PUBLIC FINANCE
A MACROECONOMIC PERSPECTIVE
Large changes in Fiscal Policy: taxes vs spending
BRAINSTORMING
Debt/GDP ratios
- Fiscal deficit (FD) = ∆debt
o FD increases national debt
o If the government spends more than it collects in taxes, it must borrow the difference
- Large Debt/GDP ratios cuts by sustained growth
o If GDP grows faster than debt, the ratio naturally declines even without reducing debt
o Strong, sustained economic growth is the most effective long-term solution
- Chipping away the real value of debt through inflation (risk of uncontrolled inflation)
o Inflation reduces the real (inflation-adjusted) value of debt
o However, excessive inflation is risky and can destabilize the economy
- No growth, the accumulation of budget surpluses to reign in the debt
o If GDP growth is weak or absent, governments must run budget surpluses (spending less than
they earn) to reduce the debt stock
- Credible fiscal stance
o Markets and investors are more confident in countries with consistent and believable fiscal
strategies, which can reduce borrowing costs and improve outcomes
1
,Cyclical and structural FD:
- Components of FD
- 𝐺, 𝑇
o Government spending and tax revenues
- 𝑇 = 𝑇₀ + 𝑡𝑌
o A linear tax function depending on income (𝑌), with a base level and marginal rate.
- Observed FD
o The actual deficit observed at the current output level 𝑌0
- 𝑌𝐹𝐸
o Full employment output (where the economy operates at its potential).
- Structural FD
o The deficit that would exist even at full employment (𝑌𝐹𝐸 ), reflects underlying policy.
- Cyclical FD
o The portion of the deficit caused by the economy being below full employment, reflects
automatic stabilizers like unemployment benefits and lower tax revenues.
- In essence:
o When output is below potential, deficits rise not only due to policy choices (structural) but
also due to cyclical weakness.
Cyclical and structural FD equations:
- FD as difference between government spending and taxes, both of which can have fixed and variable
components
𝐹𝐷 = 𝐺 − 𝑇 = 𝐺̅ + 𝑔𝑌 − (𝑇̅ + 𝑡𝑌)
- FD and GDP gap: structural (policy-based) and cyclical (how current output deviates from full
employment) deficit
𝐹𝐷 = 𝐺̅ + 𝑔𝑌𝐹𝐸 − (𝑇̅ + 𝑡𝑌𝐹𝐸 ) + (𝑔 − 𝑡)(𝑌 − 𝑌𝐹𝐸 )
- FD and unemployment
𝑂𝑘𝑢𝑛′𝑠 𝑙𝑎𝑤: 𝑌 − 𝑌𝐹𝐸 = −𝛼(𝑢 − 𝑢𝐹𝐸 ) = 𝛼(𝑢𝐹𝐸 − 𝑢)
𝐹𝐷 = 𝐺̅ + 𝑔𝑌𝐹𝐸 − (𝑇̅ + 𝑡𝑌𝐹𝐸 ) + (𝑔 − 𝑡)𝛼(𝑢𝐹𝐸 − 𝑢)
o 𝑢 = actual employment rate
o 𝑢𝐹𝐸 = natural rate of unemployment (lowest level of unemployment that an economy can
sustain over the long term without causing inflation to accelerate)
o 𝑢𝐹𝐸 − 𝑢 = unemployment gap (how far the actual unemployment is from full-employment
level)
- 𝐹𝐷 = 𝑆𝑡𝑟𝑢𝑐𝑡𝑢𝑟𝑎𝑙 𝐹𝐷 + 𝐶𝑦𝑐𝑙𝑖𝑐𝑎𝑙 𝐹𝐷
2
,INTRODUCTION
Motivation
- Fiscal policy plays a crucial role in economic growth and stability.
- Debate: Are tax (T) cuts or spending (G) increases more effective?
- Fiscal Policy
o Primary deficit: FDt = Gt - Tt; where Gt = public current and capital
o Fiscal multiplier: ∆GDP/∆T or ∆GDP/∆G
▪ how much GDP changes when taxes or spending change by one unit
o Which components of T and G are more effective? Fiscal Policy affects the economy through
consumption Ct and investment It
o Not all fiscal packages have the same effect, even if they cost the same
▪ The composition (whether it's tax cuts or spending increases) matters more than the
total amount for determining economic outcomes.
- Policy relevance: How should governments respond to economic downturns and rising debt?
Research questions
- What are the effects of tax cuts vs. spending increases on economic growth?
- Are spending cuts or tax hikes better for reducing deficits and debt?
- What do historical data and case studies suggest?
- Large change in fiscal policy stance (↑ ∆FD or ↓ ∆FD)
o Large fiscal stimulus (↑ ∆FD = higher deficit) can be can be expansionary if done through tax
cuts or spending rises
o A fiscal consolidation (↓ ΔFD = lower deficit) can reduce Debt/GDP in the medium term, but
may trigger economic slowdowns
METHODOLOGY
Major Changes in Fiscal Policy (↑ FD or ↓ FD)
- Large fiscal events are classified as either stimuli (↑FD) or adjustments (↓FD).
