Let’s begin with the obvious: modern governments in economically advanced countries spend a great deal of money and collect a lot in taxes. Figure 13-1 shows government spending and tax revenue as percentages of GDP for a selection of high-income countries in 2007. (We focus on 2007, rather than a more recent year, because it was a largely “normal” year. The numbers for later years were very much affected by the financial crisis of 2008 and its aftermath.) As you can see, the Swedish government sector is relatively large, accounting for more than half of the Swedish economy. The government of Canada may not play quite as large a role in its own national economy as governments of some European countries do in theirs, but it does play a significant role. As a result, changes in the federal budget, such as changes in government spending or in taxation, can have large effects on the Canadian economy.

To analyze these effects, we begin by showing how taxes and government spending affect the economy’s flow of income. Then we can see how changes in spending and tax policy affect aggregate demand.

In Figure 7-1 we showed the circular flow of income and spending in the economy as a whole. One of the sectors represented in that figure was the government. Funds flow into the government in the form of taxes and government borrowing; funds flow out in the form of government purchases of goods and services and government transfers to households.

What kinds of taxes do Canadians pay, and where does the money go? Figure 13-2 shows the composition of Canadian tax revenue in 2007. Taxes, of course, are required payments to the government. In Canada, taxes are collected at the national level by the federal government; at the provincial or territorial level by each provincial or territorial government; and at local levels by counties, cities, and towns. At the federal level, the taxes that generate the greatest revenue are income taxes on both personal income and corporate profits as well as social insurance taxes, which we’ll explain shortly. At the provincial and local levels, the picture is more complex: these governments rely on a mix of sales taxes, property taxes, income taxes, and fees of various kinds. Overall, taxes on personal income and corporate profits accounted for 48% of total government revenue in 2007; social insurance taxes accounted for 14%; and a variety of other taxes, collected mainly at the provincial and local levels, accounted for the rest.

Figure 13-3 shows the composition of total Canadian government spending in 2007, which, after the payment of interest on government debt, takes two broad forms.¹ One form is purchases of goods and services by government. These direct purchases are counted as part of government purchases of goods and services (the G term) in the expenditure approach to measuring GDP (as discussed in Chapter 7). These purchases include everything from diagnostic equipment for hospitals to the salaries of public school teachers (who are treated in the national accounts as providers of a service—education). The big items here are health and education. The fairly large category “Protection of persons and property” consists mainly of federal, provincial, and municipal spending on a variety of security services, from national defence, police and firefighters, correction and rehabilitation services, to legal aid and courts of law. Spending on the construction and maintenance of roads, public transit, and other publicly owned transportation and communications facilities and equipment appears in the “Transportation and communication” category.

The other form of government spending is government transfers, which are payments by the government to households for which no good or service is provided in return. These transfers might be targeted to certain types of activities or spending by households, such as education or health care. Since transfers do not represent direct spending on final output, they are not counted in the G term in the expenditure approach. In fact, should the transfer help households finance some of their consumption, this will be captured in the private sector consumption, term C, in the expenditure approach.² Government transfers represent a huge proportion of Canada’s budget, as well as those of the United States and Europe. In Canada, most transfer payments cover two broad areas:

The term social insurance describes government programs intended to protect families against economic hardship. These include payments from public pension plans such as the Canada/Quebec Pension Plan (CPP/QPP), Old Age Security (OAS), Guaranteed Income Supplement (GIS), and so on. Other social assistance payments include general welfare and family allowance payments, as well as smaller programs such as veterans’ benefits, motor vehicle accident compensation payments, legal aid, and daycare subsidies. In Canada, social insurance programs are paid for largely with special, dedicated taxes on wages—the social insurance taxes we mentioned earlier.

But how do tax policy and government spending affect the economy? The answer is that taxation and government spending have a strong effect on total aggregate expenditure in the economy.

Let’s recall the basic equation of national income accounting:

The left-hand side of this equation is GDP, the value of all final goods and services produced in the economy. The right-hand side is aggregate expenditure, total spending on final goods and services produced in the economy. It is the sum of consumer spending (C), investment spending (I), government purchases of goods and services (G), and the value of exports (X) minus the value of imports (IM). It includes all the sources of aggregate demand.

The government directly controls one of the variables on the right-hand side of Equation 13-1: government purchases of goods and services (G). But that’s not the only effect fiscal policy has on aggregate expenditure in the economy. Through changes in taxes and transfers, it also may influence consumer spending (C) and, in some cases, investment spending (I).

To see why the budget affects consumer spending, recall that disposable income, the total income households have available to spend, is equal to the total income they receive from wages, dividends, interest, and rent, minus taxes, plus government transfers. So either an increase in taxes or a reduction in government transfers reduces disposable income. And a fall in disposable income, other things equal, leads to a fall in consumer spending. Conversely, either a decrease in taxes or an increase in government transfers increases disposable income. And a rise in disposable income, other things equal, leads to a rise in consumer spending.

