1. [Economic Policy Making] Fiscal Policy
Economics 12
[Economic Policy Making]
Fiscal Policy

2. A Question of Relevance
Do you remember what you were doing the evening the last federal budget was unveiled in Parliament? Probably not. Furthermore, you quite likely think that "it has nothing to do with me." Yet, the truth is that government's annual budget affects you more than almost any other regularly scheduled event in your life, other than such personal events as birthdays and anniversaries. It determines the taxes you pay, the chances of your getting a job next summer, the likelihood of getting a student loan, and even the size of your classes next year.

3. Current News Canada budget unveiled Tuesday March 22, 2011
See Budget Home Page for details

4. Fiscal Policy and the Budget
Governments have to spend, therefore they have to tax.
What should government's attitude toward its own spending and taxation be?
How small or large should this spending and taxation be? Should the two be equal?
Does the condition of the economy have anything to do with the answers to these questions?
It is a truism that governments have to spend, and therefore they have to tax. So, what should government's attitude toward its own spending and taxation be? How small or large should this spending and taxation be? Should the two be equal? Does the condition of the economy have anything to do with the answers to these questions? For example, when the economy is in the middle of a recession with high unemployment, what should the attitude of government be? Should government decrease its own spending, increase it, or change nothing? Alternatively, should we expect it to cut taxes, to increase taxes, or to change nothing?

5. Fiscal Policy and the Budget
Fiscal policy is the government's approach toward its own spending and taxation.
The minister of finance brings down the budget in Parliament each spring, revealing the government's fiscal policy for the coming year.
Contains estimates of government's revenues and expenditures.
Fiscal policy refers to government's approach toward its own spending and taxation. When the minister of finance brings down the budget in Parliament each spring, this reveals government's fiscal policy for the coming year. The annual budget contains estimates of government's revenues and expenditures. Budget day is headline news, and TV screens across the country are filled with political comments about how good or bad the new budget is.

6. Federal Budget Plan
Table 11.1 shows the federal government's budget plan for the fiscal year beginning April 1, All figures are in billions of dollars.
Revenues are government's total receipts which were projected to be $241.9 billion in the fiscal year , which began on April 1. This figure represents approximately 15.3 percent of Canada's projected GDP. These revenues do not include the CPP payments that are made by Canadians, since this program is administrated independently of the budget. By far the largest source of revenue is the personal income tax which is estimated to be $118.6 billion, while E.I. premiums, also paid by individual income earners, are $16.5 billion. Corporate income taxes are taxes on profits paid by companies and totalled $36.8 billion. GST and excise taxes include the federal sales tax on consumption as well as excise taxes on gasoline, alcohol, and cigarettes plus tariff revenues on certain imports. Nontax revenues, at $22.3 billion, include income from government crown corporations and other government investments, plus Bank of Canada earnings.
Total outlays were projected to be $239.6 billion. Transfers to persons are projected to be $60.4 billion and include payments toward Old Age Security, Guaranteed Annual Income Supplements, Spouse's Allowances, and the EI program. Once again, CPP payments are not included here. Spending grants to other levels of government, at $46.2 billion, are earmarked for spending on postsecondary education, health, and social assistance, as well as equalization payments, which are aimed at seven provinces (all but Ontario, Alberta, and B.C.). Aid to the developing nations and dues to international organizations, such as the United Nations, are also included in this category. Public debt charges, at $101.5 billion, is the interest that is paid on government's national debt and is also treated as a form of transfer payment in national income accounting. The last item, direct program spending of $83 billion, is part of the total spending on goods and services (G) that we first identified in the circular flow treatment in Chapter 3 and includes everything from computers for government offices to salaries of the civil servants working in those offices. The projected plan for this year is for the budget to have a surplus of 2.3 with total government revenues projected to exceed total outlays.

7. Distribution of Revenues and Outlays

8. Some Definitions
Net tax revenue (NTR) is the total tax revenue received by government less transfer payments.
Transfer payments are one-way transactions in which payment is made but no good or service flows back in return – EI and CCP payments, subsidies to businesses
Government's budget balance is defined as the difference between net tax revenues and government spending  NTR - G
A positive balance means a budget surplus
A negative balance means a budget deficit
The national debt, or, as it is sometimes called, the public debt, is the sum of the federal government’s budget deficits less its surpluses over some period of time.
We now need to define net tax revenue, which is:
NTR = tax revenue – transfer payments [11.1]
Government's budget balance is defined as the difference between net tax revenues and government spending, that is:
budget balance = NTR – G [11.2]
A positive balance means a budget surplus, since net tax revenue would be greater than spending on goods and services. Conversely, a negative balance means a budget deficit, since net tax revenues would be lower than government spending. It is important to note that government tax revenues, spending, and the deficit (or surplus) are all flows because they occur over a period of time. If we were to add up all the deficit flows over the years and then subtract the sum of all the surpluses over the same time period, we would get the national debt. The national debt, or, as it is sometimes called, the public debt, is a stock concept because it is a total outstanding at any particular point in time and is the summation of the flows of all deficits and surpluses. We will return to this topic at the end of the chapter.

9. Budget Surpluses/Deficits and the Net National Debt
(The Net National Debt is the gross debt of the federal government, including accumulated budget deficits minus financial assets.)