- These are associated with:
o Economic booms or recessions.
o Success or failure in reducing Debt/GDP.
o Whether they are cyclically adjusted or just reflecting the economic cycle.
- Cyclically adjusted value
Δ𝑋𝑡𝐶𝐴 = 𝑋𝑡 |𝑢𝑡=𝑢𝑡−1 − 𝑋𝑡−1
o What the government budget would look like if the economy were at full employment (i.e. no
boom, no recession).
o The change in X (like the deficit), if unemployment stayed the same as last year so we can
focus on actual policy changes.
o The cyclically adjusted deficit lets us see whether the government actually changed its fiscal
policy, or if the improvement just happened automatically because the economy got better.
Δ𝐹𝐷𝑡𝐶𝐴 ≥ 1.5%𝐺𝐷𝑃
o Fiscal episodes are considered “major” if the cyclically adjusted change is at least 1.5% of
GDP, that means:
▪ The change is big enough to be policy-driven, not just a result of normal economic
fluctuation.
3
, ▪ Helps researchers and policymakers identify serious efforts at stimulus or deficit
reduction.
- ! Cyclicality of Fiscal Policy ≠ Cyclically Adjusted Values
o Cyclicality of Fiscal Policy
▪ What the government chooses to do in response to the economy, intentional
behavior
▪ Counter-cyclical (spend more or cut taxes during a recession to boost the economy)
or pro-cyclical (spend more during booms and cut spending during recessions, which
can make things worse)
o Cyclically Adjusted Values
▪ A method (technical tool) to remove the effects of the economic cycle and to
estimate what the fiscal position (e.g., deficit) would be if the economy were at full
employment
▪ Doesn’t describe behavior, but adjusts numbers to allow fair comparisons
Fiscal Episodes:
- 107 fiscal adjustments and 91 fiscal stimuli identified.
- Around 15.1% of observations were fiscal adjustments and 12.9% stimuli.
- Most were short-lived (1 period); very few lasted multiple years.
- Note: 1.5% threshold is used to filter out "business-as-usual" changes.
o To count as a “major” change, the cyclically adjusted deficit must change by at least 1.5% of
GDP.
o Example: Denmark (1983–1986) is cited as a multi-year fiscal adjustment episode.
Timeline of fiscal policy episodes:
- T: the year the policy change happens
o Red/left: pre-policy trend
o Green/right: post-policy outcome period
- X(T): the variable begin studies, e.g. GDP growth or Debt/GDP
o The curved line shows how the variable evolves before and after the policy change.
- What counts as expansionary or successful?
o Expansionary
4
A MACROECONOMIC PERSPECTIVE
Large changes in Fiscal Policy: taxes vs spending
BRAINSTORMING
Debt/GDP ratios
- Fiscal deficit (FD) = ∆debt
o FD increases national debt
o If the government spends more than it collects in taxes, it must borrow the difference
- Large Debt/GDP ratios cuts by sustained growth
o If GDP grows faster than debt, the ratio naturally declines even without reducing debt
o Strong, sustained economic growth is the most effective long-term solution
- Chipping away the real value of debt through inflation (risk of uncontrolled inflation)
o Inflation reduces the real (inflation-adjusted) value of debt
o However, excessive inflation is risky and can destabilize the economy
- No growth, the accumulation of budget surpluses to reign in the debt
o If GDP growth is weak or absent, governments must run budget surpluses (spending less than
they earn) to reduce the debt stock
- Credible fiscal stance
o Markets and investors are more confident in countries with consistent and believable fiscal
strategies, which can reduce borrowing costs and improve outcomes
1
,Cyclical and structural FD:
- Components of FD
- 𝐺, 𝑇
o Government spending and tax revenues
- 𝑇 = 𝑇₀ + 𝑡𝑌
o A linear tax function depending on income (𝑌), with a base level and marginal rate.
- Observed FD
o The actual deficit observed at the current output level 𝑌0
- 𝑌𝐹𝐸
o Full employment output (where the economy operates at its potential).
- Structural FD
o The deficit that would exist even at full employment (𝑌𝐹𝐸 ), reflects underlying policy.
- Cyclical FD
o The portion of the deficit caused by the economy being below full employment, reflects
automatic stabilizers like unemployment benefits and lower tax revenues.
- In essence:
o When output is below potential, deficits rise not only due to policy choices (structural) but
also due to cyclical weakness.
