August 1, 2017 | Author: Carla Macabutas | Category: Fiscal Policy, Deficit Spending, Fiscal Multiplier, Government Budget Balance, Public Finance
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Fiscal Policy

Fiscal Policy in the Philippines

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Fiscal Policy

What is Fiscal Policy? Fiscal policy refers to the "measures employed by governments to stabilize the economy, specifically by manipulating the levels and allocations of taxes and government expenditures.

Fiscal measures are frequently used in tandem with monetary policy to achieve certain goals. In the Philippines, this is characterized by continuous and increasing levels of debt and budget deficits, though there have been improvements in the last few years.

The Philippine government’s main source of revenue are taxes, with some non-tax revenue also being collected. To finance fiscal deficit and debt, the Philippines relies on both domestic and external sources.

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Fiscal Policy

Fiscal policy during the Marcos administration was primarily focused on indirect tax collection and on government spending on economic services and infrastructure development. The first Aquino administration inherited a large fiscal deficit from the previous administration, but managed to reduce fiscal imbalance and improve tax collection through the introduction of the 1986 Tax Reform Program and the value added tax. The Ramos administration experienced budget surpluses due to substantial gains from the massive sale of government assets and strong foreign investment in its early years. However, the implementation of the 1997 Comprehensive Tax Reform Program and the onset of the Asian financial crisis resulted to a deteriorating fiscal position in the succeeding years and administrations. The Estrada administration faced a large fiscal deficit due to the decrease in tax effort and the repayment of the Ramos administration’s debt to contractors and suppliers. During the Arroyo administration, the Expanded Value Added Tax Law was enacted, national debt-to-GDP ratio peaked, and under spending on public infrastructure and other capital expenditures was observed.

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Fiscal Policy

Revenues and Funding

A comparative graph of Revenue and Tax Effort from 2001-2010

A comparative graph of Tax and Non-Tax Revenue contribution from 2001-2010 Public Finance Page 4

Fiscal Policy

The Philippine government generates revenues mainly through personal and income tax collection, but a small portion of non-tax revenue is also collected through fees and licenses, privatization proceeds and income from other government operations and state-owned enterprises.

 Tax Revenue Tax collections comprise the biggest percentage of revenue collected. Its biggest contributor is the Bureau of Internal Revenue (BIR), followed by the Bureau of Customs (BOC). Tax effort as a percentage of GDP has averaged at roughly 13% for the years 2001-2010.

 Income Taxes Income tax is a tax on a person's income, wages, profits arising from property, practice of profession, conduct of trade or business or any stipulated in the National Internal Revenue Code of 1997 (NIRC), less any deductions granted. Income tax in the Philippines is a progressive tax, as people with higher incomes pay more than people with lower incomes. Personal income tax rates vary as such:

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Fiscal Policy

Annual Taxable Income

Income Tax Rate

Less than P10,000


Over P10,000 but not over P30,000

P500 + 10% of the excess over P10,000

Over P30,000 but not over P70,000

P2,500 + 15% of the excess over P30,000

Over P70,000 but not over P140,000

P8,500 + 20% of the excess over P70,000

Over P140,000 but not over P250,000 P22,500 + 25% of the excess over P140,000 Over P250,000 but not over P500,000 P50,000 + 30% of the excess over P250,000 Over P500,000

P125,000 + 32% of the excess over P500,000

The top rate was 35% until 1997, 34% in 1998, 33% in 1999, and 32% since 2000.

In 2008, Republic Act No. 9504 (passed by then-President Gloria Macapagal-Arroyo) exempted minimum wage earners from paying income taxes.

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Fiscal Policy

 E-VAT The Expanded Value Added Tax (E-VAT), is a form of sales tax that is imposed on the sale of goods and services and on the import of goods into the Philippines. It is a consumption tax (those who consume more are taxed more) and an indirect tax, which can be passed on to the buyer. The current E-VAT rate is 12% of transactions. Some items which are subject to E-VAT include petroleum, natural gases, indigenous fuels, coals, medical services, legal services, electricity, non-basic commodities, clothing, nonfood agricultural products, domestic travel by air and sea.

The E-VAT has exemptions which include basic commodities and socially sensitive products. Exemptible from the E-VAT are:

1. Agricultural and marine products in their original state (e.g. vegetables, meat, fish, fruits, eggs and rice), including those which have undergone preservation processes (e.g. freezing, drying, salting, broiling, roasting, smoking or stripping); 2. Educational services rendered by both public and private educational institutions; 3. Books, newspapers and magazines; 4. Lease of residential houses not exceeding P10,000 monthly; 5. Sale of low-cost house and lot not exceeding P2.5 million 6. Sales of persons and establishments earning not more than P1.5 million annually. Public Finance Page 7

Fiscal Policy

 Tariffs and Duties Second to the BIR in terms of revenue collection, the Bureau of Customs (BOC) imposes tariffs and duties on all items imported into the Philippines. According to Executive Order 206, returning residents, Overseas Filipino Workers (OFW’s) and former Filipino citizens are exempted from paying duties and tariffs.

 Non-Tax Revenue Non-tax revenue makes up a small percentage of total government revenue (roughly less than 20%), and consists of collections of fees and licenses, privatization proceeds and income from other state enterprises.

 The Bureau of Treasury The Bureau of Treasury (BTr) manages the finances of the government, by attempting to maximize revenue collected and minimize spending. The bulk of non-tax revenues comes from the BTr’s income. Under Executive Order No.449, the BTr collects revenue by issuing, servicing and redeeming government securities, and by controlling the Securities Stabilization Fund (which increases the liquidity and stabilizes the value of government securities) through the purchase and sale of government bills and bonds. Public Finance Page 8

Fiscal Policy

 Privatization Privatization in the Philippines occurred in three waves: The first wave in 1986-1987, the second during 1990 and the third stage, which is presently taking place. The government’s Privatization Program is handled by the inter-agency Privatization Council and the Privatization and Management Office, a sub-branch of the Department of Finance.

 PAGCOR The Philippine Amusement and Gaming Corporation (PAGCOR) is a government-owned corporation established in 1977 to stop illegal casino operations. PAGCOR is mandated to regulate and license gambling (particularly in casinos), generate revenues for the Philippine government through its own casinos and promote tourism in the country.