10. From Deficit to Surplus
What was behind the dramatic turnaround from deficit to surplus?
Government cut transfer payments to the provinces, which squeezed the delivery of health care and higher education services across the country, with the result that waiting lists for surgery grew and hospitals closed beds, while college and university classes grew in size and professors' salaries were frozen.
Despite the cut in government spending, the rate of economic growth, fuelled by increased exports to the United States, accelerated and raised government revenues, since more people were working and paying income tax and total spending was up, which meant more GST revenue.
Deficits were a permanent feature in the 1970s and 1980s and were close to $40 billion per year in the early 1990s. This led to increasing pressure on government to change policy and balance the budget. The size of the deficit started to fall in 1995 and turned into a surplus in What was behind this rather dramatic turnaround? The answer is twofold. First, government cut transfer payments to the provinces, which squeezed the delivery of health care and higher education services across the country, with the result that waiting lists for surgery grew and hospitals closed beds, while college and university classes grew in size and professors' salaries were frozen. Second, despite the cut in government spending, the rate of economic growth, fuelled by increased exports to the United States, accelerated and raised government revenues, since more people were working and paying income tax and total spending was up, which meant more GST revenue.

11. New Pressure Over Budget Surpluses
What to do with the budget surpluses?
Some called for a dramatic increase in health and education spending, citing what they saw as a threat to the viability of Canada's health care system and a deterioration in the quality of higher education in the country.
Others wanted the surpluses to go to a reduction in the national debt, which they felt was simply too large.
A third group called for reductions in taxes, expressing concern over the growing gap in after-tax income between Canadians and Americans and evidence of a growing "braindrain" to the United States.
Perhaps not surprisingly, ministers of finance have subsequently brought down budgets that have done a little of all three.
By the turn of the millennium, government was feeling a new kind of pressure: debate over what to do with the budget surpluses. Some called for a dramatic increase in health and education spending, citing what they saw as a threat to the viability of Canada's health care system and a deterioration in the quality of higher education in the country. Others wanted the surpluses to go to a reduction in the national debt, which they felt was simply too large. A third group called for reductions in taxes, expressing concern over the growing gap in after-tax income between Canadians and Americans and evidence of a growing "braindrain" to the United States. Perhaps not surprisingly, ministers of finance have subsequently brought down budgets that have done a little of all three.

12. Changes in the Economy  Government Revenues
Changes in the economy can have an impact on government revenues.
In general, net tax revenues are directly related to the level of GDP.
It is important to emphasize the fact that changes in the economy can have an impact on government revenues. A prime example of this occurred between the budget years of 1996 and In those two years, the size of the budget deficit dropped from $30 billion to $8.7 billion. As we mentioned, while transfer payments did decrease a little, the decrease in the deficit was primarily because continued growth in the economy raised government revenues. In general, net tax revenues are directly related to the level of GDP. In addition, you may recall that we treat government spending on goods and services as autonomous of (independent from) the level of real GDP. We put revenue and spending together in Figure 11.1.

13. Government Deficits and Surpluses
In Figure 11.1A, the horizontal line, G, reflects the autonomous nature of government spending on goods and services. We also have assumed that when GDP is zero, so, too, are tax revenues and transfer payments so that the net tax revenues (NTR) line begins at the origin. Since government's tax revenue is greater and transfer payments are lower at higher levels of GDP, the NTR line rises as the level of GDP rises. At a GDP level of Y1, NTR is less than the level of government spending, and there would be a budget deficit equal to ab. At a GDP level of Y3, NTR exceeds G, and there would be a budget surplus equal to de. When GDP is at a level indicated by Y2, there would be neither a budget surplus nor a deficit, as illustrated by point c. The effect of different levels of GDP on the budget itself is shown explicitly in Figure 11.1B, with the budget line, BL, showing the same deficit, ab, at GDP level Y1 and the same surplus, de, at GDP level Y3. Point c on both figures is the situation of a balanced budget.
Continuing with Figure 11.1, note that there are two things besides the level of GDP that will affect government's budget and therefore the position of the budget line: a change in either the amounts of government spending or net tax revenues. An increase in government spending, for instance, will increase the amount of the budget deficit (or reduce the surplus) at every level of GDP and result in the budget line shifting down.

14. Government Deficits and Surpluses
This is shown on Figure Here we see that an increase in government spending will shift the G curve up from G1 to G2. With the government increasing its level of spending, the budget deficit is higher (or the budget surplus lower) at each level of income. This means that the budget line shifts down from BL1 to BL2. The result is that the government is now able to achieve a balanced budget only at a higher level of income, at Y2 instead of at Y1.
You can perhaps work out for yourself that an increase in autonomous taxes would cause a smaller deficit (or increased surplus) at every level of income and is shown as a parallel shift upward in both the NTR line and the budget line. In contrast, an increase in the tax rate would also see a shift upward in both the NTR and budget lines; however, the shift would be greater at higher levels of GDP than at lower levels. We would call this an upward pivot in both lines. The essential point is that:
The state of government's budget depends on the level of GDP in the economy as well as on tax rates and its own spending.

