Theoretical literature on the effectiveness of fiscal policy

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OUTLINE OF THE STUDY

The study consists of eight chapters supported by a number of graphs and tables. The introductory chapter describes the background and objective of the study, the statement of the research problem, the research methodology and the outline of the study. Chapter 2 describes the theoretical literature on the effectiveness of fiscal policy. The chapter differentiates between discretionary and non-discretionary policies, describes the usefulness of budget rules and discusses the linkages between monetary policy and fiscal policy. In Chapter 3 automatic fiscal stabilisers are defined, the various types of automatic fiscal stabilisers described, their role and effectiveness analysed and the main determinants regarding their size documented. The main advantages and disadvantages of automatic fiscal stabilisers are evaluated together with a discussion of the various ways in which they could be measured. Chapter 3 also provides some international empirical evidence of the usefulness of automatic fiscal stabilisers, highlights some supply-side considerations that are often neglected, addresses the question whether the level of government at which fiscal stabilisation occurs has any effect on its net impact and reviews the main aspects regarding cyclically adjusted budget balances.

THEORETICAL LITERATURE ON THE EFFECTIVENESS OF FISCAL

POLICY According to Fatás and Mihov (2002:6), mainstream macroeconomic theory predicts that fiscal policy is not neutral with respect to output – changes in spending or taxes exert a strong influence on the economy in virtually every macroeconomic model. In the standard Keynesian models, the effect arises from aggregate demand, while in dynamic general equilibrium models of the real business cycle type; output changes because fiscal policy affects the incentives to work and to save. Hemming, Kell and Hahfouz (2002) highlight the theoretical literature on the demandside effects, supply-side effects and institutional aspects of fiscal policy. Theoretical literature on the effectiveness of fiscal policy spans the simple Keynesian model, closed and open economy IS-LM models, demand-side models incorporating rational expectations, Ricardian equivalence, interest rate premiums, credibility, uncertainty and supply-side models.
The authors argue that literature suggests fiscal multipliers will tend to be positive and possibly be quite large when there is excess capacity, the economy is either closed or open and the exchange rate is fixed. Furthermore, households have limited time horizons or are liquidity constrained, increased government spending does not substitute for private spending, government debt is low and the government does not face financing constraints, and there is an accompanying monetary expansion with limited inflationary consequences. On the other hand, fiscal multipliers are likely to be smaller, and could turn negative when there is crowding out, either directly as government provision substitutes for private provision and through imports or as interest rates rise and a flexible exchange rate appreciates in response to a fiscal expansion. Furthermore, households are Ricardian, in which case a permanent fiscal expansion could reduce consumption, there is a debt sustainability problem and risk premia on interest rates are large. Finally, expansionary fiscal policy increases uncertainty, which leads to more cautious saving and investment decisions by households and firms.

BUDGET RULES

Government could manage public finances by following some rules to guarantee sustainability and which allow automatic stabilisation. According to the European Central Bank’s Monthly Bulletin (2003:39), growing awareness of the limitations associated with macroeconomic fine-tuning has led to a worldwide trend towards the adoption of more rule-based institutional frameworks. These frameworks could provide authorities with specific mandates, i.e. clearly identified policy objectives, in order to set proper specific targets for decision-making level and ensure predictability of policy. Moreover, these frameworks could provide responsible authorities with guidance on the appropriate setting of their instruments in the face of constantly changing economic conditions in such a way as to keep the path of their action through time as consistent as possible with the long-term attainment of their policy objectives. Marin (2002) emphasises that there are a number of issues under discussion on rules of fiscal discipline, namely the way in which the rules of budgetary discipline are implemented, the appropriate medium-term targets, the importance of allowing automatic stabilisers to operate symmetrically over the cycle, the allowance of temporary deviations from close to balance positions or from surplus budgetary positions toward deficit positions, the operational assessment of the sustainability of public finances, etc.

SYNOPSIS

Despite some theoretical concerns regarding the effectiveness and impact of demand management, the fiscal stabilisation goal of government is still being recognised as important given the widening public deficits during the recent world economic slowdown. In the light of the arguments presented in this chapter, there is also little practical doubt that the fiscal system could be used for stabilisation. The economic policies used by government to smooth the extreme swings of the business cycle are called countercyclical or stabilisation policies. Fiscal policy instruments could contribute to the stabilisation of the economy to the extent that they can stabilise output, income and demand during an economic downturn by maintaining or even increasing government expenditure, or by reducing tax revenue. By the same token, they could moderate activity during periods of strong growth. Fiscal policy can be used as a stabilising instrument of economic activity either through the effects of built-in automatic stabilisers or through discretionary tax and expenditure measures, or through a combination of both.

