LOS 26e Explain the Limitations of discretionary fiscal policy and differentiate between discretionary fiscal policy and automatic stabilizers

Discretionary fiscal policy is not an exact science. First, economic forecasts might be wrong, leading to incorrect policy decisions. Second, complications arise in practice that delay both the implementation and resulting effect on the economy of changes in fiscal policy.

• Recognition delay. Discretionary fiscal policy decisions are made by the President and voted on by Congress. The state of the economy is complex and it may take the Administration time to recognize the extent of the economic problems.

• Administrative or law-making delay. The Administration and Congress cannot vote and enact decisions overnight. Legal changes are delayed while elected officials debate the issues.

• Impact delay. Time passes before the effects of the fiscal policy changes are felt. Delays occur in implementing increases and decreases in government spending and taxing. Moreover, it takes time for corporations and individuals to act on the fiscal policy changes.

In contrast to discretionary fiscal policy stabilizers, automatic stabilizers are built-in fiscal devices triggered by the state of the economy. Automatic fiscal stabilizers minimize timing problems encountered bv discretionary fiscal policy stabilizers. Atitomatic fiscal stabilizers fall into two main categories: induced taxes and needs-tested spending.

• Induced taxes refer to the amount of taxes collected as a percentage (i.e., income rax rate) of income. Incomes are positively related to GDP. Incomes rise during an economic boom. As incomes rise, the total amount of taxes collected automatically increases. The increase in taxes paid bv corporations and individuals slows down the economy. Conversely, incomes fall during a recession. As incomes fall, the total amount of taxes collected automatically falls. The decline in taxes paid by corporations and individuals stimulates the economy

• Needs-tested spending refers to government expenditures for programs that pass a needs" test, such as unemployment. During a recession, unemployment is high. The government automatically pays out more in unemployment compensation. The increase in unemployment compensation stimulates the economy. During an expansion, unemployment payments automatically drop. The decline in unemployment compensation dampens the economy.

Together, induced taxes and needs-tested spending offer automatic stability to the economy. Both actions are countercyclical: taxes rise and needs-based spending falls during expansions, and taxes fall and needs-based spending rises during recessions.

Because of these automatic fiscal policy effects, the government budget deficit or surplus is affected by the stage of the business cycle. We can think of any budget surplus or deficit as consisting of a structural component and a cyclical component. The structural surplus or deficit would still exist if the economy were at full employment. The cyclical surplus or deficit exists because the economy is producing above or below full employment GDP. The cyclical surplus or deficit is zero when real GDP equals potential GDP. The actual surplus or deficit at any point in time equals the sum of any structural surplus or deficit and any cyclical surplus or deficit. Over the last few decades, the U.S. government has had a persistent structural deficit.

Professor's Note: The automatic stabilizers mentioned here are based on the U.S. tax law and entitlement programs.

Was this article helpful?

0 0

Post a comment