Which scenario represents a more expansionary outcome
Answer: A fiscal deficit equivalent to 5 per cent of GDP (including the impact of automatic stabilisers equivalent to 3 per cent of GDP).
The answer is Option (a).
The question probes an understanding of the forces (components) that drive the fiscal balance that is reported by government agencies at various points in time and how to correctly interpret a fiscal balance.
In outright terms, a fiscal deficit that is equivalent to 5 per cent of GDP is more expansionary than a fiscal deficit outcome that is equivalent to 3 per cent of GDP irrespective of the cyclical and structural components.
In that sense, the question lured you into thinking that only the discretionary component (the actual policy settings) were of interest. In that context, Option (c) would have been the correct answer.
To see the why Option (a) is the best answer we have to explore the issue of decomposing the observed fiscal balance into the discretionary (now called structural) and cyclical components. The latter component is driven by the automatic stabilisers that are in-built into the fiscal process.
The federal (or national) government fiscal balance is the difference between total federal revenue and total federal outlays. So if total revenue is greater than outlays, the fiscal position is in surplus and vice versa. It is a simple matter of accounting with no theory involved. However, the fiscal balance is used by all and sundry to indicate the fiscal stance of the government.
So if the fiscal position is in surplus it is often concluded that the fiscal impact of government is contractionary (withdrawing net spending) and if the fiscal position is in deficit we say the fiscal impact expansionary (adding net spending).
Further, a rising deficit (falling surplus) is often considered to be reflecting an expansionary policy stance and vice versa. What we know is that a rising deficit may, in fact, indicate a contractionary fiscal stance - which, in turn, creates such income losses that the automatic stabilisers start driving the fiscal position back towards (or into) deficit.
So the complication is that we cannot conclude that changes in the fiscal impact reflect discretionary policy changes. The reason for this uncertainty clearly relates to the operation of the automatic stabilisers.
To see this, the most simple model of the fiscal balance we might think of can be written as:
Fiscal Balance = Revenue - Spending.
Fiscal Balance = (Tax Revenue + Other Revenue) - (Welfare Payments + Other Spending)
We know that Tax Revenue and Welfare Payments move inversely with respect to each other, with the latter rising when GDP growth falls and the former rises with GDP growth. These components of the fiscal balance are the so-called automatic stabilisers.
In other words, without any discretionary policy changes, the fiscal balance will vary over the course of the business cycle. When the economy is weak - tax revenue falls and welfare payments rise and so the fiscal balance moves towards deficit (or an increasing deficit). When the economy is stronger - tax revenue rises and welfare payments fall and the fiscal balance becomes increasingly positive. Automatic stabilisers attenuate the amplitude in the business cycle by expanding the fiscal position in a recession and contracting it in a boom.
So just because the fiscal position goes into deficit or the deficit increases as a proportion of GDP doesn't allow us to conclude that the Government has suddenly become of an expansionary mind. In other words, the presence of automatic stabilisers make it hard to discern whether the fiscal policy stance (chosen by the government) is contractionary or expansionary at any particular point in time.
To overcome this uncertainty, economists devised what used to be called the 'Full Employment' or 'High Employment Budget'. In more recent times, this concept is now called the Structural Balance. The 'Full Employment Budget Balance' was a hypothetical construct of the fiscal balance that would be realised if the economy was operating at potential or full employment. In other words, calibrating the fiscal position (and the underlying fiscal parameters) against some fixed point (full capacity) eliminated the cyclical component - the swings in activity around full employment.
So a full employment fiscal position would be balanced if total outlays and total revenue were equal when the economy was operating at total capacity. If the fiscal position was in surplus at full capacity, then we would conclude that the discretionary structure of the fiscal position was contractionary and vice versa if the fiscal position was in deficit at full capacity.
The calculation of the structural deficit spawned a bit of an industry in the past with lots of complex issues relating to adjustments for inflation, terms of trade effects, changes in interest rates and more.
Much of the debate centred on how to compute the unobserved full employment point in the economy. There were a plethora of methods used in the period of true full employment in the 1960s. All of them had issues but like all empirical work - it was a dirty science - relying on assumptions and simplifications. But that is the nature of the applied economist's life.
As I explain in the blogs cited below, the measurement issues have a long history and current techniques and frameworks based on the concept of the Non-
Accelerating Inflation Rate of Unemployment (the NAIRU) bias the resulting analysis such that actual discretionary positions which are contractionary are seen as being less so and expansionary positions are seen as being more expansionary.
The result is that modern depictions of the structural deficit systematically understate the degree of discretionary contraction coming from fiscal policy.
So the data provided by the question unambiguously points to Option (a) being the more expansionary impact - made up of a discretionary (structural) deficit of 2 per cent and a cyclical impact of 3 per cent. The cyclical impact is still expansionary - lower tax revenue and higher welfare payments.
Option (b) might in fact signal a higher structural deficit which would indicate a more expansionary fiscal intent from government but it could also indicate a large automatic stabiliser (cyclical) component.
You might like to read these blog posts for further information: