Efficiency of Fiscal Policy - Case Study Example

Efficiency of fiscal policy According to Handerson (1987), the major goals of macroeconomic policies are to achieve full employment, price stability, sustained economic growth and external balancing. To achieve these goals the Government intervenes in the economy through monetary or fiscal policies (Block & Hirt, 2008). Monetary policies are characterized by the manipulation of the stock of money in circulation in a country in order to be able to achieve the goals of macroeconomic policy. Aschauer (1985) explains that fiscal policies are the governments plan for spending and taxation. Fiscal policies are designed to steer aggregate demand in some desired direction (Chaloupka, 2011). This paper will concentrate on fiscal policy. It was felt that in a capitalist society government participation in the market should be very minimal. Those who supported this emphasized the need to leave the allocation of resources to market forces of demand and supply so that if the demand is greater than supply the prices would rise and vice versa (Clarke & Dela, 2008). This process would clear the market as they argued but over the years many changes take place. The political ideology report led to the establishment of socialistic states where the size of the public spending was larger than the private sector (Nickerson & Silverman, 2003). However, despite the different ideologies the need of government participation in economic activity is important for various reasons such as; Public spending is required to provide goods and services that cannot be provided through the market (Clarke, 2004). The government must formulate and implement economic policies that are needed to guide, correct and supplement the course that the economy will take on its growth and development (Crawford, 2007). Denis & McConnell (2003) acknowledges that even where market forces are used to allocate resources there must be a significant large public sector to provide regulation and laws that will provide the required protection otherwise there will be no property rights and there cannot be market without exclusive ownership rights. The laws and regulations are also needed to ensure free competition in the market, free entry in the market, free exit from the market and for consumer protection so that in general the contractual obligations that arise from free market transactions cannot be executed unless there is protection and enforcement of a government provided legal structure (Morris & Shin, 1999). Social values may require adjustments in the distribution of income and wealth which results from the market systems and from transmission of property rights through inheritance. Barney (1991) observes that private sector invest where the returns are high while public sector look at overall benefits of a project to the community even if the returns are low, for instance, government provide immigration schemes, hospitals, schools among others. Where the returns are very low and the maturity period of such projects is very long. A good fiscal policy should enhance the policy objectives of the public sector Public policy objectives According to Hilton (2004), there are three major functions of budgetary policy: allocation formulation, distribution and stabilization Allocation of resources: it is the process whereby the social goods or public goods are provided by the government to the individuals of a given country (Steven, Roby and Gregory, 2008). The provision of private goods and services is normally done according to consumer preferences but because social goods and services have collective consumption it is very hard to know the nature of the society preferences (Bazerman & Moore, 2009). It would be very difficult to seek individual opinion from every citizen on the type and the quantity of a social good that should be provided. Because of that the government should be responsible to allocate social goods. Sometimes the government uses the political process as a substitute to the market mechanism. Weston and Brigham (1971) observe that the political process involves voting by ballot where the item voted by the majority should be provided for by the government. The government can produce the social good or the government can get a private individual to produce and then the government distributes. Distribution functions: it is a process through which the government redistributes income among the citizens. Warren (2009) notes that in the absence of government intervention in the distribution of income the distributions depend on the distribution of factor endowment. It is important to note that people earning ability differ and the ownership of properties also differs. The distributions of income based on this factor pricing which in a competitive market sets factor returns equal to the value of the marginal produce (Weygandt, et al., 2009). The distribution of income among individuals depends on their factor supplies and the process they get in market in most countries where free market policies are followed there tends to arise a class of society where few become richer, majority poorer, Because this does not fall in time with what is considered to be fair and just the government must employ mechanisms and fiscal policy to redistribute income. An effective government intervention should result in strengthening the policies of distribution (Hoque, 2006). Stabilization function: in this function macroeconomic policies are employed to maintain and achieve the goals of high employment, acceptable price stability, favourable balance of payment (BOP) position and acceptable rate of economic growth and development (Brigham and Herhardt, 2009). Fiscal policies are necessary because high rates of employment and low rates of inflation do not come automatically in a free market economy. In fact changes in inflation rate are inversely related to the rate of unemployment. The transmission mechanism of fiscal policy According to Walter (1985), the government employs its fiscal policy through manipulation of government spending and taxation by the government. Government spending In a balanced budget the level of government expenditure is equal to the level of its taxation revenue and at an equilibrium income withdrawals are equal to injections (Merchant & Van der Stede, 2012). Spending by the government is an injection to the income flow whereas taxation is a withdrawal to the income flow. The level of income will increase with every addition of an injection to aggregate demand whereas the level of income will decrease with every deduction of a withdrawal from aggregate demand. A change in the level of government expenditure will cause a change in the budget and then cause a direct change in income. A change in income influences a direct change in the level of consumption the amount of which is determined by the marginal propensity to consume (MPC). A change in the level of consumption results to either decumulation or accumulation of inventories. Inventories are decumulated if there is increase in government spending while inventories are accumulated if there is decrease in government spending. The hypothetical graph representation below will be used to explain the transmission in details. Increased government expenditure Suppose that the economy is in equilibrium at point Y*. When the spending by the government is increased, the aggregate expenditure rises from E* to E1. Income will