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One of the most important developments in macroeconomics in the last twenty years has been the shift of attitude with respect to fiscal policy.  From emphasis on Keynesian expansionary policies (implemented in the whole western world since the 1950s) and their effectiveness in accelerating growth, dampening economic fluctuations and cutting unemployment, we have now turned to a more orthodox approach in which the long term costs of fiscal expansion and prolonged budget deficits are stressed.  From a business perspective, this change in attitude is important because efficient governments, lower taxes and market-friendly policies are a priority for the private sector.  In this chapter, after a comparison between the two different approaches to fiscal policy, the limits of fiscal activism are highlighted together with an analysis of fiscal policy in EU countries, driven by the Maastricht criteria.


Q1 Business often supports the objective of fiscal rectitude in the belief that it will lead to lower taxes. Explain how these two phenomena are linked.

Business is affected by fiscal policy in several ways and emphasis is given in the 1990s to an approach that requires fiscal rectitude, this word meaning the sustainability of the debt (i.e., a constant or decreasing debt : GDP ratio).  The link between government spending and taxes is becoming more clear in the 1990s, enlightened by the long term effects of fiscal deficits.  In the long run, as the debt : GDP ratio increases due to continuos fiscal imbalances, countries start to pay a 'debt penalty': their governments borrow in order to pay interest on previous debt.  As the interest burden grows, over time the deficit becomes a source of structural distortion: eventually fiscal deficits will not be sustainable anymore and taxes will start to rise in order to service the debt.  This will have a depressing effect on investment and growth.

Fiscal imbalances can lead to structural distortions.  Also, a rising debt : GDP ratio arouses fears that a government will not be able to pay back its debt if not by creating inflation. The financial markets will demand a higher interest on government bonds to compensate for the higher risk.  Eventually the interest payment will increase furthermore worsening the debt : GDP ratio and calling more vigorously for a stop in borrowing.   Unless expenditure can be curbed, the only alternative is a rise in taxes.

Reversing the argument, fiscal rectitude can create a positive spiral in the economy, above all for countries that are heavily indebted, a phenomenon suggesting that fiscal contraction can be expansionary.  If a country with a large deficit makes a commitment to reduce its deficit and provided that its government is fully credible, the risk premium in long-term interest rates will decline, thus having expansionary effects on investment and consumption.  Furthermore, the burden of interest repayment on previous debt will be reduced, making the implementation of budget commitments for the government even easier.

Finally, we need to add that fiscal rectitude does not necessarily imply lower taxes: a low level of borrowing can be attained either decreasing public spending or increasing taxes. However, the general belief is that the former is the most effective and efficient


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