The Role of Fiscal Policy - PowerPoint Presentation

1. The Role of Fiscal PolicyThe Macro-Economics of European EconomiesMSc in Economic Policy StudiesJohn FitzGerald, March 2015

2. Course OutlineHow does an economy work? JF 16-1-2015The genesis of macroeconomics AM 23-1-2015Modern macroeconomics AM 30-1-2015Banks and financial markets AM 6-2-2015The recent crisis AM 13-2-2015The labour market JF 20-2-2015Fiscal Policy and forecasting JF 6-3-2015Trade JF 13-3-2015The economics of global warming JF 20-3-2015The future of the Irish economy AM and JF 27-3-2015

3. Outline of LectureTheoryObjectives of fiscal policyHow fiscal policy affects the economyWhat is the “stance” of fiscal policy?SustainabilityFiscal RulesMicro-economics of fiscal policyApplied - examples of fiscal policy in operationIrish fiscal policy since 1970Fiscal adjustment in 1983-93 in Finland and IrelandFiscal policy since 2008Fiscal multipliers

4. Objectives of Fiscal PolicyFinance public expenditure on necessary goods and servicesKeep actual output close to potentialKeynesian policy. Fiscal stimulus/tightening when below/above potentialIs fiscal fine tuning possible?Sustainability of government debtEnsure that the debt can be services and rolled over, if not repaidIn EMU: manage bubbles where interest rates not appropriatePublic FinanceChoose mix of instruments (taxes and expenditure cuts/increases) to achieve objectives at minimum cost to the economy

5. Government SectorRevenue and ExpenditureRevenueEconomic costs of taxation – effects on the economyEconomic impact of taxation – who pays?Other RevenueExpenditureGovernment Consumption – employment of public servantsGovernment TransfersSubsidiesInvestmentMeasure of imbalance – Deficit or SurplusDebt - sustainability

6. The goods marketY=C+I+G (+X-M)Y= GDP, output = expenditure = income; I= investment; G= government consumption C=a + b(Y - T)C= consumption;T=Government revenue; a and b are coefficients, where b is 0<b<1Y=a + bY – bT + I + G + (X - M) Y(1-b)= a + I + (X - M) + G - bTAssumes output will respond to an increase in demand is the “multiplier” for G and for TWhy are they different? 

7. Fiscal Policy & Macro-Economy - 1Change in G – change in Y of where b<1Implies “multiplier” > 1; e.g. b=.8 multiplier is 5Change in T – change in Y of where b<1Implies “multiplier” < for G; e.g. b=.8 multiplier is -4Because of leakage through imports, crowding out etc. crude multiplier much lower:e.g. a multiplier of 1.1 

8. Fiscal Policy & Macro-Economy - 2W=f(P, Uf–U) Philips curveW=Wage rates; P=Prices; U=unemployment rate; Uf= “full employment” If U>Uf then it pulls down wages. If U<Uf this pushes up wagesP=f(W,Pi,ti)Pi= import prices; ti = indirect tax rateL=f(Y,W,Pk,Pm)Where L=employment; Y=output; W= wage rate; Pk=price of capital; Pm=price of materials and other inputs;

9. Crowding out -1 Government stimulates economyG ; This raises Y; This raises L, which reduces ULower U leads to higher wages (W) and higher prices (P).Higher W leads to less exports (X) and employment in export industriesThis is one way that a government stimulus can “crowd out” exports

10. Crowding out - 2Government stimulates economyG ; This raises Y; This raises L which reduces ULower U leads to higher wages (W) and higher prices (P).Central Bank (ECB) targets inflationIf P>P*; where P* is the target rate of inflationThen Central Bank raises interest rates rHigher interest rates affects the cost of investingLower investment has negative multiplier effectsHigher interest rates may also raise the exchange rate and affect competitivenessCrowding out:Through wages affecting exports and Interest rates affecting investment (and also consumption)

11. The stance of fiscal policy - 1If unemployment benefit rises in a recession is it a fiscal stimulus?If no change in rates or conditions it is not a policy change – not stimulatory.The increase is due to the “automatic stabilising” role of the public financesIf tax revenue rises because of economic growth is that deflationary?If no change in rates or conditions it is not a policy change.The increase is due to the “automatic stabilising” role of the public financesDistinguish between policy changes and changes induced by developments in the wider economyA fiscal stimulus is an increase in the deficit or reduction in the surplus due to policy action by the governmentIt is the CHANGE in the (structural) deficit surplus, NOT the LEVEL of the surplus or a deficit, that effects change in demand

