A Planned Budget Deficit — Effects on National Income and the Trade-Offs It Brings

Question

Singapore’s budget position for Financial Year 2019 is estimated to be in a deficit of 7.1 billion dollars in view of slowing economic conditions.

Source: The Business Times, 18 February 2019

(a) Using the concept of circular flow of income, explain the effects on Singapore’s national income and its components when the government plans for a budget deficit. [10]

(b) Discuss the extent to which economic trade-offs will occur as a result of the Singapore government’s planned budget deficit. [15]

Answer

Part (a)

A planned budget deficit, where government expenditure exceeds tax revenue ($G > T$), is a form of discretionary expansionary fiscal policy. Working through the circular flow of income, it raises national income by lifting the components of aggregate demand and amplifying that initial injection through the multiplier.

The deficit raises the components of national income. A budget deficit is engineered through higher government spending and lower taxes, each of which feeds the circular flow. Higher government expenditure ($G$) is itself a direct injection into the flow. A cut in corporate tax raises firms’ expected post-tax returns, lifting the marginal efficiency of investment so that more projects become profitable, raising investment expenditure ($I$). A cut in personal income tax raises households’ disposable income, lifting induced consumption expenditure ($C$). The reduced leakage to taxation also leaves a larger fraction of each dollar of income circulating, raising the marginal propensity to consume and so the size of the multiplier.

The multiplier amplifies the initial injection. The rise in $G$, $C$ and $I$ raises aggregate demand. As the mechanism of fiscal policy runs, the initial injection becomes income for households, who re-spend a fraction of it (the marginal propensity to consume) on domestically produced goods; that re-spending is income for others, who re-spend in turn. Each round is smaller than the last because part of every dollar leaks to saving, taxation and imports, so the rounds converge to a finite total. National income therefore rises by a multiple of the initial injection — the multiplier effect.

Part (b)

Economic trade-offs are conflicts among policy goals: a macro–macro conflict, where pursuing one macroeconomic aim worsens another, or a macro–micro conflict, where a macroeconomic gain worsens a microeconomic outcome. The planned deficit, by raising aggregate demand and national income, risks three such trade-offs. My thesis is that the trade-offs are real in principle but unlikely to bite materially in Singapore’s 2019 context, because the deficit is a counter-cyclical response to a slowdown rather than a stimulus applied to an economy at full capacity.

Trade-off 1 — growth versus price stability (macro–macro). Raising aggregate demand to lift growth risks demand-pull inflation: as AD rises against a given productive capacity, the general price level is bid up.

Evaluation: the deficit is deployed precisely because of slowing economic conditions, so the economy has spare capacity and sits in the near-horizontal (Keynesian) range of AS, where a rise in AD raises output with little upward pressure on prices. Moreover, Singapore has a small multiplier — large import leakages and compulsory CPF saving mean much of each dollar leaks out rather than re-circulating — so the AD rise, and hence the inflationary pressure, is modest. This trade-off is therefore unlikely to occur to any significant degree.

Trade-off 2 — growth versus full employment (structural unemployment) (macro–macro). Where the deficit funds restructuring towards higher-value, more capital- and skill-intensive sectors, workers displaced from declining labour-intensive sectors may lack the skills the growing sectors demand, so growth can coincide with structural unemployment. Evaluation: in 2018–19 a considerable share of Singapore’s spending went on training and reskilling — SkillsFuture, for instance — which equips displaced workers for the new jobs, mitigating structural unemployment rather than aggravating it. The trade-off is thus largely neutralised by the composition of the spending.

Trade-off 3 — growth versus equitable income distribution (macro–micro). Higher growth can widen income inequality if its gains accrue disproportionately to capital owners and high-skilled labour. Evaluation: Singapore’s deficit was directed substantially at redistributive and means-tested support — the Pioneer and Merdeka Generation packages, healthcare and housing subsidies, the Workfare Income Supplement and the Progressive Wage Model — which channel the gains towards lower-income households. The macro–micro conflict is therefore alleviated by deliberate redistribution.

Judgement. The trade-offs a planned budget deficit can generate — demand-pull inflation, structural unemployment, and a worsening income distribution — are genuine in the abstract, but the extent to which they materialise depends on the state of the economy and the composition of the spending, and on both counts Singapore’s 2019 deficit is well placed to avoid them. It is a counter-cyclical measure applied to an economy with spare capacity and a small multiplier, so the inflation risk is slight; and it is weighted towards reskilling and redistribution, which directly offset the employment and equity conflicts. The trade-offs are therefore real but limited, and to the extent they arise they are mitigated by the very design of the package rather than left to bite — so on balance the planned deficit is coherent rather than self-undermining.