15. How is the Government’s Budget Financed?
It is financed by borrowing.
When an individual buys a government bond (such as a Canada Savings Bond or a treasury bill), she is, in effect, lending government some of her savings so that it can finance a deficit.
Supply of money stays the same
Government can also borrow from the Bank of Canada. In this case, government would issue bonds and sell them to the Bank of Canada.
Results in an injection of new money into the economy (money supply is increased)
Known as monetizing the debt
Not used to a great extent in Canada today.
Has been frequently used by desperate governments in the past to finance wars or to otherwise help a country survive extreme economic conditions.
A question that often springs to people's minds at this point is: how is government's budget deficit financed? There is no mystery to the answer: it is financed by borrowing. For example, when an individual buys a government bond (such as a Canada Savings Bond or a treasury bill), she is, in effect, lending government some of her savings so that it can finance a deficit. Government can also borrow from the Bank of Canada. In this case, government would issue bonds and sell them to the Bank of Canada. However, there is a big difference between the Bank of Canada buying bonds and somebody else buying them. If a private individual or corporation buys government bonds, there is simply a transfer of money from that individual's bank account to the government account at a commercial bank. That is, the supply of money stays the same. But when the Bank of Canada buys government bonds, the money it uses to pay for them involves an injection of new money into the economy; in other words, the money supply is increased. The effect of this is pretty well the same as government printing money to pay its bills. This method of borrowing, known as monetizing the debt, is not used to a great extent in Canada today but has been frequently used by desperate governments in the past to finance wars or to otherwise help a country survive extreme economic conditions.

16. Self Test

17. Stop Here for Today

18. Schools of Thought on Fiscal Policy
What, if anything, should government do when the economy faces unemployment or, for that matter, inflation?
On the one hand we have economists and policymakers, interventionists, who believe that government needs to deliberately intervene in the economy and overspend, or underspend, from time to time in order to help the economy achieve the goals of full employment and stable prices.
On the other hand, the noninterventionists believe that these goals can be achieved only if there is no government intervention.
Three Schools of Thought on Fiscal Policy
We now want to address one of the more important questions posed at the beginning of this chapter. What, if anything, should government do when the economy faces unemployment or, for that matter, inflation? There are two distinct schools of thought on this issue. On the one hand we have economists and policymakers, interventionists, who believe that government needs to deliberately intervene in the economy and overspend, or underspend, from time to time in order to help the economy achieve the goals of full employment and stable prices. On the other hand, the noninterventionists believe that these goals can be achieved only if there is no government intervention. We shall look at both of these different philosophies as well as a third philosophy which is something of a compromise between these opposing schools of thought. Let's start with the interventionist philosophy called countercyclical fiscal policy.

19. Countercyclical Fiscal Policy
Advocated by the interventionists, who start with the premise that the modern market economy is unstable and thus prone to periods of unacceptably high levels of unemployment or inflation.
A policy used by governments in many countries around the world since World War II.
Main purpose is to close recessionary and inflationary gaps, that is, figuratively speaking, to lean against the prevailing winds.
Weak aggregate demand with a recessionary gap, use expansionary policy to deliberately stimulate demand with higher government spending or lower taxes (or both).
Strong aggregate demand with inflationary gap, use contractionary policy to dampen down demand through cuts in government spending or increases in taxes.
Let us begin our discussion of the three philosophies of fiscal policy by looking at the interventionists who start with the premise that the modern market economy is unstable and thus prone to periods of unacceptably high levels of unemployment or inflation. Thus, they advocate the use of countercyclical fiscal policy, a policy used by governments in many countries around the world since World War II. The main purpose of countercyclical fiscal policy is to close recessionary and inflationary gaps, that is, figuratively speaking, to lean against the prevailing winds. If, for example, aggregate demand is weak and a recessionary gap exists, expansionary policy should be used to deliberately stimulate demand with higher government spending or lower taxes (or both). On the other hand, if aggregate demand is so strong that an inflationary gap exists, then contractionary policy should be used to dampen down demand through cuts in government spending or increases in taxes.

20. Countercyclical Fiscal Policy
The recessionary gap situation is shown in Figure 11.3.
Given the current aggregate supply curve, ASl and the aggregate demand curve ADl equilibrium GDP is Y1. Since this level of GDP is below potential GDP of YFE, we have a recessionary gap of YFE – Y1. Countercyclical fiscal policy would call for either increased government spending or decreased taxes. This would increase aggregate demand, as indicated by the shift from AD1 to AD2. If such a policy was well-crafted, aggregate demand would increase just enough to eliminate the recessionary gap by moving the economy to YFE.

21. Countercyclical Fiscal Policy
Next, let us assume the economy is experiencing an inflationary gap. Here, the appropriate countercyclical fiscal policy would be to decrease government spending or increase taxes in order to reduce the level of aggregate demand. This is illustrated in Figure 11.4.
An inflationary gap is present because the equilibrium level of GDP, Y1 is above the full-employment level, YFE. Closing the gap requires a lower level of aggregate demand, as illustrated by the shift from AD1 to AD2. This could be accomplished by government reducing its spending or increasing taxes.

