LM03 Fiscal Policy 2024 Level I Notes

LM03 Fiscal Policy

1. Introduction ...........................................................................................................................................................2
2. Introduction to Monetary and Fiscal Policy ..............................................................................................2
3. Roles and Objectives of Fiscal Policy ...........................................................................................................2
4. Fiscal Policy Tools ...............................................................................................................................................4
5. Fiscal Policy Implementation ..........................................................................................................................7
Summary......................................................................................................................................................................9

This document should be read in conjunction with the corresponding reading in the 2023 Level I CFA®
Program curriculum. Some of the graphs, charts, tables, examples, and figures are copyright
2022, CFA Institute. Reproduced and republished with permission from CFA Institute. All rights
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LM03 Fiscal Policy 2024 Level I Notes

1. Introduction
This learning module covers:
• An introduction to monetary and fiscal policy
• Roles and objectives of fiscal policy
• Tools of fiscal policy and their advantages and disadvantages
• Fiscal policy implementation and difficulties faced in implementation
2. Introduction to Monetary and Fiscal Policy
As compared to households and corporations, the economic decisions made by governments
can have an enormous impact on economies because governments are usually the largest
employers, largest spenders and largest borrowers in an economy.
There are two types of government policy:
Fiscal policy: Refers to government decisions about taxation and spending.
Monetary policy: Refers to central bank activities directed towards influencing the quantity
of money and credit in the economy.
The overall goal of these policies is to create an economic environment in which growth is
stable and positive and inflation is stable and low.
3. Roles and Objectives of Fiscal Policy
Fiscal policy refers to the taxing and spending policies of the government. A government can
influence the following aspects of the economy:
• Overall level of aggregate demand in an economy and hence the level of economic
activity. (This is often the primary objective of a fiscal policy; secondary objectives,
which are tied to the political motive of the government, are as follows:)
• Distribution of income and wealth among different segments of the population.
• Allocation of resources between different sectors and economic agents.
Roles and Objectives of Fiscal Policy
Fiscal policy can be contractionary or expansionary.
An expansionary fiscal policy can take several forms:
• Lower taxes
o Cuts in personal income tax (This increases the disposable income).
o Cuts in sales taxes (This lowers the prices).
o Cuts in corporate taxes increase business profits (This means that corporates
have more money to invest).
• Higher government spending on social goods and infrastructure.

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LM03 Fiscal Policy 2024 Level I Notes

Contractionary fiscal policy: It is the opposite of expansionary fiscal policy. Higher taxes or
lower government spending are examples of contractionary fiscal policy.
What are the Keynesian and Monetarist views on the effectiveness of fiscal policy?
Keynesian view: Government intervention is necessary in the form of fiscal policy to get an
economy out of recession. They believe that the aggregate demand, employment, and output
increase with fiscal policy.
Monetarist view: Monetary policy is a more effective tool to tame inflation; monetarists
advocate a steady, stable monetary policy. They believe that Fiscal policy only has a
temporary effect.
Government Receipts and Expenditures in Major Economies
• Exhibits 2 and 3 from the curriculum show government revenues and expenditures as
a percentage of GDP for some of the major economies. As of 2015, for the U.S.,
government revenue as a percent of GDP was 33.4%, while the government
expenditure as a percent of GDP was 37.6%.
• The possibility that fiscal policy can influence output means that it can be used to
stabilize an economy.
• The budget deficit is the difference between government revenue and expenditure for
a fixed period of time. Government revenue includes tax revenues, net of transfer
payments; government spending includes interest paid on government debt.
• An increase in budget surplus indicates a contractionary fiscal policy.
• An increase in budget deficit indicates an expansionary fiscal policy.
• Two fiscal policies to stabilize the economy include:
o Automatic stabilizers: When the economy slows and unemployment rises,
government spending on social insurance and unemployment benefits will rise.
Whereas, if the economy is at full employment, taxes collected will be high and
there will be a budget surplus. These happen automatically without the
intervention of policymakers, and the focus is primarily on aggregate demand. They
help reduce the impact of a recession.
o Discretionary fiscal policies: Changes in government spending or tax rates. In
contrast to automatic stabilizers, this depends on the policy makers. The policies
differ primarily with respect to timing.
• A balanced budget is one where government spending is equal to government
revenues.
Deficits and the National Debt
Government deficit = Revenue – Expenses
Government deficit (national debt) is the accumulation of these deficits over time. Should we
worry about national debt? There are two schools of thought.

