The Role of Fiscal Policy

1
The Role of Fiscal Policy

• The Macro-Economics of European Economies
• MSc in Economic Policy Studies
• John FitzGerald, March 2015

2
Course Outline

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

3
Outline of Lecture

• Theory
• Objectives of fiscal policy
• How fiscal policy affects the economy
• What is the stance of fiscal policy?
• Sustainability
• Fiscal Rules
• Micro-economics of fiscal policy
• Applied - examples of fiscal policy in operation
• Irish fiscal policy since 1970
• Fiscal adjustment in 1983-93 in Finland and
  Ireland
• Fiscal policy since 2008
• Fiscal multipliers

4
Objectives of Fiscal Policy

• Finance public expenditure on necessary goods and
  services
• Keep actual output close to potential
• Keynesian policy. Fiscal stimulus/tightening when
  below/above potential
• Is fiscal fine tuning possible?
• Sustainability of government debt
• Ensure that the debt can be services and rolled
  over, if not repaid
• In EMU manage bubbles where interest rates not
  appropriate
• Public Finance
• Choose mix of instruments (taxes and expenditure
  cuts/increases) to achieve objectives at minimum
  cost to the economy

5
Government Sector

• Revenue and Expenditure
• Revenue
• Economic costs of taxation effects on the
  economy
• Economic impact of taxation who pays?
• Other Revenue
• Expenditure
• Government Consumption employment of public
  servants
• Government Transfers
• Subsidies
• Investment
• Measure of imbalance Deficit or Surplus
• Debt - sustainability

6
The goods market

•  

7
Fiscal Policy Macro-Economy - 1

•  

8
Fiscal Policy Macro-Economy - 2

• Wf(P, UfU) Philips curve
• WWage rates PPrices Uunemployment rate Uf
  full employment
• If UgtUf then it pulls down wages. If UltUf this
  pushes up wages
• Pf(W,Pi,ti)
• Pi import prices ti indirect tax rate
• Lf(Y,W,Pk,Pm)
• Where Lemployment Youtput W wage rate
  Pkprice of capital Pmprice of materials and
  other inputs

9
Crowding out -1

• Government stimulates economy
• G This raises Y This raises L, which
  reduces U
• Lower U leads to higher wages (W) and higher
  prices (P).
• Higher W leads to less exports (X) and employment
  in export industries
• This is one way that a government stimulus can
  crowd out exports

10
Crowding out - 2

• Government stimulates economy
• G This raises Y This raises L which
  reduces U
• Lower U leads to higher wages (W) and higher
  prices (P).
• Central Bank (ECB) targets inflation
• If PgtP where P is the target rate of inflation
• Then Central Bank raises interest rates r
• Higher interest rates affects the cost of
  investing
• Lower investment has negative multiplier effects
• Higher interest rates may also raise the exchange
  rate and affect competitiveness
• Crowding out
• Through wages affecting exports and
• Interest rates affecting investment (and also
  consumption)

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The stance of fiscal policy - 1

• If 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 finances
• If 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 finances
• Distinguish between policy changes and changes
  induced by developments in the wider economy
• A fiscal stimulus is an increase in the deficit
  or reduction in the surplus due to policy action
  by the government
• It is the CHANGE in the (structural) deficit
  surplus, NOT the LEVEL of the surplus or a
  deficit, that effects change in demand

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The stance of fiscal policy - 2

• Neutral if keep burden of state unchanged in face
  of growth
• Defining a neutral fiscal policy
• Keep tax rates unchanged
• Unchanged 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 prices
• Expenditure
• Welfare rates (index to price or wage rates?)
• Public service wage rates link to private
  sector
• Employment and volume of investment constant?
  Indexed price
• For an example of indexation rules
• http//www.esri.ie/UserFiles/publications/QEC2012A
  UT_SA_Kearney.pdf

13
The stance of fiscal policy - 3

• Government definitions
• Tied to legislative change
• Welfare rates assume unchanged
• Income tax bands and credits unchanged
• Where a tax is covered by a sunset clause
  assume it will end
• e.g. the levy on pension funds.
• It is the change in the structural deficit /
  surplus that matters for management of the
  economic cycle
• When 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 affected
• In Budget allow for revenue buoyancy

14
Potential Output and Structural Deficit

• Related to stance of fiscal policy but not
  identical
• Identify 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 policy
• Example if GDP 5 below potential and the
  deficit rises by 0.6GDP
• Then 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.

