Chapter 23 - Government Spending, Taxes, and Fiscal Policy

Examines the government sector’s role in the macroeconomy: how it taxes, spends, and uses fiscal policy to stabilize output. Connects to Chapter 22 - Monetary Policy (fiscal vs. monetary comparison) and Chapter 21 - Aggregate Demand and Aggregate Supply (how G and T shift AD).

Key Concepts

• Government spending has grown as social insurance and education roles have expanded
• Fiscal policy can be discretionary or automatic; both affect aggregate demand
• The multiplier effect means $1ofgovernmentspendingraisesGDPbymorethan$1
• Automatic stabilizers are the most effective fiscal policy tool: timely, targeted, and temporary by design
• Deficit (flow) accumulates into debt (stock); Canada’s net debt is low by international standards
• There are both reasons to worry and not to worry about government debt

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1. The Government Sector

Size of Government

Total government spending in Canada: $1.278 trillion (2021)

Level of Government	Share of Total Spending
Provincial	45%
Federal	39%
Local/Municipal	15%
Aboriginal	1%

Federal Spending

What does the federal government spend money on?

Category	Share
Social insurance (EI, OAS, CPP, health transfers)	46%
General government services	17%
Interest on debt	9%
Defence	7%
Public safety	6%
Education	3%
Other	~12%

Remember

Social insurance is nearly half of all federal spending — it’s the dominant category by far.

Government Revenue

Federal revenue sources:

Source	Share
Individual income tax	51%
Sales taxes (GST/HST)	18%
Corporate income tax	16%
Payroll taxes (EI, CPP contributions)	6%
Royalties and other	6%
Other	~3%

Progressive Income Tax

Taxable Income

Your income after subtracting deductions (like RRSP contributions and basic personal amount).

Marginal Tax Rate

The tax rate applied to each additional dollar of taxable income. Under a progressive system, the marginal rate rises with income.

2022 Federal Tax Brackets:

Taxable Income	Marginal Rate
Up to $50,197	15%
$50,197–$100,392	20.5%
$100,392–$155,625	26%
$155,625–$221,708	29%
Over $221,708	33%

Progressive Tax Calculation

Someone earning $60,000:

• First $50,197taxedat15$7,530
• Remaining $9,803taxedat20.5$2,010
• Total federal tax ≈ $9,540

Their average tax rate = $9,540/$60,000 = 15.9% — lower than the 20.5% marginal rate.

Exam Alert

Average tax rate ≠ marginal tax rate. The marginal rate applies only to the last dollar earned. This distinction matters for incentive analysis.

Who Bears the Corporate Tax Burden?

Corporate taxes are not paid only by shareholders. Research suggests:

• ~75 cents of every $1 in corporate tax is borne by owners (reduced dividends/capital gains)
• ~25 cents is borne by workers (firms pass costs onto wages)

Provincial and Local Revenue

Level	Primary Revenue Source	Share
Provincial	Income tax	30%
Provincial	Sales taxes	26%
Provincial	Royalties	10%
Local	Property tax	~55%

Tax Expenditures (Hidden Spending)

Tax Expenditure

A tax exemption, deduction, or credit that reduces the tax someone owes; functionally equivalent to the government writing a cheque, but delivered through the tax system.

Examples: RRSP deductions, charitable donation credits, child care deductions.

Why governments use tax expenditures:

• Lower political cost — a tax break attracts less opposition than equivalent direct spending
• Encourage preferred activities (homeownership, retirement saving, charitable giving)

Why tax expenditures disproportionately benefit high-income earners:

1. High earners pay more tax → a given deduction saves them more in dollar terms
2. Many tax breaks are for activities only high earners can afford (e.g., RRSP room is proportional to income)
3. High earners are more likely to know about and use available credits

Regulation as Hidden Spending

Regulation

Government rules that change incentives for businesses and individuals; like tax expenditures, regulation can achieve policy goals without appearing as spending in the budget.

Examples: minimum wage laws, environmental standards, rent control.

• Regulation shifts costs from the government to private parties (businesses, landlords, consumers)
• Its economic impact can be large, but it doesn’t show up in the deficit

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2. Fiscal Policy

What Is Fiscal Policy?

Fiscal Policy

The use of government spending ($G$) and taxation ($T$) to influence aggregate demand and stabilize the economy.

Fiscal policy is countercyclical — it leans against the business cycle:

• Recession ($Y<Y^{\ast }$) → Expansionary fiscal policy: ↑$G$ or ↓$T$ → AD shifts right
• Boom ($Y>Y^{\ast }$) → Contractionary fiscal policy: ↓$G$ or ↑$T$ → AD shifts left

Direct vs. Indirect Fiscal Policy

Type	Mechanism	Example
Direct (government purchases)	Government buys goods/services directly → immediate boost to AD	Building a highway, hiring teachers
Indirect (transfer payments)	Government gives money to households → households decide how to spend	EI benefits, stimulus cheques

Exam Alert

Direct spending has a larger immediate effect than transfer payments because the full $1 goes directly into GDP. Transfers only affect GDP to the extent households spend (not save) the money. With MPC < 1, some transfers leak into saving.

