Measuring Fiscal Policy

If the government desires to increase total spending in the economy with fiscal policy, it can either increase its spending or reduce taxes (or both). Either policy will increase the government's deficit (or reduce its surplus). Because policies that increase the deficit are expansionary and policies that decrease it are contractionary, it would seem reasonable to use the government's deficit or surplus as a measure of how tight or easy fiscal policy is. However, such a conclusion is wrong.

Suppose government leaves spending and taxing policies unchanged and the economy enters a recession. The lower income levels that the recession causes will cut tax receipts (income and sales taxes account for most tax revenues), and transfers will increase as more people qualify for various welfare programs and unemployment compensation. The government's budget will move into a (larger) deficit even though there has been no change in policy.

Hence, two sorts of factors influence the size of the deficit: changes in policy and changes in the economy. As an indicator of fiscal policy, the deficit suffers from a problem of feedback: the size of the deficit affects the performance of the economy, but the performance of the economy affects the size of the deficit. For a measure of fiscal policy to be a reliable indicator of how government policy is changing, it must be unaffected by changes in the economy.

To construct an acceptable measure of fiscal policy, one must eliminate feedback effects from the economy. This can be done by constructing a hypothetical government budget. Economists estimate what government expenditures and tax receipts would be if the economy were at full employment and calculate the deficit or surplus from this budget. This measure can only be affected by changes in policy; it is holding the economy constant.

Economists use this measure, sometimes called the full-employment surplus or deficit, for research and for forecasting. (An alternative name is the structural deficit or surplus. In this naming scheme, the budget is divided into structural and cyclical parts. The cyclical part varies with the level of GDP, while the structural part does not, which makes the structural part equivalent to the full employment surplus or deficit.) Incumbent politicians have on occasion used it to put their best face forward. If the economy has less than full employment, the actual government deficit will be larger than the full-employment deficit. (Can you explain why?) Since voters consider deficits undesirable, incumbents prefer to give them the smallest deficit that they can, and this is the full-employment deficit. Economists may disapprove, but ideas often end up being used in ways not intended by their discoverers.

The feedback relationship that makes the full-employment budget necessary also gives rise to an automatic stabilization pattern that many economists stress. Because most taxes are paid on income or consumption, when output decreases, tax receipts drop and when output increases, tax receipts rise. Taxes are a leakage in the flow of spending, and when leakages increase, the Keynesian multiplier model says that spending will fall and that when leakages decrease, spending rises. Hence lower output reduces leakages and reduced leakage helps stop the decline in output, and higher output increases leakages, and the increased leakage helps stop the rise in output.

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