Fiscal Framework for Ontarios Industrial Development - Term Paper Example

? THOUGHTS ON A FISCAL FRAMEWORK FOR ONTARIO’S INDUSTRIAL DEVELOPMENT A numbers of rationales have been proposed to help address market failures and inefficiencies especially in the industrial sector of Canada. The industrial development of Ontario is characterized by market failures such as negative externalities, monopolized market powers, agency problems, and information asymmetry. These economic failures impact negatively on the general economic performance of Canada, both in the long-term and short-term. However, to overcome these economic challenges, the relevant authorities (including the private and public) should effectively address design, agency problem, and daunting information. Since these challenges have adverse effect on the economic growth and performance of Ontario and Canada, it is important that economic policies (fiscal and monetary) be adjusted to match the current industrial challenges. In particular, fiscal policies, which have a wide spread immediate impact on the economy, should be recommended. Fiscal policies which are effective in addressing market imperfection are government expenditure, sectoral tax provisions, and subsidies. The Ontario government proposed price ceiling and subsidies on specific goods and services, supporting venture capital investments and increased government expenditure as appropriate fiscal policies for addressing industrial market imperfections and challenges. Sustainable fiscal policies advanced by Ontario government through sectoral neutrality and effective tax policy would be attractive to investors, thus more investments both in infrastructure and services. INTRODUCTION While analyzing effects of fiscal policies on the economic growth and development, it is important to consider both long-run and short-run implications of the proposed fiscal or monetary policy tools. Similarly, the policy maker should take into account the existing relationship between macro-economic variables and fiscal policy frameworks. In this aspect, policy makers should make a clear distinction between classical long-run and Keynesian short-run effects on the economic variable under investigation (Carl, 2008). In analyzing the effects of any fiscal policy on economic growth and development, all the potential simultaneous changes associated with such decision should be accounted for in the policy framework. As demonstrated by a number of researches, in the short-run, fiscal policies are not very effective in bringing significant changes on economic variables of growth and development, thus, Keynesian economic principles are ineffective in the short-run. However, in the long-run, generally, the economy will not benefit from expansionary fiscal policies. It is therefore essential for the government of Ontario to recognize that alterations in government expenditure without an equivalent revenue change will results into imbalanced budget, which will further impact on the economic growth indicators. Electoral process of any country is based on how effective the incoming government is going to deliver on their promises. Voters on the other hand, seek to elect leaders whose policies and manifestos have the potential of improving the living standards and reduce the cost of living to the citizens. Most governments rely on fiscal and monetary policies to deliver their promises to the voters (Walker, 2002). However, fiscal policies directly affect the voters and the economy as a whole. Through economic interventions such as special tax measure and specific subsidies, the government often seeks to deliver on its goals and promises on better economic performance. Ontario is not an exception. The government of Ontario uses fiscal interventions as leading economic and growth policies. A better fiscal policy framework focuses on fostering economic development through work promotion, encouraging investments and savings, and promoting productivity through technological inventions and innovations both in the long-run and short-run. Besides, resource mobilization is an essential step towards achieving sustainable long-term economic growth and improvement in the living standards of the public as a whole. In the coming decades, Ontario is likely to suffer from decline in key industrial growth. This is because of the low birth rates in the province (Boughton, 2010). Consequently, the aging population rises over time. With majority of the workforce being elderly, the economic productivity and output will significantly decline. Besides, induced savings and investments will suffer a great setback. With unsteady production, meeting the increasing consumption demands of the aging population, it is more challenging for the government of Ontario to meet this burden. Instead, the tax-burden is shifted to taxpayers. From an economic point of view, the concern is what are the fiscal or monetary policies which have the potential of promoting investments, savings and also improve the general productivity of the nation? The answer to this concern lies with the provincial government of Ontario (Carl, 2008). Though the powers of the provincial administration are limited especially regarding monetary policies, it has powers to manipulate region fiscal mechanisms such as transfers, taxes, subsidies and direct spending, which potentially affects