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Fiscal Policy

Spending, Debt, and Financing

Government Spending and Fiscal Imbalance In 2010, the Philippine Government spent a total of P1.5 trillion and earned a total of P1.2 trillion from tax and non-tax revenues, thus resulting to a total deficit of P314.5 billion.

Despite the national deficit of the Philippines, the Department of Finance reported an average of P29.6 billion in Local Government Unit (LGU) surplus, which is mostly due to an improved LGU financial monitoring system which the government implemented in the recent years. Efforts of the monitoring system include "debt monitoring and creditworthiness monitoring system, effective mobilization of second generation funds (SGF) to promote LGU development, and the implementation of a Land Administration and Management Project (LAMP2) which received a 'very good' rating from the World Bank (WB) and Australian Agency for International Development (AusAid)."

Microfinance management in the Philippines is improving substantially. In 2009, the Economist Intelligence Unit "recognized the Philippines as the best in the world in terms of its microfinance regulatory framework." Public Finance Page 10

Fiscal Policy The DOF-National Credit Council (DOF-NCC) focused on improving the state of local cooperatives by developing a supervision and examination manual, launching advocacies for these cooperatives, and pushing for the Philippine Cooperative Code of 2008. A standardized national strategy for micro insurance and the provisions of grants and technical assistance were formulated.

A comparative graph of National Revenues and Expenditures from 2001-2010

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Fiscal Policy

A comparative graph of Domestic and External Sources of Financing from 2001-2010

A comparative graph of Total National Debt from 2001-2010 Public Finance Page 12

Fiscal Policy

Financing and Debt Aside from Tax and Non-Tax Revenues, the government makes use of other sources of financing to support its expenses. In 2010, the government borrowed a total net of P351.646 billion for financing :

Domestic Sources Gross Financing

External Sources

P489.844 billion P257.357 billion

Less: Repayments/Amortization P271.246 billion P124.309 billion Net Financing Total Financing

P218.598 billion P133.048 billion P351.646 billion

External Sources of Financing are:

1. Program and Project Loans - the government offers project loans to external bodies and uses the proceeds to fund domestic projects like infrastructure, agriculture, and other government projects.[20] 2. Credit Facility Loans 3. Zero-coupon Treasury Bills 4. Global Bonds 5. Foreign Currencies

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Fiscal Policy

Domestic Sources of Financing are: 1. Treasury Bonds 2. Facility loans 3. Treasury Bills 4. Bond Exchanges 5. Promissory Notes 6. Term Deposits

In 2010, the total outstanding debt of the Philippines reached P4.718 trillion: P2.718 trillion from outstanding domestic sources and P2 trillion from foreign sources. According to the Department of Finance, the country has recently reduced dependency on external sources to minimize the risks caused by changes in the global exchange rates. Efforts to reduce national debt include increasing tax efforts and decreasing government spending. The Philippine government has also entered talks with other economic entities, like the ASEAN Finance Ministers Meeting (AFMM), ASEAN+3 Finance Ministers Meeting (AFMM+3), Asia-Pacific Economic Cooperation (APEC), and ASEAN Single-Window Technical Working Group (ASW-TWG), in order to strengthen the countries' and the region's debt management efforts

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Fiscal Policy

History of Philippine Fiscal Policy

 Marcos Administration (1981-1985) The tax system under the Marcos administration was generally regressive as it was heavily dependent on indirect taxes. Indirect taxes and international trade taxes accounted for about 35% of total tax revenue, while direct taxes only accounted for 25%. Government expenditure for economic services peaked during this period, focusing mainly on infrastructure development, with about 33% of the budget spent on capital outlays. In response to the higher global interest rates and to the depreciation of the peso, the government became increasingly reliant on domestic financing to finance fiscal deficit. The government also started liberalizing tariff policy during this period by enacting the initial Tariff Reform Program, which narrowed the tariff structure from a range of 100%-0% to 50%-10%, and the Import Liberalization Program, which aimed at reducing or eliminating tariffs and realigning indirect taxes.

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Fiscal Policy

 Aquino Administration (1986-1992) Faced with problems inherited from the previous administration, the most important of which being the large fiscal deficit heightened by the low tax effort due to a weak tax system, Aquino enacted the 1986 Tax Reform Program (TRP). The aim of the TRP was to “simplify the tax system, make revenues more responsive to economic activity, promote horizontal equity and promote growth by correcting existing taxes that impaired business incentives”. One of the major reforms enacted under the program was the introduction of the Value Added Tax (VAT), which was set at 10%. The 1986 tax reform program resulted in reduced fiscal imbalance and higher tax effort in the succeeding years, peaking in 1997, before the enactment of the 1997 Comprehensive Tax Reform Program (CTRP). The share of non-tax revenues during this period soared due to the sale of sequestered assets of President Marcos and his cronies (totalling to about ₱20 billion), the initial efforts to deregulate the oil industry and thrust towards the privatization of state enterprises. Public debt servicing and interest payments as a percent of the budget peaked during this period as government focused on making up for the debt incurred by the Marcos administration. Another important reform enacted during the Aquino administration was the passage of the 1991 Local Government Code which enabled fiscal decentralization. This increased the taxing and spending powers to local governments in effect increasing local government resources.

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Fiscal Policy

 Ramos Administration (1993-1998) The Ramos administration had budget surpluses for four of its six years in power. The government benefited from the massive sale of government assets (totaling to about P70 billion, the biggest among the administrations) and continued to benefit from the 1986 TRP. The administration invested heavily on the power sector as the country was beset by power outages. The government utilized its emergency powers to fast-track the construction of power projects and established contracts with independent power plants. This period also experienced a real estate boom and strong foreign direct investment to the country during the early years of the administration, in effect overvaluing the peso. However, with the onset of the Asian financial crisis, the peso depreciated by almost 40%. The Ramos administration relied heavily on external borrowing to finance its fiscal deficit but quickly switched to domestic dependence on the onset of the Asian financial crisis. The administration has been accused of resorting to “budget trickery” during the crisis: balancing assets through the sales of assets, building up accounts payable and delaying payment of government premium to social security holders. In 1997, the Comprehensive Tax Reform Program (CTRP) was enacted. Republic Act (RA) 8184 and RA 8240, which were implemented under the program, were estimated to yield additional taxes of around P7.4 billion; however, a decline in tax effort during the succeeding periods was observed after the CTRP was implemented. This was attributed to the unfavorable economic climate created by the Asian fiscal crisis and the poor implementation of the provisions of the reform. A sharp decrease in international trade tax contribution to GDP was also observed as a consequence of the trade liberalization and globalization efforts in the 1990s, more prominently, the establishment of the ASEAN Free Trade Agreement (AFTA) and membership to the World Trade Organization (WTO) and the Asia-Pacific Economic Cooperation (APEC). The Ramos administration also provided additional incentives to export-oriented firms, the most prominent among these being RA 7227 which was instrumental to the success of the Subic Bay Freeport Zone. Public Finance Page 17