increase by the amount of government spending. Since consumption is a direct function of income, it will increase due to the increase in income. As a result of increased consumption inventories will be decumulated forcing firms to employ more labour in order to replenish the inventories. As firms increase their level of production and invest in accumulating its inventories, there will be an increase in capacity utilization. The marginal efficiency of investment, MEI, which is the rate of return that is anticipated from the new capital, will increase while plant and equipment resources wear out more fast hence necessitating their replacement. Most firms will bump up against its capacity to produce forcing them to increase their investment in additional plant and equipment. The additional investment is dependent upon MEI out of the aggregate income. The new investment causes an increase in income, real output and the level of employment through the multiplier. Therefore, if employment opportunities have increased it implies that there is a decline in unemployment. Reduction in government expenditure Lets still assume that the economy is in equilibrium at point Y*. When the spending by the government is reduced, the aggregate expenditure falls from E* to E2. Income will decrease by the amount of government spending decrease. Since consumption is a direct function of income, it will decrease due to the decrease in income. As a result of decreased consumption inventories will be accumulated forcing firms to lay off some labour in order to decrease redundant inventories. As firms decrease their level of production and disinvest redundant inventories, there will be a decrease in capacity utilization and there will be an excess capacity. The marginal efficiency of investment will decrease while plant and equipment resources wear out less hence they are not replaced. This means there will be lower investment in both plant and equipment and inventories. Therefore, the desired capital will be lower than the actual capital. The additional investment is dependent upon MEI out of the aggregate income. The reduction in investment causes a decrease in income, real output and the level of employment through the multiplier. Therefore, if employment opportunities have decreased it implies that there is an increase in unemployment. Taxation Taxation is the main tool that the central government uses to collect revenue from the public. Taxes are compulsory imposed to tax payers and also withdrawn from private sector without any obligation to the government to repay. The primary motivation of taxation is to finance public administration and the public provision of economic and social goods and services. The secondary motivation is the redistribution of income and wealth, the correction of market imperfection and stabilization of the economy. A good tax system must ensure that tax burden is equally distributed, that is, everyone should be made to pay his fair share. Therefore, a firm or household should not experience a tax system that tends to make them contribute to mitigating the loss of government revenue brought about by tax avoidance by others. A good tax system must ensure that both the cost of collecting taxes to the government and the cost to tax payers of meeting their tax obligation are minimized. Taxes should be chosen so as to minimize interference with economic decisions in efficient markets. If a tax diverts resources in the public sector such that it imposes a burden on the economy that can be equated only to revenue raised, then the tax is free of excess burden. However, imposition of a tax levied on certain products may provide an incentive for households to reduce their consumption level of the taxed products, but consume more of untaxed products. This may be an attempt to minimize their tax liability. In addition a good tax system should be understandable by the tax payer. The more it is aware of the tax burden the better it is able to judge the benefit it gets against tax force and the better equipped it is to rate for the amount of the good to consume. The household is usually not aware of the tax component in the product it consumes. Therefore, it is possible for a household to continue consuming the same level of products if it thinks that there is a general increase in the price level. However, if he judges that it is only certain products that have experienced an increment in price due to tax component; it is likely to reduce the amount of products it takes. The tax revenue should be sensitive to changes in economic conditions without deliberate change in tax rates. This principle can be satisfied for at least two reasons. First, the elasticity enables government to finance the rising demand for public expenditure without disturbance of frequent tax rate changes. Secondly, elastic tax return will function as an automatic stabilizer for fiscal policy purposes. The transmission mechanism of fiscal policy through taxation Changing taxation levels is an important fiscal policy for the government since it causes an immediate change in the level of disposable income for both the firms and the households (Madura, 2006). Changing personal income taxes initially influences the aggregate economic activity through the marginal propensity to consume, MPC. On the other hand changing corporate taxation initially influences the aggregate economic activity through the marginal propensity to invest out of income. As a consequence, employment and aggregate income are influenced by the multiplier. The hypothetical graph representation below will be used to explain the transmission in details. Increased Taxation Suppose that the economy is in equilibrium at point Y*. When taxes are increased, the disposable income for households is reduced. Consumption will decrease by the marginal propensity to consume, MPC out of disposable income. Aggregate expenditure falls from E* to E2. An increase in corporate taxes reduces the MEI (rate of return that is anticipated from the new capital), the curve shifts in and investment falls by MEI out of income resulting in reduced aggregate expenditure from E* to E2. In the case of increased taxes, the spending by the private sector falls and as a result income and real output decreases. The reduced output will force labour redundancy hence increasing unemployment. Reduced taxation Lets still assume that the economy is in equilibrium at point Y*. When taxes are reduced, the disposable income for households is increased. Consumption will increase by the marginal propensity to consume, MPC out of disposable income (Ivan, 1978). Since consumption is a direct function of disposable income, it will increase due to the increase in disposable income. Aggregate expenditure rises from E* to E1. A reduction in corporate taxes raises the marginal efficiency of investment, MEI, which is the rate of return that is anticipated from the new capital, the curve shifts out and investment rises by MEI out of income resulting in increased aggregate expenditure from E* to E1. In the case of reduced taxes, the spending by the private sector is stimulated and as a result income and real output increases. As noted in Meltzer (1981) the increased output will require more labour hence reducing unemployment. References Aschauer, D. A., (1985). Fiscal Policy and Aggregate Demand. American Economic Review, 75(1): 117-27. Barney, J., (1991). 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