The automatic stabilisers increase fiscal deficits (or reduce surpluses) in times of slack aggregate demand. This sensitivity of the fiscal outcome to the business cycle would be eliminated if the government followed a fiscal rule that forced them to balance spending and taxation at all times.
Answer: False
The answer is False.
The final fiscal outcome is the difference between total federal revenue and total federal outlays. So if total revenue is greater than outlays, the fiscal balance 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 balance is in surplus it is often concluded that the fiscal impact of government is contractionary (withdrawing net spending) and if the balance 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 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 = (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 in a recession and contracting it in a boom.
So just because the fiscal balance goes into deficit 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.
The first point to always be clear about then is that the fiscal balance is not determined by the government. Its discretionary policy stance certainly is an influence but the final outcome will reflect non-government spending decisions. In other words, the concept of a fiscal rule - where the government can set a desired balance (in the case of the question - zero) and achieve that at all times is fraught.
It is likely that in attempting to achieve a balanced fiscal position the government will set its discretionary policy settings counter to the best interests of the economy - either too contractionary or too expansionary.
If there was a balanced fiscal rule and private spending fell dramatically then the automatic stabilisers would push the fiscal into the direction of deficit. The final outcome would depend on net exports and whether the private sector was saving overall or not. Assume, that net exports were in deficit (typical case) and private saving overall was positive. Then private spending declines.
In this case, the actual fiscal outcome would be a deficit equal to the sum of the other two balances.
Then in attempting to apply the fiscal rule, the discretionary component of the fiscal would have to contract. This contraction would further reduce aggregate demand and the automatic stabilisers (loss of tax revenue and increased welfare payments) would be working against the discretionary policy choice.
In that case, the application of the fiscal rule would be undermining production and employment and probably not succeeding in getting the fiscal into balance.
But every time a discretionary policy change was made the impact on aggregate demand and hence production would then trigger the automatic stabilisers via the income changes to work in the opposite direction to the discretionary policy shift.
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