22. Countercyclical Fiscal Policy
In summary, countercyclical fiscal policy means the following:
When aggregate demand is low and the economy is experiencing a recessionary gap, governments should spend and tax in a way that increases aggregate demand.
When aggregate demand is high and an inflationary gap is present, governments should spend and tax in a way that reduces the level of aggregate demand.
In this way, government policy would be helping to stabilize the economy and take some of the sting out of the fluctuations in the business cycle.
In summary, countercyclical fiscal policy means the following:
When aggregate demand is low and the economy is experiencing a recessionary gap, governments should spend and tax in a way that increases aggregate demand.
When aggregate demand is high and an inflationary gap is present, governments should spend and tax in a way that reduces the level of aggregate demand.
In this way, government policy would be helping to stabilize the economy and take some of the sting out of the fluctuations in the business cycle.

23. Self Test

24. Criticisms of Countercyclical Fiscal Policy
The three criticisms of countercyclical fiscal policy are as follows:
it is subject to serious time lags
it is ineffective because it may be inflationary and crowds out private spending
it can cause serious budget deficits
In summary, the three criticisms of countercyclical fiscal policy are as follows:
it is subject to serious time lags
it is ineffective because it may be inflationary, crowds out private spending, and thus reduces the size of the multiplier
it can cause serious budget deficits

25. Criticisms of Countercyclical Fiscal Policy
Interventionists see the essence of countercyclical fiscal policy as that of fine-tuning the economy.
Even if just the right amount of adjustment can be determined, countercyclical fiscal policy takes time to implement and is slow to take effect. This means that the economy may suffer from an overdose of spending when the policy does take full effect.
Countercyclical fiscal policy has come under a good deal of criticism in recent years. We will look at three potential problems associated with the use of countercyclical fiscal policy.
The first involves the fact that interventionists see the essence of countercyclical fiscal policy as that of fine-tuning the economy. This is done by adjusting government spending or taxation by just the right amounts to achieve a level of aggregate demand sufficient to bring about full-employment GDP with stable prices. Critics, however, argue that in practice, the use of countercyclical fiscal policy is like fine-tuning with a sledgehammer. Even if just the right amount of adjustment can be determined, countercyclical fiscal policy takes time to implement and is slow to take effect. This means that the economy may suffer from an overdose of spending when the policy does take full effect. In other words, countercyclical fiscal policy is subject to serious delays.
For example, consider a government that has just determined that the economy is in need of a $4 billion spending stimulant. This government cannot simply increase spending by $4 billion without first identifying how it is going to spend the money and then getting parliamentary approval for its fiscal plans. The next problem is that a number of procedures are necessary before the actual spending can begin, the most significant of which is putting out contracts for bids by various firms in the private sector. All of this takes time, and since major projects, such as a new port facility, may last a number of years, the full effect of the increased spending may manifest a long way down the road, by which time the need for such spending may no longer exist.

26. Criticisms of Countercyclical Fiscal Policy
It is ineffective because it may be inflationary, crowds out private spending, and thus reduces the size of the multiplier.
The second potential problem with countercyclical fiscal policy is that many believe it is ineffective because it may be inflationary and also crowds out investment and net exports. Let us look first at the inflationary effects. Suppose, for instance, that government uses countercyclical fiscal policy to get an economy out of a recession. The result will be an increase in aggregate demand, as shown in Figure 11.5.
An increase in government spending (or a reduction in taxes) would shift the aggregate demand curve to the right, from AD1 to AD2. Clearly, the level of GDP increases from Y1 to YFE. Unfortunately, the price level also rises, in this case from P1 to P2. Countercyclical fiscal policy therefore is inflationary, and the rate of inflation depends on how close the economy is to full employment. As you may recall from Chapter 6, as we approach the full-employment level of GDP, the rise in prices accelerates. This inflation will hurt consumers and investors and make Canadian goods and services less attractive to foreigners. This loss of international competitiveness has serious consequences for an economy like Canada's, which relies so heavily on exports.
However, there is another reason why countercyclical fiscal policy may be ineffective and that is because of what is termed the crowding-out effect. As we just saw, countercyclical fiscal policy used to close a recessionary gap will increase the price level. But as the price level rises, so too will the money demand, as we learned in Chapter 8. Assuming no increase in the money supply, this increase in the demand for money will tend to push up interest rates, and this increase in interest rates might lead to a reduced level of, or the crowding-out of, private investment spending. This is illustrated in Figure 11.5.

27. Criticisms of Countercyclical Fiscal Policy
In Figure 11.6A, we see that countercyclical fiscal policy results in the aggregate demand curve shifting from AD1 to AD2. If we could ignore the effect on the money market, then real GDP would increase from Y1 to Y2. However, the consequent increase in the price level will increase the transactions demand for money, and therefore the money demand curve will shift out from MD1 to MD2, as seen in Figure 11.6B. This, in turn, increases the interest rate from r1 to r2. This higher interest rate reduces investment spending, as illustrated in Figure 11.6C, where investment falls from I1 to I2. This reduces the aggregate quantity demanded (a movement up AD2) as seen in Figure 11.6A. In summary, the increase in government spending pushes up aggregate demand and real GDP, but the subsequent decrease in investment spending causes the aggregate quantity to fall back a little.
We have just seen that countercyclical fiscal policy might push up interest rates and weaken the effect of fiscal policy through the crowding-out of private investment spending. There is another possible effect of higher interest rates that we need to consider. In an open economy with flexible exchange rates, such as Canada's, the higher interest rates will pull money into the country as foreign money-fund managers buy Canadian dollars in order to make deposits in Canadian financial institutions. The effect of this inflow of foreign currencies is to increase the demand for the Canadian dollar and as a result cause the Canadian dollar to appreciate. As we know from Chapter 10, the higher exchange rate will reduce the level of Canadian exports (just as higher Canadian prices did) and increase Canadian imports.
The net effect of all this is that countercyclical fiscal policy may crowd out net exports. Thus, we have two possible aspects to this crowding-out effect-on investment spending and on net exports-both of which combine to weaken the effectiveness of fiscal policy.
As you can see, the use of fiscal policy has a number of possible undesirable side effects, which leaves it open to criticism.

