Answer to Question #47707 in Macroeconomics for Aditi

Question

3. The economy of Kenya is in recession, and the recessionary gap is large. The World Bank hires you as its economist and asks you to

a. describe the discretionary and automatic fiscal policy actions that might occur.
b. describe a discretionary fiscal stimulation package that could be used that would not bring a budget deficit.
c. describe the risks of discretionary fiscal policy in this situation.
d. explain the argument that lower corporate tax rates can increase tax revenue in Kenya. Consider the Laffer curve in your explanation.

Answer 1

a. Discretionary fiscal policy is made more difficult due to lags in recognizing the need for changed fiscal policy and the lags that occur with enacting the changed fiscal policy. Implementing the modified fiscal policy usually requires legislative action, which takes a long time to implement.

Automatic stabilizers, without specific new legislation, increase (decrease) budget deficits during times of recessions (booms). They enact countercyclical policy without the lags associated with legislative policy changes.

b. Discretionary fiscal policy such as a "stimulus package" is the sort of package does not come about automatically. There is no provision that says that the government will pay out a certain level of money if economic activity slows. Instead, the government must draft and pass a bill to specifically lay out what sorts of stimulus spending will occur. Discretionary fiscal policy provides an alternative way to stimulate the economy when aggregate demand and interest rates are low and when prices are falling or may soon be falling. A stimulus can be achieved without increasing budget deficits if the fiscal policy acts by providing an incentive for increased private spending.

c. Ultimately, if risks regarding the future course of fiscal policy are substantial, and if its credibility is undermined, unsustainable fiscal policies will have an impact on the creditworthiness of the government. In the extreme, this may lead to reduced access to capital markets for funding debt. But even more moderate debt levels are problematic. They impair the operation of automatic stabilisers. In addition, the effectiveness of fiscal policy measures could decrease as awareness increases among the public that the fiscal policy course is not sustainable, so that countervailing measures in the future are anticipated. Furthermore, increasing debt ratios lead to rising tax burdens, either now or in the future. This exacerbates current tax distortions and reduces work incentives, thus leading to less economic growth.

d. Lowering the rate would actually increase tax revenue because corporations could dedicate more resources to taxable, profit-generating activities.