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LM03 Fiscal Policy 2024 Level I Notes

We should not worry because:

• The scale of the problem may be overstated because the debt is owed internally to
fellow citizens.
• A proportion of the money borrowed may have been used for capital investment
projects or enhancing human capital. We are borrowing now to increase our
productive capacity in the future.
• Large fiscal deficits require tax changes that may actually reduce distortions caused
by existing tax structures.
• Deficits may have no net impact because the private sector may act to offset fiscal
deficit by increasing saving in anticipation of future increased taxes. This is known as
Ricardian equivalence.
o The government funds its spending by either increasing taxes or borrowing. It is
the future taxpayers who will service the government’s debt. So, it is the taxpayers
who bear the burden in both cases. What matters is only the timing: now or later.
According to Ricardian equivalence, if the government defers taxation, consumers
anticipate higher taxes and the private sector will save enough today to pay for
increased taxes in the future. This higher saving results in decreased private
demand and increased government demand. The net effect is offsetting, as
government spending does not create demand stimulus.
• If there is unemployment in an economy, then the debt is not diverting activity away
from productive uses.
We should worry because:
• High levels of debt to GDP may lead to higher tax rates in the search for higher tax
revenues. This could create disincentives for economic activity.
• If markets lose confidence in a government, then the central bank may have to print
money to finance a government deficit. This may lead to inflation.
• Government borrowing may divert private sector investment from taking place (this
effect is called crowding out). If savings are limited and the demand for funds from
the government is high, then it will lead to higher interest rates and lower private
sector investment.
4. Fiscal Policy Tools
• Government spending can take different forms:
o Transfer payments: Welfare payments provided to low-income households so that
they get a basic minimum level of income. Not included in GDP calculation. Ex:
pensions, housing, and unemployment benefit, etc.
o Current government spending: Regular spending on goods and services such as
education, healthcare, defense, etc.

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LM03 Fiscal Policy 2024 Level I Notes

o Capital expenditure: Spending on infrastructure such as building roads, schools,

hospitals, etc.
• Government spending is justified both on economic and social grounds as they ensure
employment, economic growth, and a minimum standard of living for lower income
households.
• Government revenue can take different forms.
o Direct taxes: Taxes imposed on income, property, wealth, corporate profits, capital
gains, inheritance, etc. These include taxes levied on individuals and businesses.
o Indirect taxes: Taxes imposed on goods and services such as excise duty, VAT.
Indirect taxes affect alcohol or tobacco consumption more directly than direct taxes.
• Following are the desirable attributes of tax policy:
o Simplicity: There should be no ambiguity, loopholes, or scope of interpreting the tax
liability differently. It should be simple for the taxpayer to adhere to the rules, and the
authority to enforce.
o Efficiency: The tax policy should interfere as little as possible in the choices
individuals make in the market place.
o Fairness: Are people in similar situations levied the same tax, or are rich people taxed
more? For example, should a person earning $1 million a year be in the same tax
bracket as one earning $50,000 a year? It is subjective.
o Revenue sufficiency: Tax revenues collected should be sufficient to cover
expenditure.
The Advantages and Disadvantages of Different Fiscal Policy Tools
Advantages and disadvantages of using different tools of fiscal policy
Advantages Disadvantages
Indirect taxes (such as VAT) can be Direct taxes are more difficult to change
adjusted almost immediately after they are without considerable notice, often many
announced and can influence spending months, because payroll computer systems
behavior instantly. will have to be adjusted. For instance, the
government cannot increase income tax
Generates revenue for the government at
every year.
little or no cost to the government.
Social policies such as discouraging alcohol The same may be said for welfare and other
or use of tobacco can be adjusted almost social transfers.
instantly by raising such taxes.
Capital spending plans (building highways
or schools) take longer to formulate and
implement; typically, over a period of years.

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LM03 Fiscal Policy 2024 Level I Notes

Modeling the Impact of Taxes and Government Spending: The Fiscal Multiplier
• The objective of fiscal policy is to influence output through changes in government
spending and/or taxes.
• The fiscal multiplier tells us about changes in output when there are changes in spending
and taxes.
• The derivation for the fiscal multiplier is given in the curriculum, but from an exam
perspective, it is important to know the formula given below:
1
Fiscal multiplier = 1 − c(1 − t)

where:
c = marginal propensity to consume
t = tax rate
The fiscal multiplier is inversely related to the tax rate and directly related to the
marginal propensity to consume.
For example, what is the value of the fiscal multiplier if the tax rate is 20%, and the marginal
propensity to spend is 90%?
What is the increase in total income if government spending increases by $1 billion?
Solution:
1
Fiscal multiplier = 1 − 0.9 (0.8) = 3.57

A $1 billion increase in government spending increases total income by $3.57 billion.

The Balanced Budget Multiplier
A balanced budget is a fiscal policy tool where the increase in government spending on
goods and services is equal to the increase in tax revenues. The net effect is that there is no
change in the budget deficit or surplus.
Since it is a balanced budget, government expenditure and taxes go up by the same amount.
If this is the case, then the aggregate output actually rises. How? Because the fiscal multiplier
is a function of marginal propensity to consume, c. Since c is less than 1, output Y increases.
We will see how this happens using an example.
Assume in equilibrium, output Y = 1,000; C = 900 and I = 100. Assume government spending
increases by 200, which is financed by an increase in tax revenue of 200. MPC = 0.9
Fiscal multiplier effect = 10
Taxes increase by 200. Disposable income decreases by 200.
Consumption decreases by 0.9 * 200 = 180
Initial impact on aggregate demand = 200 - 180 = 20

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LM03 Fiscal Policy 2024 Level I Notes

Impact on output because of multiplier effect = 20 * 10 = 200

5. Fiscal Policy Implementation
• The deficit may not be an indication of the government’s fiscal stance because an
economy goes through a cycle. For example, at the peak of a cycle, unemployment would
be low and government expenditure would be less with the likelihood of running a
surplus. Similarly, if the economy is in a recession year, then incomes are low and taxes
collected will be relatively low, causing the budget deficit to increase. So, one cannot
conclude if the government is following a contractionary or expansionary policy by
simply looking at the deficit.
• To get an idea of the government’s policy, one should look at the structural or cyclically
adjusted budget deficit. This is the deficit if the economy was at full employment. If the
output is at long-run equilibrium, then the surplus or deficit would be called the
structural or cyclically adjusted budget deficit.
• Automatic stabilizers such as social security payments, progressive income taxes, and
VAT must be considered to determine the fiscal stance. As unemployment rises, the
benefits increase and net tax revenues decrease. These do not require policy changes,
and automatically kick in to stimulate growth.
• In addition, there are also discretionary fiscal adjustments used by governments, such as
tax changes, or huge spending to build a highway system in a country, to increase
aggregate demand.
• The two approaches to fiscal policy vary primarily with respect to timing of
implementation. But fiscal policy does not always stabilize an economy, as executing
fiscal policy can be difficult for the following reasons:
o Recognition lag: There is a time lag before policymakers recognize whether the
economy is going through a boom or is in recession. This is because it takes time to
gather and collate the data: indicators such as unemployment and inflation are often
presented weeks later. This problem is generally referred to as driving by looking in
the rear-view mirror.
o Action lag: Once the policymakers acknowledge the problem (recession, or economy
slowing down, or inflation), then they have to decide on an action plan. The
appropriate policy takes time to implement and must be passed through the
congress/parliament/whatever is appropriate. For instance, increased spending on
infrastructure to generate employment and boost growth may take several months to
complete.
o Impact lag: It may be a while before the result of the projects undertaken can be seen.
• The timing of the policy action is critical. It is important to understand the course of the
economy without these policy changes. Is the economy in recovery mode because of a