28. Criticisms of Countercyclical Fiscal Policy
It ignores the effect it has on govern-ment's budget.
The third, and some believe the most serious problem with countercyclical fiscal policy, is that it completely ignores the effect it has on government's budget. Over the last half century, Canada's countercyclical fiscal policy has been aimed mainly at attempting to close recessionary gaps. Such policy involves either higher levels of government spending or lower levels of taxation. Either of these will have a deficit-inducing effect on the current budget. The result will be an increase in the size of an already-existing budget deficit or a decrease in the size of an already existing budget surplus. This is best illustrated with Figure 11.7.
Suppose that the current level of GDP in Figure 11.7A is Y1. This means that the economy is experiencing a recessionary gap equal to the distance between full-employment level of GDP, YFE, and the current level Y1. We can also see, in Figure 11.7B, that at GDP level Y1, government has a budget deficit of ab. The recessionary gap can be closed by the use of countercyclical fiscal policy. This would imply an increase in government spending or a decrease in taxation. The effect, graphically, would be to shift aggregate demand from AD1 to AD2. However, the greater government spending or lower taxation would also increase the size of government's budget deficit. This is illustrated in the downward shift in the budget line from BL1 to BL2, where the deficit immediately increases to ac. The overall result is the economy moving to full-employment equilibrium at YFE. We can see that as GDP increases, the size of the deficit is reduced from ac to de (a movement up the BL2 curve) as a result of an increase in net tax revenues. However, this will still leave the economy with a larger overall deficit (de) than it began with (ab).
If the deficit-inducing effects occur often and are allowed to accumulate over a period of time, the size of government's national debt will grow substantially. Increased deficits mean increased borrowing, and this then requires that government spend a larger percentage of its total spending on servicing its debt, leaving only a smaller percentage for conventional spending on such things as health care and education.

29. Self Test

30. Stop Here for Today

31. Balanced-Budget Fiscal Policy
Balanced-budget fiscal policy is the belief that a government’s budget should be balanced in each budget period.
Advocates of a balanced-budget fiscal policy use three observations to support their position.
countercyclical policy does more harm than good
the economy has effective automatic stabilizers
the economy is capable of returning to full-employment equilibrium through a self-adjustment process
Some politicians and political commentators, and even a few economists, alarmed at the effect of countercyclical fiscal policy on the size of budget deficits, argue that government should balance its spending and tax revenues in each budget period. This is known as a balanced-budget fiscal policy and is the second of the budget philosophies we are considering. Advocates of a balanced-budget fiscal policy use three observations to support their position. First, they consider the three criticisms of countercyclical fiscal policy that we just discussed as a serious indictment of that approach and see the balanced-budget approach as the only alternative.
Second, advocates of a balanced-budget fiscal policy approach believe that because of automatic stabilizers, the modern economy has enough built-in safeguards to ensure that it avoids extremes of high inflation or unemployment. Automatic stabilizers are government programs that ensure that spending remains relatively stable even in times of rapid economic change. For instance, as we have seen, when an economy enters a recession, because of the progressive nature of taxes, disposable incomes do not fall by as much as GDP. In addition, the amount paid out in unemployment benefits and welfare assistance increases, and this buoys up disposable income and therefore consumption spending.
Automatic stabilizers also come into force when the economy is booming and in danger of “overheating.” In this case, the higher levels of GDP generate proportionately higher taxes, and at the same time, the amounts paid out for unemployment benefits and welfare are also reduced. These both have the effect of dampening down expenditures.
The third point used in support of a balanced-budget fiscal policy is by far the most sig­nificant. As mentioned earlier, noninterventionists believe that if either a recessionary or an inflationary gap exists, the economy is capable of returning to full-employment equilibrium by itself through a self-adjustment process, unaided by interventionist polices of any kind. We have touched on this self-adjustment process in Chapter 5, and we will examine it in depth in Chapter 13. For now, we need only point out that if the self-adjustment process is effective, as the noninterventionists believe, then fiscal policy should be as neutral in its effects on the economy as is possible. The noninterventionists see such neutrality achieved through the use of a balanced­budget fiscal policy.
In summary, the arguments in support of a balanced-budget fiscal policy are as follows:
countercyclical policy does more harm than good
the economy has effective automatic stabilizers
the economy is capable of returning to full-employment equilibrium through a self-adjustment process
Automatic stabilizers: provisions of tax laws and government spending programs that automatically take spending out of the economy when it is booming and put spending in when it is slowing down.