The Spending Multiplier

When the government spends $1,incomerisesby$1. But that $1 becomes someone else’s income, who spends a fraction (MPC) of it, which becomes yet another person’s income, and so on.

$\text{Multiplier}=\frac{1}{1-\text{MPC}}$

Spending Multiplier

MPC = 0.8. Government spends $100 million.

$\text{Multiplier}=\frac{1}{1-0.8}=\frac{1}{0.2}=5$

Total increase in GDP = $100M\times 5=\ast \ast$500 million**

Common Mistake

The multiplier for tax cuts is smaller than for direct spending. A $100MtaxcutonlyboostsspendingbyMPC\times$100M in the first round (some is saved), so the tax multiplier is

$\frac{\text{MPC}}{1-\text{MPC}}$

Three Time Lags

Fiscal policy is slowed by three lags:

Lag	Description
Recognition lag	Time to recognize a recession is happening (GDP data are released with delay)
Legislative lag	Time to pass spending bills through Parliament
Implementation lag	Time to actually spend money (shovel-ready projects take time)

Remember

By the time fiscal stimulus arrives, the recession may be over — and now the stimulus could cause inflation. This is why automatic stabilizers are often preferred over discretionary fiscal policy.

The Three Ts of Good Fiscal Policy

Exam Alert

Good discretionary fiscal policy should be:

• Timely — implemented fast enough to matter
• Targeted — directed at those most likely to spend (high MPC, i.e., hand-to-mouth consumers)
• Temporary — withdrawn once the economy recovers to avoid long-run debt buildup

Crowding Out

Crowding Out

When government borrowing raises real interest rates, reducing private investment — partially or fully offsetting the stimulus effect of fiscal policy.

Mechanism:

1. Government borrows to finance spending → demand for loanable funds ↑
2. Real interest rate rises
3. Firms find fewer projects worth doing (investment line shifts left along the higher rate)
4. Private investment falls

Common Mistake

Crowding out does not fully negate fiscal policy — it partially offsets it. The net effect is still positive, just smaller than the full multiplier suggests.

Automatic Stabilizers

Automatic Stabilizer

A government program that automatically increases spending (or cuts taxes) in recessions and reduces spending (or raises taxes) in booms — without requiring new legislation.

Examples:

• Employment Insurance (EI): payouts rise automatically when unemployment increases
• Progressive income tax: tax revenues automatically fall in recessions (less income → lower bracket → lower taxes)
• Social assistance: spending rises as more people qualify during downturns

Why automatic stabilizers are effective:

• Timely: no legislative lag — they kick in the moment conditions change
• Targeted: EI goes directly to unemployed workers, who have high MPC
• Temporary: spending automatically falls as the economy recovers

Exam Alert

Automatic stabilizers satisfy all three Ts simultaneously, which is why economists prefer them over discretionary fiscal policy.

Fiscal vs. Monetary Policy

Feature	Fiscal Policy	Monetary Policy
Tool	$G$ and $T$	Overnight rate
Authority	Parliament / Finance Minister	Bank of Canada
Speed	Slow (legislative + implementation lags)	Fast (8 rate decisions/year)
Effectiveness in recessions	Strong (especially direct spending)	Weaker at ZLB
Crowding out	Yes (raises rates)	No
Reversibility	Hard (politically difficult to cut)	Easy (just change the rate)

Remember

Fiscal and monetary policy work together most effectively. During COVID-19, the BoC cut rates to zero while the government ran massive deficits — both policies expanded AD simultaneously.

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3. Government Deficits and Debt

Deficits, Surpluses, and Debt

Budget Deficit

When government spending exceeds tax revenue in a given year: $G>T$. A flow measure.

Budget Surplus

When tax revenue exceeds spending in a given year: $T>G$. A flow measure.

Gross Government Debt

The total accumulated amount of money the government owes — the stock of past borrowing minus past repayments. Canada’s gross federal debt: $1.2 trillion (2021).

Net Government Debt

Gross debt minus financial assets owned by the government. Measures what the government truly owes to the outside world. Canada’s net federal debt: 33% of GDP (2020).

Exam Alert

Deficit/surplus = flow (happens over a year). Debt = stock (accumulated over all time). A surplus reduces the debt; a deficit adds to it. This is the same stock-flow distinction as saving vs. wealth.

How the Government Borrows

• Sells government bonds to savers in Canada and abroad
• Bonds are IOUs: promise to repay the principal plus interest

International Comparison of Net Debt (% of GDP, 2020)

Country	Net Debt / GDP
Japan	169%
Italy	142%
France	104%
United States	103%
United Kingdom	94%
Germany	50%
Canada	33%

Remember

Canada has the lowest net debt as a share of GDP among G7 countries — a significant structural advantage.