The government’s ability to affect investment spending is a more complex story, which we won’t discuss in detail. The important point is that the government taxes profits and capital goods spending, and changes in the rules that determine how much a business owes can increase or reduce the incentive to spend on investment goods.

Because the government itself is one source of spending in the economy, and because taxes and transfers can affect spending by consumers and firms, the government can use changes in taxes or government spending to shift the aggregate demand curve. And as we saw in Chapter 12, there are sometimes good reasons to shift the aggregate demand curve. In early 2009, as this chapter’s opening story explained, the Harper government believed it was crucial that the Canadian government act to increase aggregate demand—that is, to move the aggregate demand curve to the right of where it would otherwise be. The 2009 stimulus package was a classic example of fiscal policy: the use of taxes, government transfers, or government purchases of goods and services to stabilize the economy by shifting the aggregate demand curve.

Why would the government want to shift the aggregate demand curve? Because it wants to close either a recessionary gap, created when aggregate output falls below potential output, or an inflationary gap, created when aggregate output exceeds potential output. Such gaps, created when output is not at the economy’s full employment level, are harmful to the welfare of households and firms. The government has the “power” to influence AD, by shifting the AD curve, so as to reduce the gap, thereby making households and firms better off. Governments have found that interventions to influence AS in order to close the gap are not so simple.

Figure 13-4 shows the case of an economy facing a recessionary gap. SRAS is the short-run aggregate supply curve, LRAS is the long-run aggregate supply curve, and AD₁ is the initial aggregate demand curve. At the initial short-run macroeconomic equilibrium, E₁, aggregate output is Y₁, below potential output, Y_P. What the government would like to do is increase aggregate demand, shifting the aggregate demand curve rightward to AD₂. This would increase aggregate output, making it equal to potential output while also raising the price level from P₁ to P₂.

Fiscal policy that increases aggregate demand, called expansionary fiscal policy, normally takes one of three forms, or some combination of them:

The 2009 Economic Action Plan was a combination of all three: a direct increase in federal spending and aid to provincial, territorial, and municipal governments to help them to finance “ready-to-go” infrastructure projects, targeted tax cuts for many families, and increased aid to the unemployed.

Figure 13-5 shows the opposite case—an economy facing an inflationary gap. Again, SRAS is the short-run aggregate supply curve, LRAS is the long-run aggregate supply curve, and AD₁ is the initial aggregate demand curve. At the initial equilibrium, E₁, aggregate output is Y₁, above potential output, Y_P. As we’ll explain in later chapters, policy-makers often try to head off inflation by eliminating inflationary gaps. To eliminate the inflationary gap shown in Figure 13-5, fiscal policy must reduce aggregate demand and shift the aggregate demand curve leftward to AD₂. This reduces aggregate output and makes it equal to potential output. This decrease in AD has moved the price level from P₁ to P₂ and closed the inflationary gap. Consequently, there should be less inflation, which is the government’s goal. Fiscal policy that reduces aggregate demand, called contractionary fiscal policy, is the opposite of expansionary fiscal policy. It is implemented in three possible ways:

A classic example of contractionary fiscal policy occurred in 1995, when the federal government grew worried about Canada’s large budget deficit and growing debt burden as a percentage of the economy. Things were so bad the Wall Street Journal called Canada an honorary member of the third world. As a percent of the economy, the 1995 budget introduced the largest cuts to Canadian federal spending since the end of World War II. This federal budget combined large direct spending cuts, significant reductions in transfer payments to individuals and provinces, along with small tax increases.

In practice, the use of fiscal policy—in particular, the use of expansionary fiscal policy in the face of a recessionary gap—is often controversial. We’ll examine the origins of these controversies in detail in Chapter 17. But for now, let’s quickly summarize the major points of the debate over expansionary fiscal policy, so we can understand when the critiques are justified and when they are not.

Broadly speaking, there are three arguments against the use of expansionary fiscal policy:

The first of these claims is wrong in principle, but it has nonetheless played a prominent role in public debates. The second is valid under some, but not all, circumstances. The third argument, although it raises some important issues, isn’t a good reason to believe that expansionary fiscal policy doesn’t work.

Claim 1: “Government Spending Always Crowds Out Private Spending” Some claim that expansionary fiscal policy can never raise aggregate expenditure and therefore can never raise aggregate income, with reasons that go something like this: “Every dollar that the government spends is a dollar taken away from the private sector. So any rise in government spending must be offset by an equal fall in private spending.” In other words, every dollar spent by the government crowds out, or displaces, a dollar of private spending. So what’s wrong with this view? The answer is that the statement is wrong because it assumes that resources in the economy are always fully employed and, as a result, the aggregate income earned in the economy is always a fixed sum—which isn’t true. In particular, when the economy is suffering from a recessionary gap, there are unemployed resources in the economy and output, and therefore income, is below its potential level. Expansionary fiscal policy during these periods puts unemployed resources to work and generates higher spending and higher income. So the argument that expansionary fiscal policy always crowds out private spending is wrong in principle.