READ The bank’s view on differences

TYPES OF AUTOMATIC FISCAL STABILISERS

Fluctuations in economic activity influence government revenue and expenditure automatically. During an economic upswing, the tax base grows and unemployment decreases, while the opposite happens during recessions. As a result, tax revenue and unemployment-related social security expenditure fluctuate according to the business cycle and the budget balance responds automatically to the cyclical movements of the economy. Taxes are used for stabilisation purposes, either by way of discretionary tax rate changes or via their built-in stabilisation properties. According to the OECD (1993:44), tax-based automatic stabilisers have the advantage that they are rule-based because they respond immediately to changes in activity and generate expectations of future reversals that may limit the impact of greater public borrowing on long-term interest rates. If the economy goes into recession because of a sudden decrease in autonomous consumption, for example, the collection of progressive tax revenue decreases even faster than income, and this decrease in taxes has a multiplier effect, partly offsetting the decrease in autonomous consumption, so that equilibrium income does not decrease as far or as fast as it possibly would have. According to Abel and Bernanke (2001:572), this automatic cut in tax collections helps cushion the decrease in disposable income and prevents aggregate demand from falling during recessions, making fiscal policy automatically more expansionary.

ROLE AND EFFECTIVENESS OF AUTOMATIC FISCAL STABILISERS

Automatic stabilisers help to smooth fluctuations in the business cycle by automatically moving the budget towards a deficit or higher deficit during a recession and towards a surplus or higher surplus during an expansion. The income-based tax system or the UI system could play an important role in converting some likely periods of recession into periods of normal growth as well as in boosting growth in the first year following recession troughs.

LIST OF CONTENTS :

1 INTRODUCTION AND BACKGROUND
- 1.1 Introduction
- 1.2 Statement of the research problem
- 1.3 Research methodology
- 1.4 Outline of the study
2 FISCAL STABILISATION POLICY
- 2.1 Introduction
- 2.2 Theoretical literature on the effectiveness of fiscal policy
- 2.3 Discretionary vs. non-discretionary policy
- 2.4 Budget rules
- 2.5 Monetary policy vs. fiscal policy
- 2.6 Synopsis
3 AUTOMATIC FISCAL STABILISERS
- 3.1 Introduction
- 3.2 Business cyclical properties of fiscal policy
- 3.3 Definition of automatic fiscal stabilisers
- 3.4 Types of automatic fiscal stabilisers
- 3.5 Role and effectiveness of automatic fiscal stabilisers
- 3.6 Advantages, disadvantages and risks of automatic fiscal stabilisers
- 3.7 Determinants of the size of automatic fiscal stabilisers
- 3.7.1 Size of government
- 3.7.2 Tax and expenditure structure and the sensitivity of budget components to the cycle
- 3.7.3 The effectiveness of stabilisation efforts in relation to the openness and structure of the economy
- 3.7.4 Fiscal restraints
- 3.7.5 The relationship between automatic and discretionary stabilisation
- 3.7.6 The Unemployment Insurance system
- 3.7.7 Other factors
- 3.8 Measurement of automatic fiscal stabilisers
- 3.9 Supply-side considerations
- 3.10 Level of implementation
- 3.11 International empirical evidence
- 3.12 Cyclically adjusted budget balances
- 3.13 Synopsis
4 SOUTH AFRICAN FISCAL POLICY AND THE BUSINESS CYCLE
- 4.1 Introduction
- 4.2 The South African business cycle
- 4.3 Fiscal policy objectives since the 1970s
- 4.4 Trends in general government finances
- 4.4.1 Government revenue
- 4.4.2 Government expenditure
- 4.4.3 Government balances
- 4.4.4 Government debt
- 4.5 International comparisons
- 4.6 Synopsis
5 GENERAL GOVERNMENT TAX REVENUE AS AN AUTOMATIC FISCAL STABILISER IN SOUTH AFRICA
- 5.1 Introduction
- 5.2 Empirical analysis of the role of automatic fiscal stabilisers in South Africa
- 5.2.1 The cyclical and structural components
- 5.2.2 Sensitivity analysis
- 5.2.3 The responsiveness of total tax revenue to the output gap
- 5.2.4 International comparisons
- 5.2.5 Cyclical and structural components estimated using quarterly data, 1992 to
- 5.3 Synopsis
6 THE UNEMPLOYMENT INSURANCE FUND AS AN AUTOMATIC FISCAL STABILISER IN SOUTH AFRICA
- 6.1 Introduction
- 6.2 The South African Unemployment Insurance Fund
- 6.3 Empirical investigation into the cyclical behaviour of the South African Unemployment Insurance Fund
- 6.4 Impact of the new unemployment insurance legislation
- 6.5 Synopsis
7 THE CYCLICALLY ADJUSTED BUDGET BALANCE AND AUTOMATIC STABILISATION IN SOUTH AFRICA
- 7.1 Introduction
- 7.2 A cyclically adjusted budget balance indicator for South Africa
- 7.3 The role of fiscal policy in NEPAD
- 7.4 Synopsis
8 SUMMARY, POLICY IMPLICATIONS AND FURTHER
- SUGGESTIONS
- REFERENCES