Volume 34, Issue 1, March 2020
Volume 34, Issue 1, March 2020
Tony Makin, Professor of Economics, Griffith University
Fiscal policy is the management of government spending and taxation to influence the economy’s overall behaviour. Fiscal policy can usefully improve the economy’s performance via an efficient tax system, and through the provision of necessary health, education and welfare spending as well as infrastructures, such as roads, railways, airports and ports.
It can also be deployed in an attempt to manage fluctuations in the business cycle, that is the ups and downs in national income to minimise unemployment. Monetary policy can also be used for this purpose. Monetary policy conducted by Australia’s central bank, the Reserve Bank of Australia, involves managing the issue and circulation of the money supply and setting interest rates.
Prior to the 2008-10 Global Financial Crisis (GFC), monetary policy was considered the most effective macroeconomic policy instrument for managing aggregate demand in the short run. Fiscal policy has also been used for that purpose since the GFC, although the role and effectiveness of fiscal policy remains a controversial topic in academic circles.
Nearly every decision taken by governments have implications for the government budget, a document that itemises revenues and spending for a given financial year, beginning 1 July of that year and ending 30 June the following year. Decisions to spend more for instance on education, health, defence, pensions and other welfare, hospitals and infrastructure increase government outlays, whereas decisions for instances to alter income taxes, company taxes, capital gains taxes, goods and services taxes, or excises on fuel, cigarettes and alcohol alter government revenue.
The difference between what the government raises in revenue and what it spends is the budget balance, which is in deficit if total spending exceeds total revenue, or in surplus, if total revenue exceeds total spending. Budgets are more often than not in deficit, and this creates a government borrowing requirement with funds raised through the issue of bonds to domestic and foreign lenders. In Australia’s case, most of the funds borrowed to finance budget deficits come from abroad, adding to Australia’s foreign debt.
The federal Treasurer presents the budget to parliament each year in early May and included in the budget documents are forecasts of economic activity compiled by Treasury economists which include predictions for national income, inflation, unemployment. Business and financial markets follow what is in the budget closely for it contains important information, with implications for key economic and financial variables, including stock market prices and exchange rates.
Because every citizen can potentially be affected by changes announced at budget time, the Treasurer’s annual budget presentation to parliament attracts considerable media attention. In the past, there have been changes announced affecting income tax rates, superannuation, age pensions, university fees and industry assistance.
State and local governments also have budgets which detail their spending and revenue priorities. A feature of State budgets is that their revenue is heavily dependent on funding from the federal government, much of which is raised via the Goods and Services Tax (GST).
The idea of using fiscal policy to stimulate economies during financial crises stems from the ideas of the English economist John Maynard Keynes. Keynes’ General Theory of Employment, Interest and Money (1936) most famously advocated fiscal stimulus in the form of increased spending on infrastructure (then called ‘public works’) during the Great Depression of the 1930s.
However, it was not actually general in its original form and was premised on a set of Depression conditions including a flawed banking system, a liquidity trap (interest rates near zero), ongoing deflation, and a prolonged collapse in international trade. Keynes’ disciples in the 1940s and 1950s credited fiscal expansion with saving western capitalism, although as a way of thinking about macroeconomics, it was effectively criticised subsequently.1
The nature of economies has changed significantly since then. Most notably, economies have become more integrated with other economies through cross-border trade and investment linkages which has meant that financial crises are quickly transmitted globally. Basic Keynesian theory assumes economies are closed to international trade and capital flows when, on the contrary, Australia is heavily reliant on exports and imports and foreign funds to finance its domestic investment.
Over the past half-century, successive federal governments have routinely deployed fiscal policy to counter major economic downturns stemming from crises. Discretionary fiscal stimulus was implemented in the mid-1970s, early 1980s and early 1990s and in response to the Global Financial Crisis (GFC) in 2008-10 and most recently in response to the economic impact of the coronavirus (COVID-19). Sizeable federal budget deficits emerged after each of the fiscal stimulus episodes, the largest reaching 4.2 per cent of GDP in 2008-09 in response to the GFC.
A notable historical exception was the Asian Crisis 1997- 98, the first major geofinancial crisis in the financial globalisation era that began in the 1980s. There was no discretionary fiscal response to this external financial shock and monetary policy and the exchange rate successfully insulated the economy from recession.