Claim 2: “Government Borrowing Always Crowds Out Private Investment Spending” In Chapter 10, we discussed the possibility that government borrowing uses funds that would have otherwise been used for private investment spending—that is, it crowds out private investment spending. How valid is that argument?

The answer is “it depends.” Specifically, it depends upon whether the economy is depressed or not. If the economy is not depressed, then increased government borrowing, by increasing the demand for loanable funds, can raise interest rates and crowd out private investment spending. However, what if the economy is depressed? In that case, crowding out is much less likely. When the economy is at far less than full employment, a fiscal expansion will lead to higher incomes, which in turn leads to increased savings at any given interest rate. This larger pool of savings allows the government to borrow without driving up interest rates. Canada’s Economic Action Plan of 2009 was a case in point: despite high levels of government borrowing, Canadian interest rates stayed near historic lows. This, though, was partly owing to the Bank of Canada’s expansionary monetary policy.

Claim 3: “Government Budget Deficits Lead to Reduced Private Spending” Other things equal, expansionary fiscal policy leads to a larger budget deficit and greater government debt. And higher debt will eventually require the government to raise taxes to pay it off. So, according to the third argument against expansionary fiscal policy, consumers, anticipating that they must pay higher taxes in the future to pay off today’s government debt, will cut their spending today in order to save more now—so that they are better able to afford the expected future increases. This argument, first made by the nineteenth-century economist David Ricardo, is known as Ricardian equivalence. It is an argument often taken to imply that expansionary fiscal policy will have no effect on the economy because far-sighted consumers will undo any attempts at expansion by the government. (And will also undo any contractionary fiscal policy, for that matter.)

In reality, however, it’s doubtful that consumers behave with such foresight and budgeting discipline. Most people, when provided with extra cash (generated by the fiscal expansion), will spend at least some of it. So even fiscal policy that takes the form of temporary tax cuts or transfers of cash to consumers probably does have an expansionary effect.

Moreover, it’s possible to show that even with Ricardian equivalence, a temporary rise in government spending that involves direct purchases of goods and services—such as a program of road construction—would still lead to a boost in total spending in the near term. That’s because even if consumers cut back their current spending in anticipation of higher future taxes, their reduced spending will take place over an extended period as consumers save over time to pay the future tax bill. Meanwhile, the additional government spending will be concentrated in the near future, when the economy needs it. So although the effects emphasized by Ricardian equivalence may reduce the impact of fiscal expansion, the claim that it makes fiscal expansion completely ineffective is neither consistent with how consumers actually behave nor a reason to believe that increases in government spending have no effect. So, in the end, it’s not a valid argument against expansionary fiscal policy.

In sum, then, the extent to which we should expect expansionary fiscal policy to work depends upon the circumstances. When the economy has a recessionary gap—as it did when the 2009 Economic Action Plan was passed—economics tells us that this is just the kind of situation in which expansionary fiscal policy helps the economy. However, when the economy is already at full employment, expansionary fiscal policy is the wrong policy and will lead to crowding out, an overheated economy, and higher inflation.

Looking back at Figures 13-4 and 13-5, it may seem obvious that the government should actively use fiscal policy—always adopting an expansionary fiscal policy when the economy faces a recessionary gap and always adopting a contractionary fiscal policy when the economy faces an inflationary gap. But many economists caution against an extremely active stabilization policy, arguing that a government that tries too hard to stabilize the economy—through either fiscal policy or monetary policy—can end up making the economy less stable.

We’ll leave discussion of the warnings associated with monetary policy to Chapter 19. In the case of fiscal policy, one key reason for caution is that there are important time lags between when the policy is decided upon and when it is implemented. To understand the nature of these lags, think about what has to happen before the government increases spending to fight a recessionary gap. First, the government has to realize that the recessionary gap exists: economic data take time to collect and analyze, and recessions are often recognized only months after they have begun. Second, the government has to develop a spending plan, which can itself take months, particularly if politicians take time debating how the money should be spent and passing legislation. Finally, it takes time to spend money. For example, a road construction project begins with activities such as surveying that don’t involve spending large sums. It may be quite some time before the big spending begins.

Because of these lags, an attempt to increase spending to fight a recessionary gap may take so long to get going that the economy has already recovered on its own. In fact, the recessionary gap may have turned into an inflationary gap by the time the fiscal policy takes effect. In that case, the fiscal policy will make things worse instead of better.

This doesn’t mean that fiscal policy should never be actively used. In early 2009 there was good reason to believe that the slump facing the Canadian economy would be both deep and long and that a fiscal stimulus designed to arrive over the next year or two would almost surely push aggregate demand in the right direction. In fact, as we’ll see later in this chapter, the 2009 stimulus arguably faded out too soon, leaving the economy still depressed. But the problem of lags makes the actual use of both fiscal and monetary policy harder than you might think from a simple analysis like the one we have just given.