Fiscal Policy

 Estrada Administration (1999-2000) President Estrada, who assumed office at the height of the Asian financial crisis, faced a large fiscal deficit, which was mainly attributed to the sharp deterioration in the tax effort (as a result of the 1997 CTRP: increased tax incentives, narrowing of VAT base and lowering of tariff walls) and higher interest payments given the sharp depreciation of the peso during the crisis. The administration also had to pay P60 billion worth of accounts payables left unpaid by the Ramos administration to contractors and suppliers. Public spending focused on social services, with spending on basic education reaching its peak. To finance the fiscal deficit, Estrada created a balance between domestic and foreign borrowing.

 Arroyo Administration (2002-2009) The Arroyo administration’s poor fiscal position was attributed to weakening tax effort (still resulting from the 1997 CTRP) and rising debt servicing costs (due to peso depreciation). Large fiscal deficits and heavy losses for monitored government corporations were observed during this period. National debt-to-GDP ratio reached an all-time high during the Arroyo administration, averaging at 69.2%. Investment in public infrastructure (at only 1.9% of GDP), expenditure for economic services, health spending and education spending all hit an historic-low during the Arroyo administration. The government responded to its poor fiscal position by under-spending in public infrastructure and social overhead capital (education and health care), thus sacrificing the economy’s long-term growth. In 2005, RA 9337 was enacted, the most significant amendments of which were the removal of electricity and petroleum VAT exemptions and the increase in the VAT rate from 10% to 12%. Public Finance Page 18

Fiscal Policy

ROLE OF FISCAL POLICY Fiscal policy is the use of government revenue (taxes) and expenditure (spending) to influence the economy, and meet the macroeconomic goals. The government’s revenue and expenditure form its budget. If the revenue collection in the form of taxes equals its expenditure, it’s a balanced budget. If revenue exceeds expenditure, the government has a budget surplus. On the other hand, if expenditure exceeds revenue, it’s a budget deficit. A government follows a neutral fiscal policy when the economy is in equilibrium. In such a case, the government’s expenditure is fully funded by the tax revenue. A government follows expansionary fiscal policy during times of recession. It may reduce taxes or increase expenditure in order to stimulate the economy – to increase demand, growth and employment. The government may follow contractionary fiscal policy to reduce fiscal deficit or pay down government debt. To do so, it may increase taxes or decrease expenditure, which will decrease demand, growth and employment. Fiscal policy is based on Keynesian economics, which believes that the government can influence the macroeconomic productivity levels by changing the taxes and spending. Such influence can curb inflation, increase employment rate, and stabilize the value of money. Monetarists, however, believe that the effects of fiscal policy are only temporary, and they advocate use of monetary policy to control inflation. Fiscal policy can be discretionary or nondiscretionary (automatic stabilizers). A discretionary fiscal policy refers to the deliberate changes in government spending and taxes in order to stabilize the economy; for Public Finance Page 19

Fiscal Policy example, the government decides to increase its capital expenditure on road infrastructure. On the other hand, automatic stabilizers are the automatic changes in the tax and spending levels because of the changes in economic conditions. They help stabilize business cycles. For example, when the economy is expanding, the tax revenue increases, and vice verse. There will also be lower government spending in the form of unemployment benefits. Economists have observed that automatic stabilizers can reduce the volatility of the economic cycle by up to 20%.

How Fiscal Policy Works? Fiscal policy is based on the theories of British economist John Maynard Keynes. Also known as Keynesian economics, this theory basically states that governments can influence macroeconomic productivity levels by increasing or decreasing tax levels and public spending. This influence, in turn, curbs inflation (generally considered to be healthy when between 2-3%), increases employment and maintains a healthy value of money. Fiscal policy is very important to the economy. For example, in 2012 many worried that the fiscal cliff, a simultaneous increase in tax rates and cuts in government spending set to occur in January 2013, would send the U.S. economy back to recession. The U.S. Congress avoided this problem by passing the American Taxpayer Relief Act of 2012 on Jan. 1, 2013.

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Fiscal Policy

Balancing Act The idea, however, is to find a balance between changing tax rates and public spending. For example, stimulating a stagnant economy by increasing spending or lowering taxes runs the risk of causing inflation to rise. This is because an increase in the amount of money in the economy, followed by an increase in consumer demand, can result in a decrease in the value of money - meaning that it would take more money to buy something that has not changed in value. Let's say that an economy has slowed down. Unemployment levels are up, consumer spending is down and businesses are not making substantial profits. A government thus decides to fuel the economy's engine by decreasing taxation, which gives consumers more spending money, while increasing government spending in the form of buying services from the market (such as building roads or schools). By paying for such services, the government creates jobs and wages that are in turn pumped into the economy. Pumping money into the economy by decreasing taxation and increasing government spending is also known as "pump priming." In the meantime, overall unemployment levels will fall. With more money in the economy and fewer taxes to pay, consumer demand for goods and services increases. This, in turn, rekindles businesses and turns the cycle around from stagnant to active. A good credit card can save you money. Follow these tips to find the best credit card for you. If, however, there are no reins on this process, the increase in economic productivity can cross over a very fine line and lead to too much money Public Finance Page 21

Fiscal Policy in the market. This excess in supply decreases the value of money while pushing up prices (because of the increase in demand for consumer products). Hence, inflation exceeds the reasonable level. For this reason, fine tuning the economy through fiscal policy alone can be a difficult, if not improbable, means to reach economic goals. If not closely monitored, the line between a productive economy and one that is infected by inflation can be easily blurred.