If fiscally induced domestic spending raises national output by more than the spending itself, so-called fiscal multipliers are greater than unity and fiscal stimulus can be deemed effective, at least in the short run. Many studies premised on Keynesian assumptions and behavioural relationships have estimated multipliers since the crisis using different econometric techniques with mixed results. Most show some positive effect in the short run, though in the longer run multipliers can turn negative when taxes rise to repair the budget deficit.
1 See for instance Lucas and Sargent (1979). Robert Lucas and Thomas Sargent each won the Nobel Prize in economics for their work in this field.
Ideally, fiscal policy should be focussed on medium-term economic objectives to improve the economy’s productivity and economic growth. It should ensure the education, health, welfare, defence and legal systems are well resourced and be conducive to sustaining household and business confidence. It can also foster economic growth through public sector investment in infrastructure and through a tax regime that encourages private investment.
The guiding principle in crafting short-run fiscal responses to any financial crisis should first and foremost be fiscal relief that temporarily lightens the burden of government on the supply side of the economy, which is predominantly small and large business. Business creates the most jobs in the economy, and it’s where productivity and real wage-enhancing investment decisions are made.
Fiscal relief for business from existing tax obligations aimed to counter falling profitability and laying workers off. A fiscal response of this kind counters the effects of a sharp fall in household and business confidence that Keynes termed “animal spirits”. I addition, easing of monetary policy and of the regulatory burden on business can complement fiscal relief in mitigating any downturn in economic activity.
The collapse of Lehman Brothers bank on Wall Street in September 2008 precipitated the financial storm that became known as the Global Financial Crisis with commercial banks in North Atlantic economies at its epicentre.2 Australia’s banking system remained relatively sound throughout the crisis, greatly assisted by necessary federal government intervention to underwrite commercial bank deposits and borrowing by banks, including from abroad. This contrasted with the systemic banking problems in the United States and within the banking sectors of the United Kingdom and numerous European economies. Equity values, commodity prices and the Australian dollar all fell sharply in response to the external shock.
Both monetary policy and fiscal policy were deployed to counter the real impact of the crisis3. The Reserve Bank cut the official interest rate soon after the crisis hit by three per cent and the exchange rate depreciated substantially, by around a third against the US dollar, contributing to a sharp turnaround in international competitiveness. This large competitiveness gain boosted net exports, assisted by strong demand from China for Australia’s coal and iron ore.
The fiscal response included cash transfers to targeted groups and increased government spending on public housing, school halls and subsidies for home insulation. These fiscal measures were credited with saving Australia from a technical recession, defined narrowly as two subsequent quarters of negative real GDP growth.4
However, fiscal stimulus-induced foreign investors to take up newly issued relatively high yielding government bonds whose AAA credit rating further enhanced their appeal. This contributed to exchange rate appreciation, and a subsequent competitiveness loss, fully consistent with the approach explained above. A rise in world commodity prices, a mining boom driven by strong demand from China for Australia’s coal and iron ore, and substantial easing of monetary policy in the United States also contributed to the stronger Australian dollar. Worsened competitiveness in turn reduced the viability of substantial parts of manufacturing, including the motor vehicle sector.
In sum, fiscal stimulus was not primarily responsible for saving the Australian economy from a narrowly defined recession in the wake of the GFC. This was due to a combination of lower interest rates, a major exchange rate depreciation, strong foreign demand for mining exports, especially from China, and a then more flexible labour market.5
The economic shock stemming from the coronavirus health crisis, is already proving nasty due to the disruption to supply chains and imports from China, combined with its heavy impact on exposed industries, notably travel and tourism. Under these circumstances, government action has been deemed necessary to alleviate the pressure on business and employment in the private sector.
Fiscal relief for business from the burden imposed by existing taxes should at least counter falling profitability and laying workers off, though is unlikely to rouse economic activity in current circumstances. Lightening the regulatory burden on business would also obviously complement fiscal relief in mitigating the downturn inactivity. The Morrison government’s fiscal package, as a fiscal relief response, was quite different from the fiscal stimulus response to the GFC.