Cyclical and structural FD equations:
- FD as difference between government spending and taxes, both of which can have fixed and variable
components
𝐹𝐷 = 𝐺 − 𝑇 = 𝐺̅ + 𝑔𝑌 − (𝑇̅ + 𝑡𝑌)
- FD and GDP gap: structural (policy-based) and cyclical (how current output deviates from full
employment) deficit
𝐹𝐷 = 𝐺̅ + 𝑔𝑌𝐹𝐸 − (𝑇̅ + 𝑡𝑌𝐹𝐸 ) + (𝑔 − 𝑡)(𝑌 − 𝑌𝐹𝐸 )
- FD and unemployment
𝑂𝑘𝑢𝑛′𝑠 𝑙𝑎𝑤: 𝑌 − 𝑌𝐹𝐸 = −𝛼(𝑢 − 𝑢𝐹𝐸 ) = 𝛼(𝑢𝐹𝐸 − 𝑢)
𝐹𝐷 = 𝐺̅ + 𝑔𝑌𝐹𝐸 − (𝑇̅ + 𝑡𝑌𝐹𝐸 ) + (𝑔 − 𝑡)𝛼(𝑢𝐹𝐸 − 𝑢)
o 𝑢 = actual employment rate
o 𝑢𝐹𝐸 = natural rate of unemployment (lowest level of unemployment that an economy can
sustain over the long term without causing inflation to accelerate)
o 𝑢𝐹𝐸 − 𝑢 = unemployment gap (how far the actual unemployment is from full-employment
level)
- 𝐹𝐷 = 𝑆𝑡𝑟𝑢𝑐𝑡𝑢𝑟𝑎𝑙 𝐹𝐷 + 𝐶𝑦𝑐𝑙𝑖𝑐𝑎𝑙 𝐹𝐷
2
,INTRODUCTION
Motivation
- Fiscal policy plays a crucial role in economic growth and stability.
- Debate: Are tax (T) cuts or spending (G) increases more effective?
- Fiscal Policy
o Primary deficit: FDt = Gt - Tt; where Gt = public current and capital
o Fiscal multiplier: ∆GDP/∆T or ∆GDP/∆G
▪ how much GDP changes when taxes or spending change by one unit
o Which components of T and G are more effective? Fiscal Policy affects the economy through
consumption Ct and investment It
o Not all fiscal packages have the same effect, even if they cost the same
▪ The composition (whether it's tax cuts or spending increases) matters more than the
total amount for determining economic outcomes.
- Policy relevance: How should governments respond to economic downturns and rising debt?
Research questions
- What are the effects of tax cuts vs. spending increases on economic growth?
- Are spending cuts or tax hikes better for reducing deficits and debt?
- What do historical data and case studies suggest?
- Large change in fiscal policy stance (↑ ∆FD or ↓ ∆FD)
o Large fiscal stimulus (↑ ∆FD = higher deficit) can be can be expansionary if done through tax
cuts or spending rises
o A fiscal consolidation (↓ ΔFD = lower deficit) can reduce Debt/GDP in the medium term, but
may trigger economic slowdowns
METHODOLOGY
Major Changes in Fiscal Policy (↑ FD or ↓ FD)
- Large fiscal events are classified as either stimuli (↑FD) or adjustments (↓FD).
- These are associated with:
o Economic booms or recessions.
o Success or failure in reducing Debt/GDP.
o Whether they are cyclically adjusted or just reflecting the economic cycle.
- Cyclically adjusted value
Δ𝑋𝑡𝐶𝐴 = 𝑋𝑡 |𝑢𝑡=𝑢𝑡−1 − 𝑋𝑡−1
o What the government budget would look like if the economy were at full employment (i.e. no
boom, no recession).
o The change in X (like the deficit), if unemployment stayed the same as last year so we can
focus on actual policy changes.
o The cyclically adjusted deficit lets us see whether the government actually changed its fiscal
policy, or if the improvement just happened automatically because the economy got better.
Δ𝐹𝐷𝑡𝐶𝐴 ≥ 1.5%𝐺𝐷𝑃
o Fiscal episodes are considered “major” if the cyclically adjusted change is at least 1.5% of
GDP, that means:
▪ The change is big enough to be policy-driven, not just a result of normal economic
fluctuation.
3
, ▪ Helps researchers and policymakers identify serious efforts at stimulus or deficit
reduction.
- ! Cyclicality of Fiscal Policy ≠ Cyclically Adjusted Values
o Cyclicality of Fiscal Policy
▪ What the government chooses to do in response to the economy, intentional
behavior
▪ Counter-cyclical (spend more or cut taxes during a recession to boost the economy)
or pro-cyclical (spend more during booms and cut spending during recessions, which
can make things worse)
o Cyclically Adjusted Values
▪ A method (technical tool) to remove the effects of the economic cycle and to
estimate what the fiscal position (e.g., deficit) would be if the economy were at full
employment
▪ Doesn’t describe behavior, but adjusts numbers to allow fair comparisons
Fiscal Episodes:
- 107 fiscal adjustments and 91 fiscal stimuli identified.
- Around 15.1% of observations were fiscal adjustments and 12.9% stimuli.
- Most were short-lived (1 period); very few lasted multiple years.
- Note: 1.5% threshold is used to filter out "business-as-usual" changes.
o To count as a “major” change, the cyclically adjusted deficit must change by at least 1.5% of
GDP.
o Example: Denmark (1983–1986) is cited as a multi-year fiscal adjustment episode.
Timeline of fiscal policy episodes:
- T: the year the policy change happens
o Red/left: pre-policy trend
o Green/right: post-policy outcome period
- X(T): the variable begin studies, e.g. GDP growth or Debt/GDP
o The curved line shows how the variable evolves before and after the policy change.
- What counts as expansionary or successful?
o Expansionary
4