32. Criticisms of Balanced-Budget Fiscal Policy
We now need to examine the economic effects of a government actually following a balanced-­budget fiscal policy. In doing so, we will find that the effects are significant but they are not at all neutral.
Suppose in Figure 11.8A that the economy is at income level Y1. Since income is below potential GDP, the economy finds itself in a recession. As is often the case in a recession, because of falling tax revenues government is suffering a budget deficit, as shown by the distance ab in Figure 11.8B. If government is intent on balancing the budget regardless of the condition of the economy, then it will have no choice but to either reduce government spending and/or increase taxation. The result, graphically, will be an upward shift in the budget line from BL1 to BL2 in Figure 11.8B so that at income level Y1, the budget is, initially, balanced. However, the effect of cutting government spending or increasing taxes will have an impact not only on government budget but also on the economy. The result will be a reduction in aggregate demand. This is shown graphically in Figure 11.8A as a leftward shift in the aggregate demand curve, from AD1 to AD2.
The drop in aggregate demand will cause GDP to drop by a multiple of the decrease in aggregate expenditures. At the lower equilibrium level of Y2, NTR will be smaller, with the result that the budget deficit (cd) will persist (although it is now smaller than it was at ab).

33. Criticisms of Balanced-Budget Fiscal Policy
Procyclical is the action by government that tends to push the economy in the same direction it is leaning in.
If the economy is experiencing a recessionary gap and a budget deficit, then the pursuit of a balanced-budget fiscal policy will be procyclical.
A recession implies unemployment. If the government takes action to try to eliminate the budget deficit rather than the unemployment, then the level of unemployment will rise, since the level of GDP falls. The business cycle has created a given level of unemployment, and government's fiscal policy, which was aimed at reducing the deficit, resulted in even higher unemployment.
An inflationary gap is a result of high aggregate demand, which generates a level of income that is temporarily higher than the full-employment level of GDP.
This generates sufficient tax revenue for government to be running a budget surplus. Balanced-budget fiscal policy would then necessitate that either taxes be lowered or spending be increased to eliminate the budget surplus. This would raise aggregate demand and thus the level of GDP, increasing the size of the inflationary gap – again, procyclical.
What we have just seen is that if the economy is experiencing a recessionary gap and a budget deficit, then the pursuit of a balanced-budget fiscal policy will be pro cyclical. To understand this, note that a recession implies that there is unemployment in the economy. If the government takes action to try to eliminate the budget deficit rather than the unemployment, then the level of unemployment will rise, since the level of GDP falls. In short, the business cycle has created a given level of unemployment, and government's fiscal policy, which was aimed at reducing the deficit, resulted in even higher unemployment.
Would a balanced-budget fiscal policy result in the same pro cyclical tendencies if the economy was experiencing an inflationary gap? The answer to this depends on the state of the budget associated with the gap. Recall that an inflationary gap is a result of high aggregate demand, which generates a level of income that is temporarily higher than the full-employment level of GDP.
Let us assume that this high GDP level generates sufficient tax revenue for government to be running a budget surplus. Strict adherence to a balanced-budget fiscal policy would then necessitate that either taxes be lowered or spending be increased to eliminate the budget surplus. Such fiscal policy action would raise aggregate demand and thus the level of GDP. This would increase the size of the inflationary gap, and we again see the procyclical nature of a balanced-budget fiscal policy in this situation.
Let us review what we have here. A balanced-budget fiscal policy will likely be procyclical in circumstances in which the economy is experiencing a recessionary gap, since the low levels of income will generate low levels of tax revenue, which create budget deficits. Similarly, such a policy will be procyclical when the economy is experiencing an inflationary gap if the inflationary gap comes with a budget surplus.

34. Cyclically Balanced Budget Fiscal Policy
Some economists suggest that governments should try to balance the budget, not on an annual basis but over the life of the business cycle.
A typical business cycle can last for several years so that the use of fiscal policy to smooth out the business cycle would be viewed from a longer perspective than just each budget period.
In these circumstances, deficits might be big in some years, as the economy enters a recession, resulting in lower tax revenues and higher transfer payments. On the other hand, when the business cycle moves into an expansionary phase, the result should be budget surpluses.
This longer-view approach would continue to use countercyclical fiscal policy to lean against the prevailing winds, while addressing the concerns of many people about budget deficits and the size of the national debt.
Without overstating the obvious, one could ask, as far as budgets are concerned, what is so sacred about a year? Why not balance the budget each month, each week, or, for that matter, each day? Well, a week or a month would simply not be practical because government's flow of income and expenditures is not regular. Some weeks or months would have high deficits, while others would have high surpluses. The same is true during anyone year. Given this and the fact that a government's budget also depends on the level of GDP in the economy, some economists suggest that governments should, instead, try to balance the budget, not on an annual basis but over the life of the business cycle. A typical business cycle can last for several years so that the use of fiscal policy to smooth out the business cycle would be viewed from a longer perspective than just each budget period. In these circumstances, deficits might be big in some years, as the economy enters a recession, resulting in lower tax revenues and higher transfer payments. On the other hand, when the business cycle moves into an expansionary phase, the result should be budget surpluses. This longer-view approach would continue to use countercyclical fiscal policy to lean against the prevailing winds, while addressing the concerns of many people about budget deficits and the size of the national debt.
In a sense, this policy is a compromise of the two approaches discussed above and is known as a cyclically balanced budget fiscal policy. The exact definition of this term is the use of countercyclical fiscal policy with the aim of balancing the budget over the life of the business cycle. Such a policy would require governments to spend more (or tax less) at some times but also to spend less (or tax more) at other times.