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EU methodology for structural deficit

• Potential output YAKaL(1-a)t
• Where Youtput, Kcapital, and L employment A
  and a are parameters
• In 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 output
• This does not make sense. There is no sign of
  inflationary pressures even though the
  unemployment rate is below the EU definition of
  NAWRU
• Need a sensible definition of the structural
  deficit (as it is in the constitution). (Bergin
  and Fitzgerald, 2014)

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Sustainability

• Ensuring that the state is solvent.
• Possibility of multiple equilibria.
• Multiple equilibria
• If interest high enough debt cannot be serviced
  default
• However, if interest rate low enough any debt is
  supportable
• What determines the national interest rate?
• National rate world rate risk premium
• Risk premia depend on expectations
• Expectations are unstable they depend on humans!

17
Sustainability

•  

18
Fiscal Rules

• Stability 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 crisis
• New 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 GDP
• Macro-economic imbalances procedure
• No rules on using fiscal policy to manage the
  business cycle
• Are they enforceable? Will they make a
  difference?
• See http//www.iiea.com/ftp/Publications/IIEA-Econ
  omic-Governance-Paper-1_IIEA_2013.pdf

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Fiscal adjustment in the great recession

• How fast?
• Credibility
• What instruments should be used?
• Expenditure cuts v tax increases?
• Expenditure multiplier effects, credibility
  effects
• Taxes tend to be easier and are often reversed
  credibility
• See IMF 2010 in references
• Expectations Ricardian equivalence
• If people expect the cuts to produce lower taxes
  in the future, spend today
• Questionable in practise (Giavazzi and Pagano,
  1990, Bradley and Whelan, 1997, IMF 2010)
• Distributional effects important
• Because equity matters
• Because Fairness may affect success of the
  adjustment

20
Fiscal Policy under EMU

• EMU members governed by rules SGP etc.
• Interest rates are set by the ECB to manage euro
  area inflation
• However, inflation rates in individual members
  may deviate
• For UK or Sweden, if a housing bubble is
  developing use interest rates
• In EMU must use fiscal policy
• Run a contractionary policy increase structural
  surplus/ reduce deficit
• Also can target housing / property sector through
  tax system

21
Micro-economics of fiscal policy

• Efficiency Considerations
• Choosing between different tax and welfare
  instruments.
• Deadweight losses resulting from taxation (and
  subsidies).
• Incidence
• Types of taxation
• Direct
• Indirect
• Lump sum
• Pigovian taxes

22
Deadweight losses

• If 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
  less
• This will reduce employment and output
• High deadweight in the 1980s tax system (Honohan
  and Irvine 1987)
• Direct taxes (on labour) often have highest
  deadweight
• Indirect taxes raise prices and reduce the value
  of wages.
• However, payment is shared with those out of the
  labour force
• Lump sum taxes
• Cannot escape them so limited change in behaviour
• Pigovian taxes e.g. on tobacco and carbon
  emissions
• While output may fall there is a societal benefit
  from the reduction in consumption
• The problem is that the price does not reflect
  the cost to society

23
Incidence

• The 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 wages
• If companies pass on the tax on their product as
  higher prices.
• Incidence depends on the supply and demand for a
  product or service
• Depends of the market power of the individual or
  company on whom the tax is levied.
• Example Tax on labour in Ireland

24
Wage Rates

• The tax wedge
• Employers pay W(1te) Employees get W(1-tp)
• Where teemployers taxes (rate) and tpemployees
  taxes (rate)
• The higher the tax wedge the bigger the
  difference between the 2 wage rates
• Who 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 demand