economic real incomes at domestic levels. Additionally, the interaction between firms and individual in the competitive market environment will also help increase the economic productivity. LITERATURE REVIEW The Effectiveness of Fiscal Policy The effectiveness of the fiscal policies in stimulating economic development and growth in Canada has triggered a very interactive debate. Since many economists in Canada believe in Keynesian theory of spending and investment, the move by the government to stimulate economy activities is closely examined by these groups of economists. The usefulness of fiscal stimulation in the economy is supported by Nagatani (2006), Ito (2000) and Posen (2008). The ‘Fiscalist’ View The extreme fiscalist position is represented Koo (2003) asserts the effectiveness of contractionary and expansionary as “While money is neutral, fiscal policy – and only fiscal policy – is highly effective”. However, this argument lacked empirical support especially during the 1990s. Fiscalist position held by Koo and Ito failed to explain why fiscal stimulations were not effective in producing economic recovery during the 1990s. The Keynesian View A more specific case on the effectiveness of fiscal policy was proposed by Ito (2004), following a period where zero interest rate. He argued that “when the economy is in a liquidity trap, the demand for money perfectly interest-elastic and the LM curve horizontal.” Since zero interest period did not stimulate additional investments in the economy, he added “investment was perfectly interest-inelastic and the IS curve vertical. Thus monetary policy would be ineffective and fiscal policy unusually effective, without any crowding out” (Brunner & Meltzer, 2009). Thus, he advocated for increased fiscal stimulation in a zero-interest economic environment because of its effectiveness. Theoretically and empirically, this argument is limited. By arguing for a zero-interest effective period along the relatively horizontal region of the LM curve, short-term interest rates will not fall steadily over time to this level. Empirically, the effectiveness of the expansionary fiscal policy to some extent depends on the magnitude of the fiscal expenditures. Empirically, Posen (2008) believes that fiscal policies are highly effective especially in the developing economies. According to him, “fiscal spending has not been sufficiently large to stimulate the economy. A suitably sized fiscal expansion would have been effective in ending economic stagnation and deflation”. Therefore, Posen believes that fiscal policies with no monetary mechanisms would stimulate the economy. But, a combination of both fiscal and monetary policy would be effective in producing the desired economic expansion. Ito (2004) however remains convicted that appropriate fiscal policies are essential in stimulating economic growth. Though he concedes the ‘little impact’ of fiscal policies, he argues that ineffectiveness of fiscal policy is not based on the unprecedented fiscal stimulation failures of the 1990s. By principle, the effectiveness of fiscal policies is defined by mutatis mutandis, which defines the effectiveness of fiscal policy based on its ability to create positive economic growth. As early as 1990s, private sector economists were forced to make mutatis mutandis economic decisions, which predicted economic recoveries resulting from sizeable fiscal stimulations. Unfortunately, this failed to happen, thus, they stuck by their position about the ineffectiveness of the fiscal policies in stimulating the economy. The other definition on the effectiveness of fiscal policy is founded on ceteris paribus assumption which explains that “without any fiscal stimulus, the economy undoubtedly would have contracted. The underlying economy was so weak that fiscal stimulus did not bring the economy all the way to its potential growth rate but it arguably kept things from becoming worse” ( Ito, 2004 ). While supporting fiscal policy efficacy, Posen (2008) the solution to economic challenges of Canada is found in increased fiscal stimulation. Ito and Posen depended on unspecified economic shocks which renders economic growth and development exogenous to monetary and fiscal policies. However, invoking or violating the ceteris paribus rule, the effectiveness of the fiscal policy cannot be falsified. Ineffectiveness of the Fiscal Policy A number of arguments against the effectiveness have been proposed. These arguments revolve around expansionary monetary policy through money procurement by the government to fund fiscal expenditures. This first argument is based on the relationship between investment and interest rates as proposed by the Keynesians. According to Keynes, crowding out effect through higher interest rates may occur due to fiscal expansion. The second argument against fiscal policy is the ‘Ricardian equivalence’, which asserts that “consumers believe that any fiscal spending funded by the issuance of government debt (as most of it has been) will require the debt to be fully paid off in the relevant future by raising taxes on individuals” (Walker, 2002). Crowding effect policy argument states that tax-finance increased government expenditure, as opposed to bond-financed, would crowd-out private investments through raised interest rates as reflected in Keynesian standard IS-LM Model. Therefore, Keynesian, post-Keynesians