And When the Economy Needs to Be Curbed… When inflation is too strong, the economy may need a slowdown. In such a situation, a government can use fiscal policy to increase taxes to suck money out of the economy. Fiscal policy could also dictate a decrease in government spending and thereby decrease the money in circulation. Of course, the possible negative effects of such a policy in the long run could be a sluggish economy and high unemployment levels. Nonetheless, the process continues as the government uses its fiscal policy to fine-tune spending and taxation levels, with the goal of evening out the business cycles.

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Fiscal Policy

Who Does Fiscal Policy Affect? Unfortunately, the effects of any fiscal policy are not the same for everyone. Depending on the political orientations and goals of the policymakers, a tax cut could affect only the middle class, which is typically the largest economic group. In times of economic decline and rising taxation, it is this same group that may have to pay more taxes than the wealthier upper class. Similarly, when a government decides to adjust its spending, its policy may affect only a specific group of people. A decision to build a new bridge, for example, will give work and more income to hundreds of construction workers. A decision to spend money on building a new space shuttle, on the other hand, benefits only a small, specialized pool of experts, which would not do much to increase aggregate employment levels.

The Bottom Line One of the biggest obstacles facing policymakers is deciding how much involvement the government should have in the economy. Indeed, there have been various degrees of interference by the government over the years. But for the most part, it is accepted that a degree of government involvement is necessary to sustain a vibrant economy, on which the economic well-being of the population depends.

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Fiscal Policy

Tools of Fiscal Policy The government has two primary fiscal tools to influence the economy. They are revenue tools and spending tools.

 Revenue tools Revenue tools refer to the taxes collected by the government in various forms. The taxes can be direct or indirect. Direct taxes are taxes levied on the income or wealth individuals and firms. This includes income tax, wealth tax, estate tax, corporate tax, capital gains tax, social security tax, etc. Indirect taxes are taxes levied on goods and services. This includes sales tax, value added tax, excise duty, etc.

 Spending Tools Spending tools refer to increasing or decreasing government spending/expenditure to influence the economy. Government spending can be in the form of transfer payments, current spending and capital spending.

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Fiscal Policy Current spending includes expenditure on essential goods and services such as health, education, defense, etc. Capital spending is the public investment in infrastructure such as roads, hospitals, schools, etc. The above two also include subsidy or direct provision of merit goods and public goods, which would otherwise be underprovided.

Transfer payments are the redistribution of income from taxpayers to those requiring support, for example, unemployment benefits. It also includes interest payments on government debt.

Fiscal policy tools have several advantages. Spending tools enable services such as defense to benefit everyone in the country and build infrastructure that propels growth. Spending tools also ensure a minimum standard of living for the residents. Subsidies in research and development also help in future economic growth. Taxes help government in meeting their fiscal needs. By levying high indirect taxes, the government can also discourage use of items such as tobacco, and alcohol.

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Fiscal Policy

Challenges in Implementing Fiscal Policy The government has two tools to implement its fiscal policy :  Taxes  Government spending If the economy is in recession, the government may decide to increase aggregate demand, or decrease taxes to stimulate the economy and increase aggregate demand. Similarly, if the economy is facing inflationary economic boom, it may decrease spending or increase taxes. When the government takes specific actions to influence aggregate demand, it’s called the discretionary fiscal policy.

The discretionary fiscal policy does not always work as intended by the government. There are many reasons as to why the fiscal policy may not be as effective as desired, or sometimes even be counterproductive. Some of these reasons are discussed below: 1. If the government relies on inaccurate statistics, then it’s likely to make wrong policy decisions in the first place.

2. There could be a lag in implementing a policy decision, and/or the impact of a policy decision. For example, by the time the policymakers recognize the problem and take decision to do something, it may already be too late (Recognition lag and action lag). Once the government implements a policy, there may be a time lag till the policy has an impact on the economy (impact lag).

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Fiscal Policy 3. An expansionary fiscal policy may end up decreasing aggregate demand because of crowding-out effect. Increased government borrowing leads to an increase in interest rates, which leads to a decrease in aggregate demand.

4. The economy may be slow because of shortage of resources rather than lower demand. In this case, fiscal policy will not help (it may actually increase inflation).

5. Since expansionary fiscal policy increases fiscal deficit, there is constraint over how much deficit the government can tolerate.

6. While fiscal policy solves one problem, it may aggravate another problem.

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Fiscal Policy

OBJECTIVES The major objectives of fiscal policy are as follows:

A. Full employment It is very important objective of fiscal policy. Unemployment reduces the level of production, and hence the level of economic growth. It also creates many problems to the unemployed people in their day to day life. So, countries try to remove unemployment and attain full employment. Full employment refers to that situation, where there is no involuntary unemployment in the economy. To attain this objective, government should:    

increase its spending lower the personal income taxes lower the business taxes, or employ a combination of increasing government spending and decreasing taxes

However, in practice, it is difficult to achieve full employment. As the factor markets are not perfect, factor units may lose their jobs and may not get the new jobs immediately.

B. Price stability Both sharp rise and sharp fall in general price level are not desirable. It is because sharp rise in prices makes many goods and services unaffordable to the consumers whereas sharp fall in prices discourages the producers to produce goods and services. So, price stability is desirable. However, it should be noted that the principle that general price level should be reasonably stable is generally accepted, the determination of exact trends which are most satisfactory from the stand point of welfare of society is difficult. There are

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Fiscal Policy following three alternative points of view regarding the price stability (Due, 1970:513-518):  It is sometimes argued that a slightly downward trend best serves the interest of the community as a whole, because the gains from increased productivity and lower cost would be shared among all persons in society instead of going chiefly to the workers in the industries affected. On the other hand, a downward trend would increase the difficulty of maintaining full employment because of its adverse effects upon investment and business optimism. Furthermore, such a trend appears to be impossible of attainment in the light of present day union strength and policies.  A gradually increasing general price level has likewise been advocated, primarily because it would encourage investment and lessen labour strife, since annual money wage increases would be possible. However, this alternative would produce a gradual worsening of the economic position of the fixed income receivers.  The third alternative point of view, a compromise between the other two, regards a perfectly stable general price level as the optimum. The gains from greater productivity would go primarily to the workers in the industries, but the injury to the economic well-being of the fixed income groups would be avoided, as well as dampening effects of declining prices.