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LM03 Fiscal Policy 2024 Level I Notes

surprise increase in investment spending? Some issues associated with discretionary

fiscal adjustments are:
o If a government is concerned with unemployment and inflation, then increasing AD to
full employment may push prices further up.
o If the deficit is already large relative to GDP, then it may be difficult for the
government to borrow more money to provide fiscal stimulus. Interest on
government debt would rise.
o Crowding out effect: Limited savings and increase in government spending →
investment available for private sector decreases → less investment spending → less
growth.
• Macroeconomic forecasting models are not accurate and cannot be used for
policymaking decision effectively.

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LM03 Fiscal Policy 2024 Level I Notes

Summary
LO: Compare monetary and fiscal policy.
Monetary policy refers to central bank activities directed towards influencing the quantity of
money and credit in the economy.
Fiscal policy refers to government decisions about taxation and spending.
LO: Describe roles and objectives of fiscal policy as well as arguments as to whether
the size of a national debt relative to GDP matters.
Primary objective is to manage the economy through spending and taxation and their
influences on aggregate national output (real GDP). Secondary objectives include:
• Distribution of income and wealth among different segments of the population.
• Allocation of resources between different sectors and economic agents.
The fiscal multiplier tells us about changes in output when there are changes in spending
and taxes. Higher future taxes lead to disincentives to work, negatively affecting long-term
economic growth. Fiscal deficits may not be financed by the market when debt levels are
high.
A crowding-out effect may occur as government borrowing increases demand for loanable
funds, thus leading to increased interest rates and decreased private sector investments.
Deficits for capital spending can boost the productive capacity of the economy.
Ricardian equivalence may prevail: private savings rise in anticipation of the need to repay
principal on government debt. At below full employment levels, deficits do not necessarily
crowd out private investment.
LO: Describe tools of fiscal policy, including their advantages and disadvantages.
Government spending can take different forms such as transfer payments, current
government spending, and capital expenditure.
Government revenue can be in the form of direct and indirect taxes.
Advantages and disadvantages of using different tools of fiscal policy
Advantages Disadvantages
Indirect taxes (such as VAT) can be Direct taxes are more difficult to change
adjusted almost immediately after they without considerable notice, often many
are announced and can influence months, because payroll computer systems
spending behavior instantly. will have to be adjusted. For instance, the
government cannot increase income tax
Generates revenue for the government at
every year.
little or no cost to the government.

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LM03 Fiscal Policy 2024 Level I Notes

Social policies such as discouraging The same may be said for welfare and
alcohol or use of tobacco can be adjusted other social transfers.
almost instantly by raising such taxes.
Capital spending plans (building highways
or schools) take longer to formulate and
implement, typically over a period of years.

LO: Explain the implementation of fiscal policy and difficulties of implementation as

well as whether a fiscal policy is expansionary or contractionary.
Fiscal policy is difficult to execute because it suffers from the following lags:
• Recognition lag: Time taken to recognize that policy needs changes.
• Action lag: Time taken by governments to enact required fiscal policy changes.
• Impact lag: Time taken for fiscal policy to affect economic activity.
Fiscal policy can be contractionary or expansionary.
An expansionary fiscal policy can take several forms:
• Lower taxes
o Cuts in personal income tax (This increases the disposable income).
o Cuts in sales taxes (This lowers the prices).
o Cuts in corporate taxes increase business profits (This means that corporates
have more money to invest).
• Higher government spending on social goods and infrastructure.
Contractionary fiscal policy: It is the opposite of expansionary fiscal policy. Higher taxes or
lower government spending are examples of contractionary fiscal policy.

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