• Impose a tax on labour of W1-W3.
• Labour bargains in terms of after tax wages
• Labour supply moves from S1 to S2
• Labour demand downward sloping
• Employment falls from L2 to L1
• Wage rates rise from W1 to W2 that share of the
  tax is paid by employer
• The part of the tax W2-W3 is paid by the employee
• The flatter more elastic labour supply the
  bigger the share of the tax is paid by employers
  increasing the employment effect
• Partnership in Ireland 1987 trade off tax cuts
  for wage moderation
• This reflected the behaviour of the market with
  an elastic labour supply
• Other countries labour supply less elastic
  because limited migration

26
Elastic Labour Supply
Wage Rates
W
S1L
W1
L
L2
Employment
27
Elastic Labour Supply
Wage Rates
S2L
W
S1L
W3
W2
L
L2
Employment
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Distributional Effects

• Very Important
• Because society cares about equity
• Because an unfair tax may come unstuck
  politically
• Need a model to determine the effects
• Because there are no typical families or
  individuals
• Also need to take account of incidence

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Distributional effect of Budgets
Impact of Budgetary Policy 2009-2015 - Percentage
Change in Disposable Income by Income Decile
30
Applied

• Irish Fiscal Policy since 1970
• Fiscal adjustment in Finland and Ireland in the
  1980s/1990s
• Fiscal adjustment in this crisis

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Fiscal Policy

• 1970s Keynesian bias
• Economics v public perception
• 1980s Recognition of supply side
• Economics v public perception
• Impetus to demand leaks out in current account
• 1980s fiscal adjustment 1
• 1990s order restored
• 2009-14 fiscal adjustment - 2

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Fiscal Policy 1970-77

• 1972-3 Stimulated growing economy
• Because forecasts suggested low growth
• Suggested danger of fine tuning
• Mistaken interpretation of oil price shocks
• Treated as a demand shock not a supply shock
• Fiscal adjustment
• Budget for 1977 toughest in 50 years

33
Fiscal Policy
34
1977-1981 Fiscal Stimulus

• Election promises major tax cuts spending
• Simplistic Keynesian model
• No consciousness of what drives real output
• Limited media or independent assessment
• Exception Geary, April 1978
• Consequences
• e.g. Moneypoint and public service hiring
• Build up of borrowing and debt when real interest
  rates low
• There was a black hole which was not seen
• Things even worse than they looked on BOP current
  account
• Then.

35
Fiscal Policy
36
1980s Fiscal Adjustment

• Problems partly tackled 1983-4
• Too much reliance on tax and not enough on cuts
• Delayed adjustment
• 1985-6 eased off too early
• 1987-9 adjustment completed
• More reliance on expenditure cuts
• Lessons?
• External environment very important
• Get it over with faster
• More on expenditure than taxation
• De facto co-operation between 82-87 and 87-89
  govts.
• Myth of an Expansionary Fiscal Contraction

37
Ireland 1980s, Finland 1990s
38
Ireland 1980s, UK end of 1980s
39
Comparison of Adjustments

• In each case the adjustment in current a/c of BOP
  occurs first
• Success of fiscal adjustment takes time to be
  realised
• When take tough budgetary action
• Deflate economy cuts consumption and imports
• Lower growth tends to push deficit back up (but
  by less than cuts)
• Reduces inflationary pressures Private sector
  gradually crowded in
• Exports respond gradually return to growth
• When no longer deflating economy growth
  strengthens

40
Fiscal Policy in the 1990s

• Economy very competitive ready to grow in 1990s
• Signs of rapid growth commencing in 1989
• German unification German monetary policy
• Delayed the Celtic Tiger, which was purring
  1989-90
• Fiscal policy broadly stimulatory in 1990s
• Economy began decade well below potential
• Fine tuning seen to be difficult