C. Economic growth It is also an important objective of fiscal policy. By means of higher rate of economic growth the problem of unemployment can also be solved. However, it may create some problems in the maintenance of price stability. The developed countries, like USA, UK, Japan, etc. give attention to the relationship of actual growth rate to the potential growth rate permitted by the consumption – saving ratio, technological considerations and other factors. Public Finance Page 29

Fiscal Policy The less developed countries give emphasis to the increase in the potential growth rate as well as the relationship of the actual and potential growth rate (Due, 1970:517).

The concept of actual and potential growth of output can be explained with the help of figure (a)

In figure (a), AB is the original production possibility curve (PPC) of the economy. The movement from X to Y on the PPC shows the actual growth of output. This increases the level of gross domestic product (GDP) of the country. Such type of movement is possible by means of better utilization of existing resources and increasing the aggregate demand by means of fiscal policy. On the other hand, the rightward shift in PPC of the country from AB to CD shows the potential growth of output. It is possible due to the increase in Public Finance Page 30

Fiscal Policy quantity and quality of the resources, and improvement in technology. For this, fiscal policy can be employed.

D. Resource allocation Resource allocation refers to assigning the available resources of the economy to the specific uses chosen among many possible and competing alternatives. It gives answer to what to produce and how to produce questions of the economy (Tragakes, 2009:17). Fiscal policy should ensure the optimum allocation of the resources. It should divert the resources from unproductive sectors to the productive sectors of the economy. It is the long-run objective of the government. The emphasis of the government upon the full employment, price stability and economic growth should not overshadow the resource allocation goal.

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Fiscal Policy


A. Fiscal policy during the contraction     

increase in government spending reduction in personal income taxes reduction in business taxes increase in transfer payments practicing deficit budget

B. Fiscal policy during the expansion     

decrease in government spending increase in personal income taxes increase in business taxes reduction in transfer payments practicing surplus budget

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Fiscal Policy

NATURE AND TECHNIQUES The nature of fiscal policy may be either expansionary or contractionary.

 Expansionary fiscal policy Expansionary fiscal policy increases the AD of the economy. It increases the level of production, and hence the level of employment. It eliminates the recessionary gap existing in the economy. It should be noted that recessionary gap occurs when the equilibrium real GDP is less than the potential real GDP of the country. In this situation, unemployment is greater than natural rate of unemployment. It can be explained with the help of following diagram:

In figure (b), the short-run aggregate supply (SRAS) curve and AD curve are intersecting to each other at point E1 so that the equilibrium price level is OP1 and equilibrium real GDP is OQ1. Here, OQ2 is the potential GDP. It should be noted that potential real GDP refers to the economy’s full employment level of real GDP. As here the economy’s equilibrium real GDP is less than the Public Finance Page 33

Fiscal Policy potential real GDP, there is recessionary gap. Recessionary gap is also known as deflationary gap. Fiscal policy can be used to eliminate the recessionary gap. For this, AD should be increased. To increase AD:  government spending should be increased  personal income taxes and business taxes should be reduced

Each of the above actions shift the AD curve from AD1 to AD2 so that economy achieves the potential real GDP as follows:

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Fiscal Policy  Contractionary fiscal policy Contractionary fiscal policy reduces the AD of the economy. It reduces the level of production, and hence the level of employment. It eliminates the inflationary gap existing in the economy. It should be noted that inflationary gap occurs when the equilibrium real GDP is greater than potential real GDP. In this situation, unemployment is lower than the natural rate of unemployment. It can be explained with the help of following diagram:

Here, equilibrium is established at point E1 ,where there is the intersection between the SRAS curve and AD curve so that equilibrium price level is OP1 and equilibrium real GDP is OQ1.As here equilibrium real GDP is greater than potential real GDP, which is equal to OQ , there is inflationary gap.

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Fiscal Policy The fiscal policy can be used to eliminate the inflationary gap. For this:  government spending should be reduced  personal income taxes and business taxes should be increased

Each of the above actions shift the AD curve from AD1 to AD2 so that the economy produces the potential real GDP as follows:

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Fiscal Policy

EFFECTIVENESS Fiscal policy becomes effective when it produces the intended result. There are different objectives of fiscal policy, like achievement of full employment, price stability, economic growth, and so on. If the government is able to achieve these objectives by employing the fiscal policy, then such fiscal policy becomes effective, otherwise it becomes ineffective. Government employs the fiscal policy in order to influence the AD and through the AD, it wants to influence other macroeconomic problems, like inflation, unemployment, and so on. So, by means of fiscal policy, government makes intervention in the market. It is a very important tool in the hands of government to correct the market failure. Fiscal policy becomes effective, when it increases the economic efficiency. The effectiveness of fiscal policy depends upon the following factors:  The availability and accuracy of information To bring the intended result, government should have sufficient information on the related problem. It should get these information on the appropriate time .Before employing the fiscal policy, government requires the information about the economy. In such situation, government can employ the appropriate fiscal instruments to correct the problems. Similarly, during the period of implementation of different fiscal tools, it requires information to know whether fiscal tools are working properly or not. If the employed fiscal tools are not working properly, government should make changes in the use of fiscal tools. The information collected by the government must be accurate; otherwise the use of the fiscal policy can not solve the economic problems. Sometimes, it may be difficult to get the information on a problem. Public Finance Page 37

Fiscal Policy For example, it is difficult to get information on true value of negative externality. Due to which it is difficult to determine a correct rate of taxation, which reduces the actual production to the socially efficient level.

 Size of the multiplier effect If the size of multiplier is large, the effect of fiscal policy on AD is also large so that fiscal policy becomes effective to achieve the desired objectives, and vice versa.

 Timing of the effects of fiscal policy This significantly influences the effectiveness of fiscal policy. If the techniques of fiscal policy take very long period of time to create the effects on AD, fiscal policy will be less effective, and vice versa.