12. The stance of fiscal policy - 2Neutral if keep burden of state unchanged in face of growthDefining a neutral fiscal policyKeep tax rates unchangedUnchanged direct tax rate – index bands and credits?Unchanged VAT rate but index excise rates to prices.Property tax – a % of value – revenue will rise with pricesExpenditureWelfare rates (index to price or wage rates?)Public service wage rates – link to private sectorEmployment and volume of investment – constant? Indexed priceFor an example of indexation rules:http://www.esri.ie/UserFiles/publications/QEC2012AUT_SA_Kearney.pdf

13. The stance of fiscal policy - 3Government definitions:Tied to legislative changeWelfare rates – assume unchangedIncome tax bands and credits – unchangedWhere a tax is covered by a “sunset clause” – assume it will ende.g. the levy on pension funds.It is the change in the structural deficit / surplus that matters for management of the economic cycleWhen government raises (cuts) taxes or (raises) expenditure the effect on borrowing is less than the direct impact.Because cuts deflate the economy – other sources of revenue / expenditure affectedIn Budget allow for revenue “buoyancy”

14. Potential Output and Structural DeficitRelated to stance of fiscal policy – but not identicalIdentify what is potential output of the economy? To extent actual output is below potential – cyclical downturn (or opposite)Without government intervention the cycle will return actual output so it is in line with potential output.The deficit due to the fact that output is below potential is cyclical – it will go away without government intervention What is left of the deficit is then “structural” – it needs a tightening of fiscal policyExample: if GDP 5% below potential and the deficit rises by 0.6*GDPThen the cyclical deficit is 3%. If the actual deficit is 4% then the structural deficit is 1% of GDP; the 5% deficit less the effects of the economic cycle of 3%.

15. EU methodology for structural deficitPotential output Y=AKαL(1-α)tWhere Y=output, K=capital, and L= employment; A and α are parametersIn the EU methodology L is defined as the level of employment consistent with the “non-accelerating wage rate of unemployment” or NAWRU.For Ireland currently assume NAWRU over 10% - higher than actual unemployment so Actual output is above Potential outputThis does not make sense. There is no sign of inflationary pressures even though the unemployment rate is below the EU definition of NAWRUNeed a sensible definition of the structural deficit (as it is in the constitution). (Bergin and Fitzgerald, 2014)

16. SustainabilityEnsuring that the state is solvent. Possibility of multiple equilibria.Multiple equilibria:If interest high enough – debt cannot be serviced –defaultHowever, if interest rate low enough any debt is supportableWhat determines the national interest rate?National rate = world rate + risk premiumRisk premia depend on expectationsExpectations are unstable – they depend on humans!

17. Sustainability Where D= public debt; Y= nominal GDP; r=interest rate; B=government primary deficitWhere lower case means that it is a ratio of nominal GDP: e.g. =Where is the rate of growth in nominal GDPFor the debt GDP ratio to be stable =0=; then borrowing, b, must satisfy: =E.g if r=.03; g=.05; d=.6; then b=.012 + interest paid or a deficit of 3% of GDP 

18. Fiscal RulesStability and growth pact (SGP)Balanced budget over the cycle; maximum deficit 3%; debt/GDP ratio of 60%Neither observed (Germany and France) nor adequate for the crisisNew rules to ensure solvency (creditors get paid)Treaty on Stability, Coordination and Governance (TSCG)Maximum deficit 1% and take measures to get debt back to 60% of GDPMacro-economic imbalances procedureNo rules on using fiscal policy to manage the business cycleAre they enforceable? Will they make a difference?See http://www.iiea.com/ftp/Publications/IIEA-Economic-Governance-Paper-1_IIEA_2013.pdf

19. Fiscal adjustment in the “great recession”How fast?CredibilityWhat instruments should be used?Expenditure cuts v tax increases?Expenditure: multiplier effects, credibility effectsTaxes: tend to be “easier” and are often reversed – credibilitySee IMF 2010 in referencesExpectations – Ricardian equivalenceIf people expect the cuts to produce lower taxes in the future, spend todayQuestionable in practise (Giavazzi and Pagano, 1990, Bradley and Whelan, 1997, IMF 2010)Distributional effects importantBecause equity mattersBecause “Fairness” may affect success of the adjustment