41
Fiscal Policy
42
Managing the 2000s boom

• From 2001 economy began to move too fast
• Turning point probably 2003
• Monetary policy
• Not able to manage property boom
• Fiscal policy an answer
• Belief that fiscal policy no longer useful fine
  tuning
• Needed to run an increasing surplus to take steam
  out
• Make housing more expensive to reduce demand
• Irish housing supply squeezed rest of economy
• Either or both fiscal policy or regulation could
  have worked
• Economic advice concentrated on fiscal policy.
• Lack of attention to financial economics and
  regulation
• See http//www.esri.ie/UserFiles/publications/JACB
  201142.pdf

43
Restoring Order 2009-2015

• Size of banking problem underestimated
• Only clear from autumn 2010
• There was a huge hole in the public finances
• Also a massive increase in welfare expenditure
• c. 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
  finances

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Government Transfers as of GDP
              Change
2007 2008 2009 2010 2011 2012 2013 2007-2011
Germany 16.0 15.8 17.4 16.7 15.7 15.6 15.7 -0.3
France 17.4 17.6 19.2 19.2 19.1 19.5 19.9 1.7
Netherlands 9.7 9.7 10.7 11.0 11.1 11.5 11.9 1.4
UK 12.1 12.6 14.3 14.2 14.2 14.6 14.5 2.1
Ireland 11.5 13.8 17.7 17.6 17.5 17.5 16.3 6.0
Greece 14.6 16.1 17.6 17.8 19.3 19.8 18.5 4.7
Spain 11.5 12.3 14.4 15.1 15.3 16.0 16.3 3.8
Portugal 14.1 14.6 16.4 16.4 17.0 17.5 18.4 2.9
Source EU AMECO database. GNP is used for
Ireland, not GDP.
45
Fiscal Policy
46
Spanish v Irish approach to adjustment
2010 2011 2012 2013
Plan of Spain
Spring 2010 9.8 7.5 5.3 3
Spring 2011 9.2 6 4.4 3
Spring 2012 5.3 3
Latest 9.4 9.4 10.3 6.8
Plan of Ireland
Winter 2009 11.6 10 7.2 4.9
Winter 2010 10.6 8.6 7.5
Latest 10.7 8.5 7.9 5.7
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Restoring Order 2009-2015

• Apart from avoiding a crisis!
• Caution in fiscal policy important, asymmetric
  risks
• Regulation better safe than sorry
• Ireland - Tackling the Crisis
• Under-promise and over-deliver
• Irelands plan not the Troikas
• For EU
• Bail-outs worked (except Greece).
• Need EU banking system EU regulation being
  delivered
• Need an appropriate EU fiscal Policy not
  happening

48
Fiscal stance for euro area

• Measure by cyclically adjusted deficit
• Take out effects of recession - a measure of
  structural deficit
• Deficit continuously cut 2011-2014
• A 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 Multipliers

• Uses HERMES model
• Many channels through which economy adjusts
• Look 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 billion
YEAR   1 2 5 1 2 5 1 2 5
  GDP GDP GDP Unemployment Rate Unemployment Rate Unemployment Rate Deficit as GDP of GDP Deficit as GDP of GDP Deficit as GDP of GDP
  ? ? ? ? ? ? ? ? ?
Growth and competitiveness shocks Growth and competitiveness shocks Growth and competitiveness shocks Growth and competitiveness shocks Growth and competitiveness shocks Growth and competitiveness shocks Growth and competitiveness shocks Growth and competitiveness shocks Growth and competitiveness shocks Growth and competitiveness shocks Growth and competitiveness shocks
World growth 1 0.8 0.9 1.1 -0.2 -0.4 -0.4 -0.1 -0.2 -0.3
Foreign prices 1 0.5 0.6 0.8 -0.1 -0.2 -0.2 -0.1 -0.2 -0.2
Domestic wage rates 1 0.0 0.0 -0.1 0.2 0.3 0.4 0.0 0.0 0.1
Domestic interest rates 1pp 0.0 -0.2 -0.5 0.0 0.1 0.2 0.0 0.3 0.5
House Prices -10 -0.5 -0.6 -0.3 0.4 0.7 0.3 0.5 0.9 0.5
Standardised policy shocks Standardised policy shocks Standardised policy shocks Standardised policy shocks Standardised policy shocks Standardised policy shocks Standardised policy shocks Standardised policy shocks Standardised policy shocks Standardised policy shocks Standardised policy shocks
Income tax 1bn -0.2 -0.4 -0.4 0.1 0.1 0.2 -0.5 -0.4 -0.4
Public sector wage -1bn -0.2 -0.3 -0.3 0.1 0.0 -0.2 -0.3 -0.3 -0.3
Public sector employment -1bn -0.7 -0.8 -0.7 1.0 0.9 0.7 -0.2 -0.2 -0.2
Current transfer Payments -1bn -0.2 -0.3 -0.3 0.1 0.2 0.1 -0.5 -0.4 -0.4
Capital expenditure -1bn -0.3 -0.4 -0.3 0.5 0.5 0.3 -0.4 -0.4 -0.4
59
Questions