 Effects of change in AD The different techniques of fiscal policy influence the AD. The effectiveness of fiscal policy also depends upon the effects of change in AD on the level of output, employment, inflation, and so on. Larger such effects, stronger will be the impact of fiscal policy and vice versa.

 Effects on incentives The use of fiscal policy has some effects on the incentives. These effects may be positive as well as negative. Such effects on the incentives influence the effectiveness of fiscal policy. For example, reduction in government spending and increase in the taxation may have some undesirable side-effects. This influences the Public Finance Page 38

Fiscal Policy effectiveness of fiscal policy. If these undesirable side-effects are strong, fiscal policy creates inefficiencies in the economy.

 Size of accelerator effect If the accelerator effect is strong, fiscal policy becomes more effective.

CONCLUSION Government can influence the level of production, inflation and unemployment by using the fiscal policy. Thus, fiscal policy is an important tool in the hands of the government to achieve its macroeconomic goals. Depending upon the existing situation of the economy and priority of the government, it can use the different instruments of fiscal policy as mentioned above.

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Fiscal Policy

Expansionary Vs. Contractionary Fiscal Policy

A government’s fiscal policy involves increasing/decreasing spending and taxes to control the economy. The governments fiscal actions are reflected in the fiscal budget.

When the taxes collected are more than the spending, there’s a budget surplus. Similarly when spending exceeds tax collection, there’s a budget deficit.

Whether the fiscal policy is expansionary or contractionary can be gauged by whether there is budget surplus or budget deficit. The basic rules are given below:

   

Increase in surplus indicates contractionary fiscal policy Decrease in surplus indicates expansionary fiscal policy Increase in deficit indicates expansionary fiscal policy Decrease in deficit indicates expansionary fiscal policy

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Fiscal Policy

An increase in surplus indicates that the increase in tax revenue is more than the increase in spending, which indicates contraction.

Even though the fiscal deficit provides some indication about direction of fiscal policy, it may not indicate the true intention of government with respect to its fiscal policy. For example, if government is in recession, and its taking actions to expand economy, the government is aiming for an expansionary policy.

the the the the

However, the current economic conditions may not truly reflect that. Therefore, to understand the true impact of the fiscal policy, the economists adjust the budget for cyclical issues.

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Fiscal Policy

Fiscal Multiplier and Balanced Budget Multiplier

 Fiscal Multiplier As a part of its expansionary fiscal policy, when the government of a country decides to increase spending, it has a multiplier effect on the aggregate demand, i.e., the aggregate demand increases much more than the actual increase in spending.

The actual increase in the aggregate demand depends on the tax rate (again set by the government), and the marginal propensity to consume (MCP), i.e., how much will the consumption increase with an increase in disposable income.

Let’s take a simple example to understand this multiplier effect. Assume that the government increases its spending by $100. Assume that the tax rate and MCP for those who receive this money is 30% and 90%. So, a $100 increase in government spending increases income by $100*(10.30) = $70. From this disposable income of $70, people will spend $70 *0.90 = $63. This $63 will become income for other people, and their disposable income will be $63*(1-0.30) = $44.1, out of which they will spend $44.1*0.90 = $39.69. This process will continue till the additionally created disposable income becomes close to zero.

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Fiscal Policy The actual increase in aggregate demand due to increased spending can be calculated using the fiscal multiplier. Fiscal Multiplier = 1/(1-MCP(1-t)) Where, t is the tax rate. With t = 30% and MCP = 90%, the Fiscal multiplier will be: Fiscal multiplier = 1/(1-0.90*(1-0.30)) = 2.7 With a fiscal multiplier of 2.7, a $100 increase in spending will increase the aggregate demand by $270. As you can see, fiscal multiplier is directly related to MCP and inversely related to the tax rate.

 Balanced Budget Multiplier When the government increases spending, it may also want to increase taxes to balance its budget. If the spending is increased by $100, then it may also increase the taxes by $100 to offset the increase in spending. However, even the taxes have a multiplier effect on the aggregate demand. With an MCP of 90%, when the taxes are increased by $100, the aggregate demand will initially reduce by $100*0.90 = $90. This again will have multiple iterations, and the total decrease in aggregate demand will be $100*0.9*2.7 = $243. So, a $100 increase in spending and taxes each will have a net effect of increase in aggregate demand by $27 ($270 – $243). This means that the balanced budget multiplier is positive. The government can increase the taxes a little more to make the net increase in aggregate demand zero

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Fiscal Policy

Ricardian Equivalence The Ricardian equivalence is a proposition named after the economist David Ricardo. The key idea behind Ricardian equivalence is that the choice of financing the current deficit by the government (increase in tax, or spending with debt) is irrelevant. This is because effect of this choice on aggregate demand is the same. When the government has a deficit, it has two choices to raise money: increase tax, or issue bonds. The second option of using debt is also related to the first option, because the bonds represent debt that needs to be repaid in the future. To repay the debt, the government is likely to raise taxes. So, the real choice is whether to increase taxes now or in the future. Assume that the government issues debt to finance its extra spending, that is, it has chosen to increase taxes later. The tax payers will now expect that they will have to pay higher taxes in the future. To offset this additional future cost, they will reduce their consumption and increase saving. Therefore, the effect on the aggregate demand will be the same, as if the government had chosen to increase taxes now. Ricardian equivalence depends on how well the taxpayers are able to predict their future increase in liability.

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Fiscal Policy

What is Fiscal Deficit? When a government's total expenditures exceed the revenue that it generates (excluding money from borrowings). Deficit differs from debt, which is an accumulation of yearly deficits.

Should We Worry About the Size of Fiscal Deficit? At the time of this writing, the US is currently running a deficit of over $1.3 trillion. As the fiscal deficit grows, so does the government borrowings which need to be repaid along with the interest expense. The fiscal deficit is usually observed as a percentage of the country’s GDP. The US fiscal deficit is ~8.5% of the GDP, which seems pretty high compared to ~3.2% in 2008. For some people this is a big cause of concern, while for others the concern is overrated.

Why High Fiscal Deficit is a real concern? 1. It leads to an increase in future taxes. 2. If investors don’t refinance, government may default, or print more money. 3. Printing money will cause high inflation. 4. Crowding-out effect. Increased government borrowing leads to an increase in interest rates, which leads to a decrease in aggregate demand. The purpose of spending more has failed

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Fiscal Policy

Why High Fiscal Deficit is not that big a problem?