20. Fiscal Policy under EMUEMU members governed by rules SGP etc.Interest rates are set by the ECB to manage euro area inflationHowever, inflation rates in individual members may deviateFor UK or Sweden, if a housing bubble is developing: use interest ratesIn EMU must use fiscal policyRun a contractionary policy – increase structural surplus/ reduce deficitAlso can target housing / property sector through tax system

21. Micro-economics of fiscal policyEfficiency ConsiderationsChoosing between different tax and welfare instruments.Deadweight losses resulting from taxation (and subsidies).IncidenceTypes of taxationDirectIndirectLump sumPigovian taxes

22. Deadweight lossesIf a tax changes behaviour so output falls – that is a loss.For example, if the marginal tax rate rises:People will want higher pay or they will work lessThis will reduce employment and outputHigh deadweight in the 1980s tax system (Honohan and Irvine 1987)Direct taxes (on labour) often have highest deadweightIndirect taxes raise prices and reduce the value of wages.However, payment is shared with those out of the labour forceLump sum taxesCannot escape them so limited change in behaviourPigovian taxes e.g. on tobacco and carbon emissionsWhile output may fall there is a societal benefit from the reduction in consumptionThe problem is that the price does not reflect the cost to society

23. IncidenceThe person or company who pays the tax to the revenue may not suffer from the full effects of the tax.If employees pass on some or all of the tax to the employer as higher wagesIf companies pass on the tax on their product as higher prices.Incidence depends on the supply and demand for a product or serviceDepends of the market power of the individual or company on whom the tax is levied.Example: Tax on labour in Ireland

24. Wage RatesThe tax wedge:Employers pay W*(1+te); Employees get W*(1-tp)Where te=employers taxes (rate) and tp=employees taxes (rate)The higher the tax wedge the bigger the difference between the 2 wage ratesWho pays the taxes on labour – where is the incidence?Depends on the shape of the labour supply and demand curves

25. Tax incidence: affected by labour supply & demandImpose a tax on labour of W1-W3. Labour bargains in terms of after tax wagesLabour supply moves from S1 to S2Labour demand downward slopingEmployment falls from L2 to L1Wage rates rise from W1 to W2 – that share of the tax is paid by employerThe part of the tax W2-W3 is paid by the employeeThe flatter – more elastic – labour supply the bigger the share of the tax is paid by employers – increasing the employment effectPartnership in Ireland 1987 – trade off tax cuts for wage moderationThis reflected the behaviour of the market with an elastic labour supplyOther countries – labour supply less elastic because limited migration

26. Elastic Labour SupplyDLS1LWLW1L2Wage RatesEmployment

27. Elastic Labour SupplyDLS1LWLW1L1W2L2Wage RatesEmploymentS2LW3

28. Distributional EffectsVery ImportantBecause society cares about equityBecause an unfair tax may come unstuck politicallyNeed a model to determine the effectsBecause there are no typical families or individualsAlso need to take account of incidence

29. Distributional effect of BudgetsImpact of Budgetary Policy 2009-2015 - Percentage Change in Disposable Income by Income Decile

30. AppliedIrish Fiscal Policy since 1970Fiscal adjustment in Finland and Ireland in the 1980s/1990sFiscal adjustment in this crisis

31. Fiscal Policy1970s – Keynesian biasEconomics v public perception1980s – Recognition of supply sideEconomics v public perceptionImpetus to demand leaks out in current account1980s – fiscal adjustment – 11990s – order restored2009-14 – fiscal adjustment - 231

32. Fiscal Policy 1970-771972-3 Stimulated growing economyBecause forecasts suggested low growthSuggested danger of fine tuningMistaken interpretation of oil price shocksTreated as a demand shock not a supply shockFiscal adjustmentBudget for 1977 – toughest in 50 years32

33. Fiscal Policy33

34. 1977-1981 Fiscal StimulusElection promises – major tax cuts & spendingSimplistic Keynesian modelNo consciousness of what drives real outputLimited media or independent assessmentException: Geary, April 1978Consequences: e.g. Moneypoint and public service hiringBuild up of borrowing and debt when real interest rates lowThere was a “black hole” which was not seenThings even worse than they looked on BOP current accountThen….34

