4.5 role of the state in the macroeconomy

types of govt expenditure

1. Capital govt expenditure

2. Transfer payments

3. Current govt expenditure

Capital govt expenditure

spending on investment goods eg roads, schools and hospitals

Transfer payments

money taken from one group and give to another e.g tax -> pension

Current govt expenditure

recurring day to day spending by governments on public services

things that affect the Composition and size of public expenditure

• level of GDP

• inflation

• Higher income countries demand more services from govt

• Trade cycle

• crisis e.g. global financial crisis

• Pressure on govt spending due to aging population

• Provision of public + merit goods

• Interest payments on national debt

• Infrastructure needs

how does inflation affect govt expenditure

increases the nominal value of goods therefore reduces real spending power of govts money therefore increases govt expenditure

how did the global financial crisis affect govt expenditure

increase govt spending on welfare payments, some govt used taxpayers money to bail out banks

impacts of levels of public expenditure on productivity and growth

1. Increase borrowing -> Crowding out

2. Spending on infrastructure 

3. Economies of scale - improves productivity

4. Education - provides human capital

5. Increase RandD

6. Multiplier effect

impacts of levels of public expenditure on living standards

1. Spending corrects market failure and provides public goods

2. Reduce absolute poverty - benefits, education, healthcare

3. Govt may suffer from principal agent problem - loss in welfare and fall in living standards

crowding out

1. Govt borrows from individuals and businesses - money in economy doesn’t increase so govt competes with private sector for finance -> pressures interest rates to rise, discourage firms from investing and individuals buying on credit

2. Either done by Limited number of resources (increases scarcity for resources - higher ROI required for capital owners) in economy or financial  (leads to fiscal deficit)- govt borrowing crowds out private sector

3. In terms of high unemployment govt spending lead to “crowding in” encourages investment through multiplier

impacts of levels of public expenditure on the level of taxation

1. Increase in debt/govt spending -> require increase tax or increase IRs for govt bonds for funds or econ growth

2. Consequences? - incentive? Increase leakage -> decrease AD

impacts of levels of public expenditure on equality

1. Increase govt spending -> Increase Welfare support policies to help lower income individuals

2. Increase govt spending - Increase Provision of public services to provide equal opportunities

3. However some spending e.g. military - no obvious impact on equality

direct taxation

taxes that cant be avoided → tax on income

indirect taxation

taxes on spending that can be passed on to others e.g. in the price of goods

Proportional tax

taxes that are paid as an equal % income at each income level e.g. 23% income tax rate -> Lithuania

Progressive tax

increase as income increases, helps reduce inequality, based on the person's ability to pay. Usually direct taxes

Regressive tax

proportion of income paid on tax is higher in lower incomes, less equitable distribution of income. Usually indirect taxes

objectives of taxation

Raise tax revenue to fund public services (include productive capacity LRAS)

Change patterns of economic activity → e.g. tax on demerit goods

Redistribute income especially progressive tax

Manage the macroeconomy (to change AD)

Raise money for specific causes → hypothecated tax

main taxes in UK

Income tax

Nat insurance

VAT - indirect - uk 20%

Corporation tax - direct - profits

Fuel duty - indirect - demerit good

Council tax - local govt

how does tax changes affect incentives to work

• High marginal rates of tax will discourage work, supply of labour is relatively elastic

• High tax can cause high income earners to move abroad

• Poverty traps

• High tax -> increase hours of work -> increase income

how does tax changes impact the tax revenue

• Laffer curve shows the impact of direct taxes on incentives

• If ppl were taxed 100% then no work done so tax rev is 0 at 0% and 100%

• Similarly increase corp tax may decrease I + FDI

• T is not known

• Revenue from indirect taxes uncertain due to consumer spending patterns

how does tax changes impact income distribution

• Progressive tax will increase income equality

• Regressive will increase income inequality

• Tax does not give the poor anything so benefits are required

how does tax changes impact Real output and employment

• Rise in direct taxes -> decrease income -> fall in AD, effect on output depends on if full employment or not

• Higher indirect taxes and NICs increase costs for firms and will decrease SRAS

• Incomes taxes cause a disincentive to work -> reduce LRAS

how does tax changes impact Price level

• Tax impact LRAS,SRAS,AD -> shift price

• Indirect taxes -> cost push inflation

how does tax changes impact Trade balance

• Rise taxes - reduce imports, imports at highly income elastic - improve trade balance

• Long run - lower AD -> reduce businesses need to I -> reduce competitiveness

 

how does tax changes impact FDI flows:

Low taxes on profit -> increase business I

Problem - “race to the bottom”, countries continue to decrease tax to encourage I resulting in falling revenues for all countries

fiscal balance

difference between G and T

EU considers deficit as <3% is the benchmark

automatic stabilisers

changes in fiscal policy (G+T) that occur as a result of a change in GDP -> changes in GDP are linked to economy cycle

How do automatic stabilisers help in recession and boom

In recession stabilisers reduce the overall fall in AD e.g. increase benefits (G) + decrease income tax, and in boom tax increases which limits demand

Discretionary fiscal policy

deliberate manipulation of government expenditure and taxes to influence the economy, expansionary and deflationary policies