1. If the debt raised is used for capital investment, it will pay off in the future. 2. The government may want to consider tax reforms. 3. If Ricardian equivalence holds true, this is not a problem as there won’t be any impact on aggregate demand. 4. Deficits can help in increasing GDP and employment. 5. If most debt is raised domestically, the problem is not that big.

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Fiscal Policy

What Are the Four Most Important Limitations of Fiscal Policy?

Lag Time  Lag time is the time it takes to implement fiscal policy. For example, governments around the world announced several fiscal and monetary policy initiatives to deal with the 2008 financial crisis. Central banks, including the U.S. Federal Reserve, implemented the monetary policies very quickly, including cutting interest rates and increasing the money supply. Monetary policy changes affect the economy faster because financial institutions generally match Federal Reserve rate cuts immediately. However, fiscal policy measures, such as income tax cuts and stimulus spending, usually require changes to existing legislation or the creation of new legislation. Economic circumstances might be quite different by the time legislation goes through the committee process and enacted into law.

Limited Discretion  Fiscal policy makers often have limited discretion because a significant portion of the budget is reserved for non-discretionary spending, such as Social Security and Medicare. This limitation becomes more severe when governments run large budgetary deficits and the resulting debt servicing costs limit policy-making flexibility. Deficit spending also worsens the long-time fiscal position because rising interest rates increase debt servicing costs and put pressure on lawmakers to reduce rather than increase spending. Electoral realities may also limit budgetary discretion because short-term spending measures to improve electoral Public Finance Page 47

Fiscal Policy prospects takes precedence over prudent long-term fiscal planning

Information Availability  Real gross domestic product might be below, above or at full Gross Domestic Product, or GDP, which is the maximum amount of individual consumption, government investment, private sector investment and net exports in the economy. Therefore, policy makers might not be able to determine whether contractionary or expansionary policy is necessary. Contractionary policy includes spending cuts and increased taxes, while expansionary policy refers to tax reductions and stimulus spending. Policy makers also require accurate forecasts of the impact of various fiscal policy alternatives. However, economic forecasting is not an exact science, which makes long-range budgetary projections inherently unreliable.

Crowding-Out Effect  Fiscal policy could have a crowding-out effect. This occurs when government borrowing hampers private sector borrowing. Investors are more likely to buy low-risk government bonds than riskier corporate bonds. This makes it more difficult -- and potentially more expensive in the form of higher interest rates -for the private sector to raise funds for business expansion and job creation.

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Fiscal Policy

Terms relating to fiscal policy

 Fiscal Stance - This refers to whether the government is increasing AD or decreasing AD, e.g. expansionary or tight fiscal policy  Fine Tuning - This involves maintaining a steady rate of economic growth through using fiscal policy. However this has proved quite difficult to achieve precisely.  Automatic fiscal stabilisers -If the economy is growing, people will automatically pay more taxes ( VAT and Income tax) and the Government will spend less on unemployment benefits. The increased T and lower G will act as a check on AD. But, in a recession the opposite will occur with tax revenue falling but increased government spending on benefits, this will help increase AD  Discretionary fiscal stabilisers - This is a deliberate attempt by the govt to affect AD and stabilise the economy, e.g. in a boom the government will increase taxes to reduce inflation.  The multiplier effect - When an increase in injections causes a bigger final increase in Real GDP.  Injections (J) - This is an increase of expenditure into the circular flow, it includes govt spending(G), Exports (X) and Investment (I)  Withdrawals (W) - This is leakages from the circular flow This is household income that is not spent on the circular flow. It includes: Net savings (S) + Net Taxes (T) + Net Imports (M) Public Finance Page 49

Fiscal Policy

Criticism of Fiscal Policy

1. The government may have poor information about the state of the economy and struggle to have the best information about what the economy needs. 2. Time lags. To increase government spending will take time. It could take several months for a government decision to filter through into the economy and actually affect AD. By then it may be too late. 3. Crowding out. Some economists argue that expansionary fiscal policy (higher government spending) will not increase AD, because the higher government spending will crowd out the private sector. This is because government have to borrow from the private sector who will then have lower funds for private investment. 4. Government spending is inefficient. Free market economists argue that higher government spending will tend to be wasted on inefficient spending projects. Also, it can then be difficult to reduce spending in the future because interest groups put political pressure on maintaining stimulus spending as permanent. 5. Higher borrowing costs. Under certain conditions, expansionary fiscal policy can lead to higher bond yields, increasing the cost of debt repayments.

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Fiscal Policy

Evaluation of Fiscal Policy The success of fiscal policy will depend on several factors, such as: 1. It depends on the size of the multiplier. If the multiplier effect is large, then changes in government spending will have a bigger effect on overall demand. 2. It depends on the state of the economy. Fiscal policy is most effective in a deep recession where monetary policy is insufficient to boost demand. In a deep recession (liquidity trap). Higher government spending will not cause crowding out because the private sector saving has increased substantially. Liquidity trap and fiscal policy – why fiscal policy is more important during a liquidity trap. 3. It depends on other factors in the economy. For example, if the government pursue expansionary fiscal policy, but interest rates rise and the global economy is in a recession, it may be insufficient to boost demand. 4. Bond yields. If there is concern over the state of government finances, the government may not be able to borrow to finance fiscal policy. Countries in the Eurozone experienced this problem in the 2008-13 recession.

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Fiscal Policy

Objective of Monetary Policy The primary objective of BSP's monetary policy is to promote a low and stable inflation conducive to a balanced and sustainable economic growth. The adoption of inflation targeting framework for monetary policy in January 2002 is aimed at achieving this objective.

What is Monetary Policy? measures or actions taken by the central bank to influence the general price level and the level of liquidity in the economy. Monetary policy actions of the BSP are aimed at influencing the timing, cost and availability of money and credit, as well as other financial factors, for the main objective of stabilizing the price level.

 Expansionary Monetary Policy monetary policy setting that intends to increase the level of liquidity/money supply in the economy and which could also result in a relatively higher inflation path for the economy. Examples are the lowering of policy interest rates and the reduction in reserve requirements. Expansionary monetary policy tends to encourage economic activity as more funds are made available for lending by banks. This, in turn, increases aggregate demand which could eventually fuel inflation pressures in the domestic economy.