35. Cyclically Balanced Budget Fiscal Policy
Two potential problems with cyclically balanced budget fiscal policy.
No guarantee that the size and length of the recessionary gap, when government is running a budget deficit, will be exactly offset by the size and length of the inflationary gap, when government is running a budget surplus.
Result – the end of the business cycle may still show a net budget deficit
Political
Most governments find it easier to increase spending in bad times than to decrease it in good times.
Most business cycles are longer than the term of office of any particular government. This invites the existing government to leave the problem of balancing the budget to the succeeding government.
Although it sounds like a sound idea, there are two potential problems with this cyclically balanced budget fiscal policy. The first is that there is no guarantee that the size and length of the recessionary gap, when government is running a budget deficit, will be exactly offset by the size and length of the inflationary gap, when government is running a budget surplus. As a result, the end of the business cycle may still show a net budget deficit. The second is a political problem: most governments find it easier to increase spending in bad times than to decrease it in good times. In short, pursuing a cyclically balanced budget fiscal policy would take a remarkable amount of discipline on the part of government. In addition, most business cycles are longer than the term of office of any particular government. This invites the existing government to leave the problem of balancing the budget to the succeeding government.

36. Just how big is our national debt?
It certainly seems like a "staggering" increase. But since the population of Canada has increased appreciably during the past hundred years, it might be better to show the figures in terms of per capita debt, as in Table 11.4.
Before considering some of the problems associated with big government deficits and debt, let us look at the facts. It is unfortunate that public discussion of the national debt often runs to hyperbole, and we used to hear mention of a "staggering" debt of "enormous" proportions as a result of "crippling" deficits. Dollar amounts in billions are certainly enormous from an individual's perspective, but one seldom hears the size of Canada's GDP described as staggering. We therefore need to put things in perspective. Just how big is our national debt? It might help if we look at it over a period of time. Table 11.3 shows some figures for selected years.

37. Just how big is our national debt?
So the average debt per person has increased from a mere $254 in 1926 to over $ eighty years later. It certainly looks like a fairly staggering increase. But we need to make one further adjustment to allow for the effects of inflation over the years. So, let us show the total debt, but this time, in constant 2002 dollars, as in Table 11.5.

38. Just how big is our national debt?
Finally, let us combine both factors in Table 11.6 to give us figures in terms of constant dollars per capita.
This puts things in perspective. In real terms, the per capita debt increased 32 percent in the 14 years leading up to World War II; it more than tripled during the war, declined to less than half by 1967, but has more than tripled in the last 40 years.

39. Just how big is our national debt?
The best measure of the size of any debt is relative to the ability to repay, and this is relative to income. Table 11.7 shows the size of Canada's debt relative to the country's income, that is, as a percentage of GDP (of GNP till 1967).
In recent years the percentage has steadily declined. In fact, since 1995, Canada's debt burden has fallen from being the second highest to the lowest of the G8 countries. (The USA sits at 44 percent, with Japan at over 88 percent, and Italy topping the list at 91 percent).

40. Just how big is our national debt?
Major causes of the growth of Canada's debt
Financing of World War II
Deficit financing to prevent or escape from a recession
Financing of necessary infrastructure, such as bridges and airports
Increase in the size of income-support programs. (especially since the early 1970s)
Very high interest rates between the mid-1970s and the 1990s have compounded the size of the debt.
These figures show clearly that one of the major causes of the growth of Canada's debt was the financing of World War II. During a major war, few nations are able to finance their military expenditures through taxation alone. They are often left with little choice but to borrow, and the majority of this borrowing is from the nation's own citizens. Most would feel this is a legitimate reason to increase the debt and might also agree that there are other legitimate reasons for the increased debt-for example, deficit financing to prevent or escape from a recession or the financing of necessary infrastructure, such as bridges and airports. The third explanation for the increased Canadian debt, especially since the early 1970s, has been the increase in the size of income-support programs. Here, controversy about whether this is a good reason for the debt to increase heats up; some have suggested that these programs are too generous in comparison with those of some other countries.
Finally, it should be noted that the very high interest rates between the mid-1970s and the 1990s have compounded the size of the debt. (As we saw, some economists suggest that the reason that interest rates were so high in the first place was the result of borrowing by governments, that is, the crowding-out effect. Complicated world, isn't it?) Let us just mention the fact that the federal government has been achieving budget surpluses of the last several years resulting in the size of the federal debt decreasing between 1998 and One reason for these budget surpluses is that the federal government "downloaded" billions of dollars of health and education spending onto the provinces during this period. Leaving the statistics behind, let us examine some of the problems associated with the debt.

