Fiscal Policy

1. Fiscal Policy • How it works? • What are the goals of fiscal policy? • What are the limitations of fiscal policy? • How does fiscal policy affect aggregate supply? • What is budget deficit? • Does budget deficit matters?

2. Macroeconomics Objectives Recap Low inflation to keep value of money under control Low unemployment to make full use of country’s resources Macroeconomics Objectives A sound balance of payment for exports & imports A good rate of growth to raise standard of living

3. Increase AS Influence AD Policies Supply-side Demand - management Fiscal Policy Monetary Policy

4. What is fiscal policy? Fiscal policy involves using government expenditure (G) and tax policy (T) to influence the level and growth of aggregate demand, output and employment. Also: budgetary policy

5. Government expenditure Tools of fiscal policy Government Taxes

6. Where does the government get the money to spend? What does the government spend on?

7. Current (ordinary) Expenditure incurred in daily routine work & is recurrent year after year.Examples: salaries of the policeforce & teachers Government Expenditure Capital (development) expenditure expenditure for the purpose of economic and social development. Examples: government spending on ports and schools

8. Government Expenditure How is it financed? Direct Taxes - on incomes and wealth of individuals or firmseg. income tax, corporate tax Tax Revenue Indirect taxes: on gds & services part of payment for g&s eg. GST, excise duties on alcohol & tobacco Major source of government revenue

9. Government Expenditure How is it financed? Tax Revenue Other Receipts Major source of government revenue • rents from govt. properties • profits of nationalised industries

10. Objectives of fiscal policy Short run stabilisation Long run growth Low inflation Low uN+ Output growth Shaping the supply-side of economy keep the economy as close as possible to its long-term trend rate of potential growth

11. What’s the problem with Japan? The Japanese economy has officially gone back into recession for the fourth time in a decade. Gross domestic product fell by 0.1% in the last three months of 2004.The fall reflects weak exports and a slowdown in consumer spending, and follows similar falls in GDP in the two previous quarters…. …. Japanese unemployment has climbed ever higher. Slack demand is forcing the closure of thousands of small and medium size businesses every month…… (BBC News, Feb 2005) 2 consecutive quarters of negative growth Cyclical unemployment

12. Recession & cyclical unemployment During recession (NY falling, cyclical uN+ rising) govt must stimulate / curb spending;  expansionary/contractionary FP 1. _____ govt expenditure (G) 2. _____ taxes; Cut income tax  _____ disposable Y  ___ C Cut corporate tax  investment more profitable  ___ I Effect on AD [= C + I + G + X -M] Increase in _____  raise AD Macroeconomic goals Raise AD  _____ NY via multiplier process, stimulate output growth & reduce cyclical uN+ raise cut

13. Recession & cyclical unemployment During recession (NY falling, cyclical uN+ rising) govt must stimulate / curb spending;  expansionary/contractionary FP 1. _____ govt expenditure (G) 2. _____ taxes; Cut income tax  more disposable Y  ↑ C Cut corporate tax  investment more profitable  ↑ I Effect on AD [= C + I + G + X -M] Increase in G, C, I  raise AD Macroeconomic goals Raise AD  increase NY via multiplier process, stimulate output growth & reduce cyclical uN+ raise cut

14. Price Level AS Pe AD AD1 Ye Ye1 National Income / National Output Expansionary FP

15. What do you think? Question: An increase in G will raise the level of AD. A reduction in T will also raise the level of AD. BUT are they equally effective? Answer: An increase in G will have greater effect on AD than a similar-sized reduction in T.

16. Comparing G v.s. T AD = C + I + G + (X-M) Increase in G by $100m AD will also increase by $100m, ceteris paribus

17. Comparing G v.s. T AD = C + I +G + (X-M) AD only increases by $70m Increase consumption by $70m Increase disposable income by $100m The other $30m is saved Reduction in T by $100m

18. How effective is expansionary FP? • Crowding out effect Excessive borrowing  high interest rates  crowding out effect on private investment AD does not increase by the full amount of G

19. Limitations of expansionary FP recognition lag implementation lag impact lag • Time lag

20. Limitations of expansionary FP • Low multiplier values Size of multiplier difficult to predict; depends on response of economy to the change in policy For eg. if the government reduces taxation  consumers regard this as a temporary measure, likely to be reversed in the near future  they may well decide to save any increase in their disposable income (reminder: size of multiplier depends on MPW)  limiting the impact of the tax cut.

