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How does the fiscal policy affect economic activity and income distribution in the Australian economy?

By insight97 Aug 24, 2014 782 Words
How does the fiscal policy affect economic activity and income distribution in the Australian economy?

Fiscal Policy is a macroeconomic policy that can be used by the government to regulate aggregate demand and production. Fiscal Policy is implemented through the government’s annual budget and also involves the regulation of aggregate demand by the government changing its level of planned spending (G) and planned tax revenue (T). Fiscal policy has the power to redistribute income, reallocate resources and regulate (stabilise) the economy through policies affecting economic activity.

The main tools of the fiscal policy are spending, revenue collection and the budget outcome (either as a surplus, deficit or balanced). The budget stance gives an indication of the overall impact of fiscal policy on the state of the economy, which can be described as expansionary (G > T), contractionary (T > G) or neutral (T = G). According to David Gruen, “…fiscal policy has always been with us; what has returned in the past couple of years is the use of active discretionary fiscal policy as a counter- cyclical tool.” [Source]. Spending, revenue and budget outcomes are affected by discretionary or structural factors, involving policy changes by the government, whereas, non- discretionary or cyclical factors relate to the impact of changing economic conditions regarding the levels of spending and revenue collection.

*should budget outcomes be defined

Economic growth occurs when there is a sustained increase in a country’s productive capacity over time, which can be measured by Gross Domestic Product (GDP). An increase of economic activity, subject to an expansionary fiscal policy, involves increased economic growth, investment and business/consumer confidence. This stimulates aggregate demand. Aggregate demand determines how much firms will produce (output = GDP) and the quantity of resources firms require to produce goods and services (this will determine employment). If aggregate demand increases, unemployment will fall and living standards will rise, causing a boom in the business cycle. However, as a result, demand inflation may occur.

In comparison, an economic recession produces an opposite outcome. Recession is the stage of the business cycle where there is decreasing economic activity, or a fall in the GDP. For example, to combat the effects of the Global Financial Crisis (GFC) in 2008, a counter- cyclical approach by the Australian government, injecting a fiscal stimulus package to encourage investment and spending in the domestic economy, implemented policy approach. This resulted in a deficit in the government’s budget, but encountered a return of economic growth post the GFC.

*should the counter- cyclical approach be defined

Changes in the fiscal policy play the most important role in influencing the distribution of income in the economy. Income distribution refers to the way in which an economy’s income is spread among the members of different social and socio-economic groups. Australia has a progressive income tax system designed to create a more equal distribution of income. People on higher incomes pay higher rates of income tax, allowing the government to use this money for community services and transfer payments. Transfer payments or social welfare payments are payments from the government to assist people with basic costs of living.

Budgetary changes involving government spending can also greatly affect income distribution. Increases in spending on community services such as health care and labour market programs, or increases in welfare payments (such as the age pension and unemployment benefits), will tend to reduce income inequality because they have a greater proportional benefit for low income earners. In comparison, government spending cuts often affect the distribution of income in a negative way, as low income earners tend to be more reliant on income support payments and government services than higher income earners.

Changes to taxation arrangements can affect income distribution significantly. For example, a reduction in tax rates at the upper end of the income scale would make the tax system less progressive and may create a less equal distribution of income. If the government were to increase the rate of the Goods and Services Tax (regressive and indirect tax in nature), the tax system would also be less progressive and would result in lower income earners paying a relatively higher proportion of their incomes in tax, influencing income inequality. The government can also influence taxation revenue through higher/lower direct taxation on company tax in order to obtain more funds.

Fiscal policy can greatly impact economic growth and income distribution in either a positive or negative way. When customised to current economic conditions, the budget stance analyses the impact of fiscal policy on economic growth, which ultimately determines its impact on income distribution. Several tweaks to the fiscal policy assist in creating an even distribution of income with sustainable levels of economic growth.

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