41. Problems of the National Debt: Fact or Fantasy?
The problems with high deficits and debt are as follows:
the potential crowding out of private investment spending and net exports
the interest payments that must be paid on the foreign-held debt
the income redistribution effects of large interest payments
the reduced ability of government to meet the needs of its citizens
the possible increased greed and wastefulness of government
Well, we have already mentioned three of the problems. First, we have seen how borrowing by government may well crowd out private investment and leave the economy with a smaller capital stock in the future. However, some would point out that this is a cost only if one assumes that private capital investment (say, another shopping mall) is superior to public capital investment (a hospital). It obviously depends on what sort of investment is crowded out.
The second potential problem involves the size of the foreign portion of the debt. Private financial agencies give ratings for government bonds sold around the world, as an aid to their clients for investing. The lower the rating given a particular government's bonds, the higher the interest payments that must be paid. In early 1995, there was a perception that Canada's national debt was too large. The result was a lower bond rating, and the outflow of interest payments on the foreign-held debt increased.
Third, we noted that payment of interest on the debt represents a big redistribution of income. As a fourth point, the big interest payments also mean, from government's point of view, that each year it has to earmark several tens of billions of dollars to be paid in interest before it can even start to consider other spending claims. This obviously curtails its ability to satisfy other demands in the economy. (The annual total interest payments in the 1990s were approximately $40 billion, which is higher than the annual deficits during the period.) This is a conundrum: if government did not have to pay these interest charges, then it could balance the budget. But because it did not balance the budget in the past, it has to pay these interest charges.
A final criticism comes from the fact that a federal government has almost unlimited power to spend. Theoretically (and legally), there is no upper limit to how big a deficit can be. That does not mean that big deficits are not harmful to an economy; it simply means that a national government has supreme power to tax, to borrow, and to print money. This means that without checks on its spending, a government can become greedy and wasteful in its fiscal affairs. And for this we would all suffer.

42. A Few Other Notes
A federal government cannot go broke as a result of internal borrowing. A federal government, which has unlimited powers of taxation and borrowing, has direct control over the nation's supply of money.
A big national debt suggests we are encumbering future generations. It is true that our children and grandchildren will inherit a larger debt and the interest charges associated with it. However, it is also true that future generations will inherit the Canadian-held portion of the assets (bonds) represented by that debt.
Federal government is in debt hundreds of billions of dollars, but it also owns assets – airports, military hardware, land, buildings, and so on – that total a great deal.
Most observers suggest that a debt/GDP ratio of less than 50 percent is not particularly worrisome.
Let us now take a brief look at what are sometimes seen as problems of the debt but are really not.
One of these bogus arguments seeks to draw an analogy between a household or a business and the operations of the federal government. It suggests that just like an individual or a business, if revenue falls short of expenses for a long enough period of time, then bankruptcy will follow. This is just not a legitimate concern when applied to a federal government, which has unlimited powers of taxation and borrowing, and has direct control over the nation's supply of money. Therefore, a federal government cannot go broke as a result of internal borrowing. The German government went broke following World War I, but this was a result of external debt imposed on it by the war's victors. A particular city might go broke in the sense of defaulting on interest payments on the bonds it sold to borrow money, if urban decay and high taxes drive many higher-income taxpayers and businesses out of the city. The same might be said, although this would be stretching it, of a particular province or state, but not of a country as large and as desirable to live in as Canada.
Another argument suggests that a big national debt means that we are encumbering future generations, who will eventually have to pay it. It is true that our children and grandchildren will inherit a larger debt and the interest charges associated with it. However, it is also true that future generations will inherit the Canadian-held portion of the assets (bonds) represented by that debt. That is, if our descendants have to pay extra taxes to service a larger debt, they also, as a generation, will get those same taxes back as the interest payments are made to whoever holds those bonds.
While it is true that the federal government is in debt to the tune of hundreds of billions of dollars, it is also true that the government owns assets-airports, military hardware, land, buildings, and so on-that also total a great deal. Is the debt too large relative to the assets owned?
Most observers suggest that a debt/GDP ratio of less than 50 percent is not particularly worrisome. Canada's debt in the early 1990s was cause for some concern; but as we saw in Table 11.7, the national debt in 2007 has been reduced to a manageable 33 percent.

43. In Summary
Budget deficits when the economy is otherwise strong can be inflationary, while budget surpluses can make a weak economy even weaker.
Accepting deficits as a way of life regardless of the state of the economy is as dangerous for a government as single-mindedly attempting to reduce the national debt while ignoring other more important economic goals.
The federal government's fiscal performance in recent years has shown remarkable improvement. If we just compare an eight-year period, , we can see how quickly things have turned around. In 1996, the national debt represented 66 percent of GDP and 27 percent of it was foreign-owned; 11 years later, the first figure was down to 33 percent, with only 13 percent being foreign-owned. Eleven years ago, interest on the national debt amounted to 30 percent of total federal government expenditures; by 2007, this figure was down to 15 percent. This is significant change. It seems that government has shifted completely from tolerating large budget deficits to pursuing record surpluses. But, of course, both budget surpluses and deficits can involve costs. Budget deficits when the economy is otherwise strong can be inflationary, while budget surpluses can make a weak economy even weaker. Accepting deficits as a way of life regardless of the state of the economy is as dangerous for a government as single-mindedly attempting to reduce the national debt while ignoring other more important economic goals.

44. Self Test