21. What is India’s problem? India's finance minister Palaniappan Chidambaram added on Friday that it was "inevitable" that inflation would rise to about 5%. Separate economic figures also showed continued strength in India's industrial sector, with output growing 7.3% in September from a year ago. "Industry is clearly showing sustained resurgence," SP Prabhu of IDBI Capital Market Services in Mumbai told the Reuters news agency. "Certainly, as industry and GDP expand, concerns of demand-pull inflation getting in will rise." (BBC News, Nov 2005)

22. Demand-pull inflation During periods of inflation  govt must stimulate / curb spending;  expansionary/contractionary FP 1. _____ govt expenditure (G) 2. _____ taxes; Raise income tax  _____ disposable Y  ___ C Raise corporate tax  investment ___ profitable  ___ I Effect on AD [= C + I + G + X -M] Decrease in _____  reduce AD Macroeconomic goals Reduce AD  reduce dd-pull inflation cut raise

23. Demand-pull inflation Draw the diagram to show how contractionary FP can reduce dd- pull inflation During periods of inflation  govt must stimulate / curb spending;  expansionary/contractionary FP 1. _____ govt expenditure (G) 2. _____ taxes; Raise income tax  _less____ disposable Y  ___ C Raise corporate tax  investment less profitable  ___ I Effect on AD [= C + I + G + X -M] Decrease in _C, I, G____  reduce AD Macroeconomic goals Reduce AD  reduce dd-pull inflation cut raise

24. Price Level AS Pe1 Pe AD AD1 National Income / National Output Contractionary FP

25. Limitations of contractionary FP • Time lag • Inflexible nature of G in the short run G is geared to important social & political pogrammes. Eg. costly or difficult to postpone public projects like road construction once the work is begun.

26. Limitations of contractionary FP • Time lag • Inflexible nature of G in the short run • High taxes create disincentive effects on desire to work, save and invest

27. Reflect

28. Fiscal Policy Objectives Tools

29. Expansionary FP Contractionary FP Limitations of Fiscal Policy

30. How can government fiscal policy affect the aggregate supply of an economy?

31. 1st Example of Sg Fiscal Policy A CUT in Singapore's corporate tax rate at the upcoming Feb 15 Budget may well be just the first of more to come in the next few years. Economists and tax experts say the Government may set a longer-term target to further reduce taxes on businesses to ensure that the country remains competitive in the global race for investment dollars. Budget watchers say a cut in corporate taxes will help Singapore remain an attractive location for foreign investments while helping businesses here to cope with rising costs. (ST, Jan 07)

32. 2nd Example of Sg Fiscal Policy SCHOOLS will get a grant of up to $150,000 to help needy students have an equal shot at educational and enrichment opportunities, with neighbourhood schools getting the lion's share. The money will come from Opportunity Funds that the Ministry of Education (MOE) will create at every school. Students from low-income families can tap these funds to subsidise the cost of enrichment programmes or other schemes that will expand their learning and broaden their horizons, said Prime Minister Lee Hsien Loong. The Government will spend $50 million on this initiative. (ST Feb’06)

33. 3rd Example of Sg Fiscal Policy MORE Workfare bonuses will be given out to lower- income Singaporeans to tilt the balance in their favour, pledged Prime Minister Lee Hsien Loong yesterday. For the poor, three areas will get a shot of financial adrenaline from the Government: education, housing and Workfare. Workfare will become more than a one-off measure. The scheme, which rewards workers for staying employed, will make regular appearances in the future - in different forms and mechanisms. Essentially, it will deliver money to the lower-income group, provided they work, in two forms: cash and into their CPF accounts. (ST Nov’06)

34. Fiscal policy & Aggregate Supply LT growth Eg 1. Govt increases expenditure on items like • infrastructure development • human resource training • improvement in productivity, ability to move up value chain • sustained growth in the LR

35. Fiscal policy & Aggregate Supply LT growth Eg 2. Tax reforms Govt cuts corporate & income tax • attract higher level of investment from domestic & foreign firms • improve incentives for people to seek work & boost labour productivity Overall: expansion of productive capacity & LR economic growth

36. Fiscal policy & Aggregate Supply LT growth Eg 3. Tax Credits • encourage increase in business research & development Overall: expansion of productive capacity & LR economic growth Draw a diagram to show how fiscal policy leads to LR economic growth.