and classical economist believe that fiscal policies are ineffective in restoring or stimulating economic growth as it results into higher interest rates, which further discourages investments (Brunner & Meltzer, 2009). ANALYSIS AND DISCUSSION Framework for Fiscal Intervention Government intervention in imperfect market is commonly based on tax measures and spending programs. Economic presumption for intervention is that firms and individuals within the market setting often respond to financial incentives which steer effective combination of factors of production, hence increasing productivity. The case for government intervention through taxation, regulation or subsidization rests on off-setting market powers, reducing impacts of externalities and public goods, or redistribution of resources (Blinder & Solow, 2003). Offsetting Market Powers When a market is dominated by a firm or a group of cartels which operate as monopoly, such monopoly powers will result into market imperfection. A monopoly market is characterized with super-normal prices as a result of higher prices and below optimal quantities. Such dominating firms have the power to exert pricing authority and restrict the amount of goods or services supplied to the market. To solve the problem and restore competitiveness in the market, regulation is important. The government would use direct price regulation through price ceiling. Alternatively, increasing tax rate and reducing subsidies to monopoly firms will help promote fairness and competitiveness in the market (Boughton, 2010). Externalities & Public Goods When enjoyment of a good or service cannot only be restricted to the person who pays for it and the cost of excluding other from consuming the same good is more expensive than allowing them to consume the good, the government should extent financial support through fiscal interventions. Such goods are commonly referred to as ‘public goods’ as they are non-excludable and non-rivalries. In addition, consumption of goods and services produces negative externalities which are not accounted for in the production process. To restore sanity and minimize the impact of externalities, tax intervention and regulation is necessary (Carl, 2008). The government would therefore use fiscal policy of tax increase to firms which pollutes the environment or pose danger to the environment without accounting for such external costs. Information Asymmetries and resource redistribution Differences in prices of the same commodity within the same geographical location can be explained by information asymmetry. Consumers and suppliers do not have equal access to information regarding a given market condition. To reduce or eliminate such informational variations, it calls for the intervention of the government (Blinder & Solow, 2003). This would be essential in reducing exploitation of the least informed consumers and increase efficiency in resource allocation. Government of Ontario uses its fiscal policies to as a tool for resource redistribution in the economy. Since resources are unevenly distributed in the economy, the government would redistribute income between the poor and the rich through income tax and subsidies. By adopting vertical tax structure, income inequality and resource disparities would be minimized. CONCLUSION Given the economic state of Ontario, the local government in collaboration with the central government should consider the fate of the all sectors of the economy. More particular, since Ontario is an industrial province, economic policies favoring industrial investments should be enacted and formulated. This calls for strong monetary and fiscal mechanisms. Though fiscal policy is ineffective in stimulating economic development, fiscal and monetary authorities should work together to stimulate economic growth. For instance, during economic recession, the central bank should create more credit by lowering interest rates which would further increase the amount of money in circulation, thus stimulating aggregate demand. In addition expansionary monetary policies are only effective in a medium economy if accompanied by expansionary fiscal policies. REFERENCES Blinder, Alan S. and Robert M. Solow (2003), Does fiscal policy matter?, Journal of Public Economics, vol. 2, pp. 319-337. Boughton, James M. (2010), Long-run money demand in large industrial countries, IMF Staff Papers, vol. 38, no. 1, March, pp. 1-32. Brunner, Karl and Allan Meltzer (2009), An aggregate theory for a closed economy, in Jerome Stein, ed., Monetarism, Amerstdam: North-Holland Publishing Co. Christ, Carl F. (2008), A simple macroeconomic model with a government budget restraint, Journal of Political Economy, vol. 76, January, pp. 53-67. Ito, Takatoshi (2004), The stagnant Japanese economy in the 1990s: the need for financial supervision to restore sustained growth, in: Takeo Hoshi and Hugh Patrick (eds.) (2000), Crisis and change in the Japanese financial system, Norwell, Kluwer Academic Publishers. Koo, Richard (2003), Keizai Kyoushitsu: Kouzouhenka taiou, teokurefusege, Nihon Keizai Shinbun, 11 January. Posen, Adam (2008), Restoring Japan’s Economic Growth, Institute for International Economics, Washington, D.C. Walker, W. Christopher (2002), Ricardian equivalence and fiscal policy effectiveness in Canada, Europe Economic Journal, vol. 16, no. 3, pp. 285-302. Read More