant, the tax rate would have to fall.

Fiscal Policy 8.9 of 10 on the basis of 3924 Review.