Budgetary policy is the management of revenues (taxes) and government expenditure in a country or a state. Budgetary policy therefore also includes tax policy. Each year, the competent authorities vote a budget based on forecast revenues and expenditures. The budget can be presented in three forms:
- A balanced budget
- A budget in deficit
- A budget in surplus
The budgetary balance (incomes - expenditures) is an assessment of the budgetary policy conducted during the year. This balance will vary of course depending on economic conditions. A period of growth will have a positive effect on the budget balance, while a recession will have a negative effect.
Budgetary Policy during a Recession Period
In a recession, the budget will be almost in all cases in deficit. Indeed, the state will seek to stimulate economic activity by public spending to revive growth. Returning to the Keynesian theory (JM Keynes in 1936), this budget looks like a budget stimulus (higher costs) but if in some cases, the budget deficit may be due to a decline in tax revenues (lower rates taxation). We must distinguish whether it is a proactive budget or an endemic situation reflects a failure of the state to contain spending.
A budget in deficit leads to a period of money creation. Inflation will be mechanically strong and ultimately lead to higher interest rates to control inflation. The aim is to inject a maximum of liquidity in the economy to restore confidence among economic actors. Furthermore, increased public investment and private (banks providing easier credit for businesses) will create new jobs and household incomes will increase as well.
Due to the deposit multiplier and credit divider effects, it is accepted that the increase in household income will be greater than the amount of the debt-induced by measures of revival. Indeed, the increase in household income will grow tax revenues and therefore the deficit will be covered in theory.
In practice, this is not always the case. Cash injected into the economy by the state may be diverted from their original purpose to foster credit. This happens when the money is not redistributed by banks to companies and households. The banks then use this cash to its own purposes such as proprietary trading. The money is not redistributed, job creation is insufficient and the increase in household income does not cover the increase of the deficit. This may then have devastating effects.
Budgetary Policy during a Growth period
In times of growth, budgetary discipline should in theory reduce the deficit. Indeed, during this period, revenues increased and expenditures are reduced because the economy is already in a virtuous circle. However, be careful not to kill growth by cutting spending because if the investment leads to job creation, the divestment at the opposite induced destruction of jobs. Periods of expansion are not necessarily the easiest to manage for the States because we have to choose what we decide to do with the revenue in surplus due to favorable economic climate. The State may:
- pay back a part of the public debt
- develop social programs
- engage a public investment policy
- Lighten the tax burden
- use the surplus in unforeseen circumstances
All these choices have very different consequences both immediate and long term.
- Pay back a part of the public debt (decrease of "long term" interest rate ; less competition in the private / public sector in the research of funding; lightening the burden of debt)
- Development of social programs (none)
- Public Investment Policy (job creation)
- Lighten the tax burden (increased consumption)
- Use the surplus in unforeseen circumstances (it was the case of the USA after 9/11/2001. The Government have kept an imposing tax reliefs may decide to cover directly losses ($ 40MM for airlines and insurance companies and reinsurance) and to stimulate consumption ($ 100MM in tax relief for households)
Long term consequences:
- Pay back a part of the public debt (tax cuts, resulting in higher disposable income (which will be split between consumption and savings.)
- Development of social programs (more power for the welfare state and increase of the disposable income of households)
- Lighten the tax burden (the consequences depend on the nature of the decrease of the taxation; If it is a direct reduction of taxes (For USA), on the long term the consumption growth will increase revenue from indirect taxes; in the case of a decline in tax base, no long-term consequences.
- Use the surplus in unforeseen circumstances (long term consequences will depend both on the severity of events and policy choices made to correct this situation)
However, regardless the choice of monetary policy, the budgetary balance is highly dependent on changes of economic conditions. For this reason, budgetary policy has sometimes counterproductive effects compare to objectives fixed by the State.