35. Fiscal Policy35

36. 1980s Fiscal AdjustmentProblems partly tackled 1983-4Too much reliance on tax and not enough on cutsDelayed adjustment1985-6 eased off – too early1987-9 adjustment completedMore reliance on expenditure cutsLessons?External environment very importantGet it over with fasterMore on expenditure than taxationDe facto co-operation between 82-87 and 87-89 govts.Myth of an “Expansionary Fiscal Contraction”36

37. Ireland 1980s, Finland 1990s

38. Ireland 1980s, UK end of 1980s

39. Comparison of AdjustmentsIn each case the adjustment in current a/c of BOP occurs firstSuccess of fiscal adjustment takes time to be realisedWhen take tough budgetary actionDeflate economy – cuts consumption and importsLower growth – tends to push deficit back up (but by less than cuts)Reduces inflationary pressures; Private sector gradually crowded inExports respond gradually – return to growthWhen no longer deflating economy growth strengthens

40. Fiscal Policy in the 1990sEconomy very competitive & ready to grow in 1990sSigns of rapid growth commencing in 1989German unification & German monetary policyDelayed the Celtic Tiger, which was purring 1989-90Fiscal policy broadly stimulatory in 1990sEconomy began decade well below potentialFine tuning seen to be difficult40

41. Fiscal Policy41

42. Managing the 2000s boomFrom 2001 economy began to move too fastTurning point probably 2003Monetary policyNot able to manage property boomFiscal policy – an answerBelief that fiscal policy no longer useful – fine tuningNeeded to run an increasing surplus to take steam outMake housing more expensive to reduce demandIrish housing supply squeezed rest of economyEither or both fiscal policy or regulation could have workedEconomic advice concentrated on fiscal policy. Lack of attention to financial economics and regulationSee http://www.esri.ie/UserFiles/publications/JACB201142.pdf42

43. Restoring Order – 2009-2015Size of banking problem underestimatedOnly clear from autumn 2010There was a huge hole in the public financesAlso a massive increase in welfare expenditurec. €30 billion of cuts, using Dept. Finance (legislative) definitions€9 billion to increase welfare expenditure – automatic stabilisers€1 billion to pay for interest on banking debt€20 billion to plug the hole in the public finances43

44. Government Transfers as % of GDP       Change20072008200920102011201220132007-2011Germany16.015.817.416.715.715.615.7-0.3France17.417.619.219.219.119.519.91.7Netherlands9.79.710.711.011.111.511.91.4UK12.112.614.314.214.214.614.52.1Ireland11.513.817.717.617.517.516.36.0Greece14.616.117.617.819.319.818.54.7Spain11.512.314.415.115.316.016.33.8Portugal14.114.616.416.417.017.518.42.9Source: EU AMECO database. GNP is used for Ireland, not GDP.

45. Fiscal Policy45

46. Spanish v Irish approach to adjustment 2010201120122013Plan of: SpainSpring 20109.87.55.33Spring 20119.264.43Spring 20125.33Latest9.49.410.36.8Plan of: IrelandWinter 200911.6107.24.9Winter 201010.68.67.5Latest10.78.57.95.7

47. Restoring Order – 2009-2015Apart from avoiding a crisis!Caution in fiscal policy important, asymmetric risksRegulation – better safe than sorryIreland - Tackling the CrisisUnder-promise and over-deliverIreland’s plan – not the Troika’sFor EUBail-outs worked (except Greece). Need EU banking system: EU regulation – being deliveredNeed an appropriate EU fiscal Policy – not happening47

48. Fiscal stance for euro areaMeasure by cyclically adjusted deficitTake out effects of recession - a measure of structural deficitDeficit continuously cut 2011-2014A measure of the EA12 fiscal stance – pro-cyclical

49. Euro 12, Cyclically adjusted deficit, % of GDP

50. The Latvian fiscal adjustment

51. Latvia – current account of BOP

52. Latvia – government borrowing as % of GDP

53. Latvian Adjustment

54. Latvia – Debt as % of GDP

55. Fiscal MultipliersUses HERMES modelMany channels through which economy adjustsLook at public sector employment cut by €1 billion

56. Public sector employment shock, €1 billion

57. Income tax shock, +€1 billion

58. Overview of shocks, €1 billionYEAR 125125125 GDPUnemploymentRateDeficit as % GDP% of GDP %ΔΔΔGrowth and competitiveness shocks:World growth+1%0.80.91.1-0.2-0.4-0.4-0.1-0.2-0.3Foreign prices+1%0.50.60.8-0.1-0.2-0.2-0.1-0.2-0.2Domestic wage rates+1%0.00.0-0.10.20.30.40.00.00.1Domestic interest rates+1pp0.0-0.2-0.50.00.10.20.00.30.5House Prices-10%-0.5-0.6-0.30.40.70.30.50.90.5Standardised policy shocks:Income tax+€1bn-0.2-0.4-0.40.10.10.2-0.5-0.4-0.4Public sector wage-€1bn-0.2-0.3-0.30.10.0-0.2-0.3-0.3-0.3Public sector employment-€1bn-0.7-0.8-0.71.00.90.7-0.2-0.2-0.2 Current transfer Payments-€1bn-0.2-0.3-0.30.10.20.1-0.5-0.4-0.4Capital expenditure-€1bn-0.3-0.4-0.30.50.50.3-0.4-0.4-0.4

59. QuestionsWas the speed of adjustment right?Was the composition of the adjustment right?Will EU rules make a difference in the future?What should be the target for fiscal policy over rest of decade?Priorities for relaxing public finances?

60. AMECO DatabaseMany annual variables for EU economies, US, Japan etc.Don’t assume that the data are always right!Where available, runs from 1960. Includes EU forecasts to 2016Be careful that 2014 onwards are EU forecasts!Three approaches to accessing it:Online: http://ec.europa.eu/economy_finance/ameco/user/serie/SelectSerie.cfmExcel File: AMECONov14.xlsx plus list_of_variables.pdfExcel File: AMECOTCD.xlsx – a limited number of variables, 1 variable per sheetHouse prices from BIS database:Online: http://www.bis.org/statistics/pp_detailed.htm#selected

61. Future PresentationsThe origins and resolution of the current crisis in Estonia, Bulgaria, Greece and Spain (20th March)What were the origins? How is it resolving? Look at disequilibria in marketsThe origins and resolution of the current crisis in Latvia, Portugal, Spain and Italy (20th March)What were the origins? How is it resolving? Look at disequilibria in marketsThe crisis in Scandinavia (Finland, Sweden, Denmark) 1988-1995 (13th March)What were the origins? How was it resolved? Look at disequilibria in markets

62. Reading for this lectureBasic text:“Macroeconomics a European Perspective”, Blanchard, Amighini and Giavazzi. Probably more theory than you need, but provides the basicsChapters 8&9, and 24The rest of the reading discusses real economic situations.On past experience with fiscal adjustments:https://www.imf.org/external/pubs/ft/weo/2010/02/pdf/text.pdf Chapter 3Look at one or two of these publications for the EU and its component economiesIMF World Economic Outlook, October 2014. http://www.imf.org/external/pubs/ft/weo/2014/02/pdf/text.pdfOECD Economic Outlook, November 2014, http://www.oecd.org/eco/outlook/General-assessment-of-the-macroeconomic-situation.pdfEuropean Commission: European Economic Forecast, Winter 2014 http://ec.europa.eu/economy_finance/publications/european_economy/2014/pdf/ee2_en.pdf

63. Possible additional readingFiscal Ruleshttp://www.iiea.com/ftp/Publications/EU%20Economic%20Policy%20Surveillance%20of%20Member%20States-IIEA%20Economic%20Governance%20Paper%206%20_Michael%20G%20Tutty.pdfhttp://www.iiea.com/ftp/Publications/IIEA-Economic-Governance-Paper-1_IIEA_2013.pdf Irish fiscal adjustmenthttp://www.esri.ie/UserFiles/publications/JACB201142.pdfExamples of multipliers for Irelandhttp://www.esri.ie/UserFiles/publications/WP460/WP460.pdf Pp. 48-54 gives fiscal multipliers for IrelandThe Stance of fiscal policy in Ireland and the Structural Balancehttp://www.esri.ie/UserFiles/publications/QEC2014SPR_SA_Bergin.pdfhttp://www.esri.ie/UserFiles/publications/QEC2012AUT_SA_Kearney.pdfhttp://www.esri.ie/UserFiles/publications/JACB201239/BP201301.pdfDistributional effectshttp://www.esri.ie/UserFiles/publications/QEC2014Win_SA_Keane.pdf

64. Possible additional readingDeadweight losses in taxation:http://www.tara.tcd.ie/bitstream/handle/2262/68590/v19n11987_2.pdf?sequence=1&isAllowed=yImpact of different types of taxes:http://www.esr.ie/article/view/93/73