37. AS1 P AD Yf Yf1 Aggregate Supply Price Level AS National Income / National Output

38. US in the headlines The US will be in the red by almost half a trillion dollars next year – but will the growing budget deficit harm the economy? (BBC, Feb’04)

39. 1. What is budget deficit? 2. Does budget deficit matter? The US will be in the red by almost half a trillion dollars next year - but will the growing budget deficit harm the economy?(BBC, Feb’04) The non-partisan Congressional Budget Office says the US government will run up a budget deficit of nearly $500bn in 2004 - a figure likely to be confirmed by the Bush administration when it reveals its budget forecast on Monday. It is the largest in US history in absolute terms, and, at 5% of GDP, the largest since 1993 as a percentage of the economy. And within the space of a few years, a projected surplus over ten years of $5.6 trillion has turned into a deficit for the same period of $1.4 trillion. The budget deficit is equal to $1,600 per US citizen this year, and the accumulated deficit over ten years would be nearly $20,000 per person.

40. What is the government budget? • Govt budget = Govt receipts – Govt expenditure • Budget deficit = Govt receipts < Govt expenditure • Budget surplus = Govt receipts > Govt expenditure

41. Does Budget Deficit matter? Internal: • Higher interest rates Why? • Government borrows money to finance or pay for the deficit • competing with firms for funds  higher i/r • Crowding out private investments detrimental to ctry’s econ growth in long run

42. Does budget deficit matter? Empirical Evidence ……large budget deficits take a substantial proportion of America's savings, preventing it being put to more productive use in the private sector, which should be buying new equipment, developing new technologies, and retraining the workforce. ……… the Reagan years (1981-5) of high budget deficits, when net investment fell to historic lows and the standard of living and real wages of the typical American family stagnated…… (BBC, Feb’04) Internal: • Higher interest rates Why? • Government borrows money to finance or pay for the deficit • competing with firms for funds  higher i/r • Crowding out private investments detrimental to ctry’s econ growth in long run

43. Does Budget Deficit matter? External: • SR capital account (KA) surplus • LR current account (CA) deficit Why? • High i/r attracts inflow of hot money  KA surplus • Large inflows of hot money can cause the dollar to appreciate  exports decreases as ctry loses its export competitiveness while imports rises  CA deficit

44. Now that you have learnt about fiscal policy and government budget, • If YOU were the Finance Minister, what would you do? • What do you think Sg’s future budget would be like? • Read the following slides & proceed to be the Finance Minister!

45. What of Sg’s future budget? WITH public spending projected to go up and pressure on the Government to keep direct taxes low, what new sources of revenue can it hope to mine? Will it be left with one option whenever spending needs to go up - that of raising GST? At this stage, economists and financial experts say they would not bet against GST rising beyond 7 per cent in future. 'The move from direct to indirect taxes makes the economy more competitive and helps to grow the cake. It is also market oriented because it puts money in the hands of individuals and lets them decide whether to spend or save,‘ 'The Government will find it difficult to raise direct tax rates and indeed may even have to lower direct tax rates in order to stave off competitive tax pressure from other countries...that have slashed their corporate tax rates to attract foreign investment. This would keep businesses in Singapore and ensure...jobs and opportunities for Singaporeans,''

46. What of Sg’s future budget? In deciding the GST rate, the Government would also make comparisons with GST and Value Added Tax (VAT) rates elsewhere, 'to assess the impact...on those who have to pay it'. Stressing that even at 7 per cent, the rate here would still be one of the lowest in the world, the ministry notes that some countries, like Japan and Taiwan, with a lower GST rate actually have higher personal income taxes. Both Japan and Taiwan levy a GST of 5 per cent, but even those in the lowest income brackets pay personal income taxes of 10 and 6 per cent respectively. In effect, they impose an even greater tax burden on lower-wage workers, compared to Singapore 'where lower-wage workers, and indeed around 60 per cent of Singaporeans, do not pay any personal income tax'.

47. What of Sg’s future budget? Over the past few years, the Government has employed a range of measures to cut back on public spending, from levying a headcount tax on ministries to launching an economy drive. Recently, it floated the idea of the private sector sharing the cost of infrastructure development, for projects such as new underground highways. These efforts are likely to continue in the years ahead, as one way to help stave off more tax hikes and the political cost they invariably exact, along with populist calls to spend yet more of the income of the reserves. What is certain is that this Government will continue to focus its efforts on growing the economy, as this will in turn enlarge the tax base and generate the resources to fund new public spending. This strategy has worked in the past and all signs point to the Government continuing to bank on it as the most fiscally sound way to keep its Budget balanced. (ST Nov’06)

48. Budget 2007 – If I were the Finance Minister • http://app.mof.gov.sg/budget_2007/choice/fiscal_choices.asp