9 - Further fiscal policy challenges

Summary

Beyond stabilization policies

This chapter extends and complements the analysis of the previous two in a different sphere. Monetary and fiscal policy are not just a mechanical device to manage aggregate demand in specific circumstances, or a means to correct market failures, promote structural reform, or pursue some special interest. All of those things are important. But economic policy can be used strategically to model society in a form that we might prefer – an argument made very clear in the Mirrlees Review (Adam et al., 2010; Mirrlees et al., 2011).

We now focus on further aspects of policymaking considering its capacity to promote risk sharing over different regions and sectors of the economy as well as different ages of the population. We look at its ability to act as a shock absorber when imbalances appear elsewhere in the economy, for example in trade or the financial sector; its capacity to help us to face up to demographic change; and the possibility of using economic policies to address inequality and welfare provision.

The chapter is organized as follows. Section 9.2 introduces the issue of risk sharing and regional stabilization. Section 9.3 looks at the macroeconomic imbalances. Then, Section 9.4 focuses on demographic change and age-related spending. Finally, the last section discusses redistribution, inequality and welfare.

Fiscal federalism and regional stabilization

In a federal regime, some taxes and expenditures are assigned to regional governments and some to central government. This creates a central budget into which regions pay, or receive payments from, on an automatic basis – in each case at rates chosen by the central government.

There will also be separate budgets at the regional level since not all taxes/expenditures are centralized. Those taxes or expenditures will be charged or paid out at rates chosen by regional governments. There may be no grants or discretionary payments made from the center. However, adding an upper level of federalist transfers (creating “vertical imbalances”) to the regions is always possible and would increase efficiency since those transfers will enhance the system's ability to adapt to local conditions and create an ability to undertake long-run redistributions.

Long-term redistributions can also be created by choosing the federal tax and expenditure functions such that there is a net transfer to certain regions on average and, if the central budget is balanced, away from others.