2 Taylor (2009) and Tanzi (2013) detail underlying causes of the GFC.
3 Makin (2016) elaborates.
4 While no recession occurred according to the GDP(A) measure, GDP(P), GDP(E), real national income which accounts for the change in Australia’s international purchasing power due to terms of trade fluctuations and real GDP per capita showed two successive quarters of negative growth.
5 Makin (2010) elaborates.
Keynesian fiscal theory neglects the consequences of large budget deficits and rising public debt. In contrast, several theoretical perspectives that take budget deficits and public debt into account suggest caution in using fiscal policy to stabilise the economy in the short term.6
For instance, in the classic loanable funds approach, fiscal stimulus crowds out private investment because the take up of public debt instruments, including by commercial banks, divert funds from more productive private investment. Business confidence may also be negatively affected by the uncertainty that fiscal deficits, and how they will be repaired, creates. Such ‘regime uncertainty’ is inimical to asset price recovery, private investment and future economic growth.
Relatedly, from a longer-term perspective, the prospect of increased income taxation to repay future public debt stemming from stimulus-induced budget deficits may crowd out private consumption as households save more to meet future tax liabilities. In a similar way, business wary of future tax obligations may retain more earnings for this purpose instead of investing.
The open economy extension of the loanable funds approach provides a rationale for the twin deficits hypothesis. To the extent that fiscal stimulus increases government or private spending, it reduces national saving relative to investment, which raises foreign borrowing and widens the current account deficit.
According to another university textbook approach,7 if the government implements a relatively large fiscal stimulus in an open economy like Australia with a floating exchange rate, there is upward pressure on domestic interest rates. As a result, foreign capital pours in to purchase bonds issued to fund the budget deficit, and the nominal and real exchange rates appreciate. Exchange rate appreciation worsens international competitiveness, reducing exports and rising imports, thereby crowding out net exports. Hence, this perspective provides another rationale for the ‘twin deficits hypothesis.’
Finally, there is the intergenerational equity argument focused on the public debt legacy that stems from fiscal stimulus. This perspective simply proposes that it is unfair for future generations to repay the public debt incurred by the present generation via higher future taxes or cuts in government services.
The above theoretical perspectives suggest multipliers which measure the extent to which a cut in either taxes, increase in transfers, or rise in spending from the demand side of the economy leads to a rise in national income are small, zero or even negative in the short run. However, income and company tax cuts, as well as additional government spending on productive infrastructure, can yield lasting benefits on the output, or supply, side of the economy.
6 This section draws on Makin (2016).
7 See for instance Makin (2017).
1. Explain the three main ways that fiscal policy can be used to improve the performance of an economy.
2. How are budget deficits financed?
3. Why is Keynesian economic theory less likely to apply now when compared with the Great Depression?
4. What are fiscal multipliers? What value do they need to be, to be regarded as useful, and in what time frame are they most likely to show a positive effect?
5. Explain how the government can use fiscal policy to temporarily lighten the ‘burden of government on the supply side of the economy’.
6. Discuss the advantages and disadvantages of Australia’s fiscal response to the Global Financial Crisis.
7. What fiscal measures should be used in Australia to counter the economic impact of the coronavirus?
8. Examine the following limitations of fiscal policy:
crowding out
twin deficits
intergenerational equity.
9. Analyse the benefits of the following in an expansionary fiscal policy:
income and company tax cuts
spending on productive infrastructure.
10. ESSAY: Discuss the reasons why an expansionary fiscal policy needs to be tailored to suit different economic circumstances.
Keynes, J.M.(1936) The General Theory of Employment, Interest and Money, Macmillan, London.
Lucas, R.and Sargent, T.(1979) “After Keynesian Economics” Federal Reserve Bank of Minneapolis Quarterly Review, Spring, 1-16.
Makin, A. (2017) International Money and Finance Routledge, London and New York.
Makin, A. (2016) The Effectiveness of Fiscal Policy: A Review Australian Treasury External Paper, Canberra, November.
Makin, A. (2010a) “Did Fiscal Stimulus Counter Recession? Evidence from the National Accounts” Agenda 17 (2), 5-16.
Tanzi, V. (2013) Dollars, Euros and Debt, Palgrave Macmillan, London.
Taylor, J. (2009) Getting Off Track: How Government Actions and Interventions Caused, Prolonged, and Worsened the Financial Crisis, Hoover Institution Press.