Historical Debt Peaks

Canadian federal debt as % of GDP has peaked at crisis moments:

Period	Cause	Peak
WWI	War financing	~70%
Great Depression	Reduced revenues	~75%
WWII	Massive war spending	~135%
Post-WWII → 1990s	Gradual decline, then welfare state expansion	Rose to ~65% by 1995
2000s–2010s	Fiscal consolidation	Fell to ~25%
COVID-19	Emergency spending	~48%

Remember

Debt-to-GDP ratio can fall either by paying down debt or by growing GDP faster than debt. Post-WWII Canada used both.

Federal vs. Provincial Debt Outlook

• Federal debt is projected to come down in the 2030s as baby boomers collecting Old Age Security (OAS) peak and then the cohort shrinks
• Provincial/territorial debt is projected to explode in the 2030s driven by rising healthcare costs for an aging population

When Do Deficits Make Sense?

Deficits are appropriate when:

1. Recession: countercyclical spending supports AD when the economy is below potential
2. Crisis: wartime, pandemics, or natural disasters justify temporary borrowing
3. Productive investment: borrowing to fund infrastructure with long-term returns (matching cost to future beneficiaries)

Short-Run Political Incentives for Deficits

Politicians face electoral incentives to run deficits even in good times:

• Spending is visible and popular; the costs (future taxes/debt) are diffuse and distant
• Cutting spending is painful; raising taxes is unpopular
• Result: a systematic bias toward deficits — deficits in recessions and in booms

Why a Balanced Budget Requirement Would Be Counterproductive

• Requiring a balanced budget at all times would force pro-cyclical policy:
  • Recession → revenues fall → must cut spending or raise taxes → worsens the recession
• This would eliminate the automatic stabilizers — the most effective fiscal tool
• Balanced budget rules work for structural (long-run) balance, not year-by-year balance

Reasons NOT to Worry About Government Debt

1. Most debt is owed by Canadians to Canadians — it’s a transfer within the country, not a burden on future Canadians as a whole
2. Future generations can help repay the debt — especially if the debt-financed spending also benefits them
3. Repayment wouldn’t require a large adjustment — at Canada’s debt level, modest future surpluses would suffice
4. The government never really needs to fully repay — it can always roll over debt as bonds mature
5. The government has options households don’t:
   • Raise taxes (legally compelled revenue)
   • Print money (though this risks inflation or hyperinflation)

Reasons TO Worry About Government Debt

1. Slower economic growth — government borrowing competes for loanable funds → crowds out productive private investment
2. Future fiscal choices constrained — high debt loads mean more revenue goes to interest payments, leaving less for programs or tax cuts
3. Risk of a crisis of confidence — if lenders doubt repayment, they charge higher interest rates → makes repayment even harder → self-fulfilling spiral
4. Debt crisis becomes more likely — at high enough debt levels, the government simply cannot repay; a sovereign default is catastrophic for the financial system

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Definitions

Fiscal Policy The use of government spending and taxation to influence aggregate demand and stabilize the economy.

Expansionary Fiscal Policy Increasing government spending or cutting taxes to boost AD; appropriate during recessions.

Contractionary Fiscal Policy Decreasing government spending or raising taxes to reduce AD; appropriate during inflationary booms.

Government Purchases (G) Direct government spending on goods and services; counted immediately in GDP.

Transfer Payments Payments from the government to households (EI, OAS, social assistance) that affect GDP only when spent.

Multiplier Effect The process by which an initial change in spending leads to a larger total change in GDP as income cascades through the economy. Multiplier = $1/(1-\text{MPC})$.

Crowding Out The reduction in private investment caused by rising interest rates when government borrowing increases demand for loanable funds.

Automatic Stabilizer A program that automatically increases government spending (or reduces taxes) in recessions and does the reverse in booms, without new legislation. Examples: EI, progressive income tax.

Taxable Income Income after subtracting eligible deductions; the base on which income tax is calculated.

Marginal Tax Rate The rate of tax applied to each additional dollar of income; rises with income under a progressive tax system.

Tax Expenditure A tax break (deduction, credit, or exemption) that reduces tax owed; economically equivalent to direct spending but delivered through the tax code.

Budget Deficit When government spending exceeds tax revenue in a year ($G>T$). A flow measure.

Budget Surplus When tax revenue exceeds government spending in a year ($T>G$). A flow measure.

Gross Government Debt The total accumulated stock of government borrowing; includes all outstanding bonds.

Net Government Debt Gross debt minus the government’s financial assets; the true net liability of the government.

Sovereign Default A government’s failure to repay its debt obligations; can trigger a financial crisis.