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Fiscal Policy  Contractionary Monetary Policy

monetary policy setting that intends to decrease the level of liquidity/money supply in the economy and which could also result in a relatively lower inflation path for the economy. Examples of this are increases in policy interest rates and reserve requirements. Contractionary monetary policy tends to limit economic activity as less funds are made available for lending by banks. This, in turn, lowers aggregate demand which could eventually temper inflation pressures in the domestic economy.

Which is More Effective Monetary or Fiscal Policy? In recent decades, monetary policy has become more popular because:  Monetary policy is set by the Central Bank, and therefore reduces political influence (e.g. politicians may cut interest rates in desire to have a booming economy before a general election)  Fiscal Policy can have more supply side effects on the wider economy. E.g. to reduce inflation – higher tax and lower spending would not be popular and the government may be reluctant to purse this. Also lower spending could lead to reduced public services and the higher income tax could create disincentives to work.  Monetarists argue expansionary fiscal policy (larger budget deficit) is likely to cause crowding out – higher government spending reduces private sector spending, and higher government borrowing pushes up interest rates. (However, this analysis is disputed)  Expansionary fiscal policy (e.g. more government spending) may lead to special interest groups pushing for spending which isn’t really helpful and then proves difficult to reduce when recession is over. Public Finance Page 53

Fiscal Policy  Monetary policy is quicker to implement. Interest rates can be set every month. A decision to increase government spending may take time to decide where to spend the money. However, the recent recession shows that Monetary Policy too can have many limitations.  Targeting inflation is too narrow. This meant Central banks ignored an unsustainable boom in housing market and bank lending.  Liquidity Trap. In a recession, cutting interest rates may prove insufficient to boost demand because banks don’t want to lend and consumers are too nervous to spend. Interest rates were cut from 5% to 0.5% in March 2009, but this didn’t solve recession in UK.  Even quantitative easing – creating money may be ineffective if banks just want to keep the extra money in their balance sheets.  Government spending directly creates demand in the economy and can provide a kick-start to get the economy out of recession. Thus in a deep recession, relying on monetary policy alone, may be insufficient to restore equilibrium in the economy.  In a liquidity trap, expansionary fiscal policy will not cause crowding out because the government is making use of surplus saving to inject demand into the economy.  In a deep recession, expansionary fiscal policy may be important for confidence – if monetary policy has proved to be a failure.

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Fiscal Policy

Impact on the Composition of Output Monetary policy is seen as something of a blunt policy instrument – affecting all sectors of the economy although in different ways and with a variable impact Fiscal policy changes can be targeted to affect certain groups (e.g. increases in means-tested benefits for low income households, reductions in the rate of corporation tax for small-medium sized enterprises, investment allowances for businesses in certain regions) Consider too the effects of using either monetary or fiscal policy to achieve a given increase in national income because actual GDP lies below potential GDP (i.e. there is a negative output gap)

 Monetary policy expansion Lower interest rates will lead to an increase in both consumer and fixed capital spending both of which increases current equilibrium national income. Since investment spending results in a larger capital stock, then incomes in the future will also be higher through the impact on LRAS.

 Fiscal policy expansion An expansion in fiscal policy (i.e. an increase in government spending) adds directly to AD but if financed by higher government borrowing, this may result in higher interest rates and lower investment. The net result (by adjusting the increase in G) is the same increase in current income. However, since investment spending is lower, the capital stock is lower than it would have been, so that future incomes are lower.

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Fiscal Policy

Differences in the Effectiveness of Monetary and Fiscal Policies When the economy is in a recession (when business and consumer confidence is very low and perhaps where deflationary pressures are taking hold) monetary policy may be ineffective in increasing current national spending and income. The problems experienced by the Japanese in trying to stimulate their economy through a zero-interest rate policy might be mentioned here. In this case, fiscal policy might be more effective in stimulating demand. Other economists disagree – they argue that short term changes in monetary policy do impact quite quickly and strongly on consumer and business behaviour. Consider the way in which domestic demand in both the United States and the UK has responded to the interest rate cuts introduced in the wake of the terror attacks on the USA in the autumn of 2001 However, there may be factors which make fiscal policy ineffective aside from the usual crowding out phenomena. Future-oriented consumption theories hold that individuals undo government fiscal policy through changes in their own behaviour – for example, if government spending and borrowing rises, people may expect an increase in the tax burden in future years, and therefore increase their current savings in anticipation of this

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Differences in the Lags of Monetary and Fiscal Policies Monetary and fiscal policies differ in the speed with which each takes effect the time lags are variable Monetary policy in the UK is extremely flexible (rates can be changed each month) and emergency rate changes can be made in between meetings of the MPC, whereas changes in taxation take longer to organize and implement. Because capital investment requires planning for the future, it may take some time before decreases in interest rates are translated into increased investment spending. Typically it takes six months – twelve months or more before the effects of changes in UK monetary policy are felt. The impact of increased government spending is felt as soon as the spending takes place and cuts in direct and indirect taxation feed through into the economy pretty quickly. However, considerable time may pass between the decision to adopt a government spending programme and its implementation. In recent years, the government has undershot on its planned spending, partly because of problems in attracting sufficient extra staff into key public services such as transport, education and health

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Fiscal Policy

What are the similarities between fiscal and monetary policy? They're both methods (of macroeconomics) used by the government to stabilize the economy.

 Fiscal policy mainly involves changing expenditures or changing taxes to increase aggregate demand and achieve economic growth and higher employment.

 Monetary policies involve changing the money supply in order to affect interest rates in order to increase employment and achieve stable prices. They are basically two methods through which you can achieve the same goal.

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Fiscal Program For 2013, we aim to increase our target revenues to 1.78 billion, which would translate to 14.9 percent of the proposed GDP for the same year, with a projected growth rate of 14.1, including the impact of the pending sin tax law, when it is passed. Disbursements projections are also positive for 2013, with a target of P2.021 trillion, a record in terms of public budgeting. The deficit target is also set lower than the target set for 2012, at P241 billion, or 2 percent of the projected GDP.


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Fiscal Policy Disbursements


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