• Was 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 Database

• Many annual variables for EU economies, US, Japan
  etc.
• Dont assume that the data are always right!
• Where available, runs from 1960. Includes EU
  forecasts to 2016
• Be careful that 2014 onwards are EU forecasts!
• Three approaches to accessing it
• Online http//ec.europa.eu/economy_finance/ameco/
  user/serie/SelectSerie.cfm
• Excel File AMECONov14.xlsx plus
  list_of_variables.pdf
• Excel File AMECOTCD.xlsx a limited number of
  variables, 1 variable per sheet
• House prices from BIS database
• Online http//www.bis.org/statistics/pp_detailed.
  htmselected

61
Future Presentations

• The 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 markets
• The 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 markets
• The 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 lecture

• Basic text
• Macroeconomics a European Perspective,
  Blanchard, Amighini and Giavazzi. Probably more
  theory than you need, but provides the basics
• Chapters 89, and 24
• The rest of the reading discusses real economic
  situations.
• On past experience with fiscal adjustments
• https//www.imf.org/external/pubs/ft/weo/2010/02/p
  df/text.pdf Chapter 3
• Look at one or two of these publications for the
  EU and its component economies
• IMF World Economic Outlook, October 2014.
  http//www.imf.org/external/pubs/ft/weo/2014/02/pd
  f/text.pdf
• OECD Economic Outlook, November 2014,
  http//www.oecd.org/eco/outlook/General-assessment
  -of-the-macroeconomic-situation.pdf
• European Commission European Economic Forecast,
  Winter 2014 http//ec.europa.eu/economy_finance/pu
  blications/european_economy/2014/pdf/ee2_en.pdf

63
Possible additional reading

• Fiscal Rules
• http//www.iiea.com/ftp/Publications/EU20Economic
  20Policy20Surveillance20of20Member20States-II
  EA20Economic20Governance20Paper20620_Michael
  20G20Tutty.pdf
• http//www.iiea.com/ftp/Publications/IIEA-Economic
  -Governance-Paper-1_IIEA_2013.pdf
• Irish fiscal adjustment
• http//www.esri.ie/UserFiles/publications/JACB2011
  42.pdf
• Examples of multipliers for Ireland
• http//www.esri.ie/UserFiles/publications/WP460/WP
  460.pdf Pp. 48-54 gives fiscal multipliers for
  Ireland
• The Stance of fiscal policy in Ireland and the
  Structural Balance
• http//www.esri.ie/UserFiles/publications/QEC2014S
  PR_SA_Bergin.pdf
• http//www.esri.ie/UserFiles/publications/QEC2012A
  UT_SA_Kearney.pdf
• http//www.esri.ie/UserFiles/publications/JACB2012
  39/BP201301.pdf
• Distributional effects
• http//www.esri.ie/UserFiles/publications/QEC2014W
  in_SA_Keane.pdf

64
Possible additional reading

• Deadweight losses in taxation
• http//www.tara.tcd.ie/bitstream/handle/2262/68590
  /v19n11987_2.pdf?sequence1isAllowedy
• Impact of different types of taxes
• http//www.esr.ie/article/view/93/73