National debt

Sum of all govt borrowing built over the years when a country runs a fiscal deficit

This debt has an interest which needs to be paid by the govt e.g. uk 24/25 $106 billion

usually measured as a percentage of GDP (EU <3% sensible)

How does govt borrow

BofE -> issues govt bonds to the financial markets, UK govt bonds are bought by financial institutes -> usually seen as ‘safe’ investment, guarantees a fixed return -> interest rate

This IR is effectively fixed borrowing rate

Cyclical deficit

deficit that occurs because G and T fluctuate around the trade cycle e.g. recessions T is low and G is high

Structural deficit

long term, a budget deficit that remain even when economic growth is at trend (e.g. UK -> 2.0/2.5%) or higher

Why is cyclical deficit easier to eliminate than structural deficit

Cyclical deficit will be eliminated by increase econ growth -> trend therefore policy focus = increase econ growth

However difficult to eliminate structural deficits:

1. Decrease govt expenditure

2. Increase tax receipts

Actual deficit

structural deficit + the fiscal deficit

Structural surplus

long term, a budget surplus that remain even when economic growth is at trend (e.g. UK -> 2.0/2.5%) or below

Factors influencing the size of fiscal deficits

• Trade cycle

• Unforeseen events

• Interest rates - IR increase -> increase govt debt -> increase deficit

• Privatisation - one off payments to the govt

• Govt aims

• Number of dependants

• Govt revenue

Considerations of national debt

• ND is often expressed As a percentage of GDP, gives creditors an idea of affordability

• If ND becomes too large - creditors may see govt bonds as high risk - demand higher IR

• However its possible for ND to go up in absolute terms but fall as % of GDP

Factors influencing the size of national debts

• Govt runs a deficit -> increase national debt i.e. fiscal deficits over 3% will lead to growing national debt

• Ageing populations  - govt runs structural deficit - increase national debt

• Interest rates

Significance of fiscal deficits and national debts

• high borrowing -> increase IR -> may cause crowding out

• Large amount of money goes to servicing national debt - opportunity cost

• High fiscal deficits -> inflation

• High debt -> reduced credit rating for the govt -> higher IRS demanded

• Borrowed from abroad - difficulty in foreign currency repayments

• Borrowing -> increase govt spending -> increase supply side -> may reduce deficit and econ growth

How can govt reduce fiscal deficits and national debts

• Policy of austerity - decrease spending, increase taxes - unpopular and could limit growth

• Demand stimulus by high spending -> cause econ growth -> rise in tax revenues -> reduce fiscal deficit

• Rely on automatic stabilisers - allow econ growth so national debt/fiscal deficit will reduce as percentage of GDP

• Defaulting on loans - desperate option as cost is large

How can govt reduce poverty and inequality

• Redistribution from rich to poor

• Progressive tax system

• Benefits

• Provision of goods and services - e.g. healthcare, education, housing

• Reduce wage differentials

• Access to education and training opportunities - allow children from poorer backgrounds to be educated

• Price controls - on essential goods

• Trickle down concept

• Law of diminishing marginal utility

Types of govt benefits

Universal benefits - available to anyone who meet certain criteria, irrespective of personal income

Means tested benefits - only for people with low income, target those who need most help and provide a safety net

How can govt reduce wage differentials

• National minimum wage - improve income of the poor

• Maximum wages or pay ratios - reduce the incomes of the rich

• Equal pay legislation - prevent inequality from race or gender

• Trade union friendly legislation - increase wages for workers

• Worker benefits - employers can provide sickness benefits, pensions and medical care

Trickle down concept

increasing income of rich, rich spend their money and employ others which creates jobs, increasing the income of the poor

Law of diminishing marginal utility

suggest that redistribution increases total utility, the higher the spending of an individual the less satisfaction gained from spending an extra pound, extra money to poor family increase utility more than for a rich family

Govt policy in changing interest rate and money supply

• Central bank has ability to change IR and monetary supply - done for domestic reasons i.e. or control inflation or global issues i.e. low ER

• Quantitative easing - BofE used since IR could not be lowered any further

How can govt change international competitiveness

Supply side measures - improve productivity, encourages competition therefore firms competitive in global market

• Exchange rate policies - control inflation and macroeconomic stability e.g. China devalues currency to reduce export price

• Join WTO or sign trade agreements

Macro policies to reduce external shock of globalisation

• Commodity price shock - e.g. oil prices greatly increase, expansionary policy reduce the fall in GDP or deflationary to reduce impact on inflation

• Financial crisis - expansionary policy to increase AS

• Changes in exchange rates - IR can be changed etc

• Political instability - in UK and other countries would mean the govt would need to take action

Transnational companies

• Creates jobs

• High tax revenues

• Investment

• Negative economic and social impact e.g. loss in culture, environmental impacts, high profit withdrawal from the economy > injection through investment

How can govt regulate transfer pricing

• Transfer pricing allows firm to avoid tax - firm produces good in one country then transfers it to another to make it into another good which it then sells, moves it profits from the high tax country in which it sells the good to a tax haven country to pay little tax

• Arm's length principle - aim for the price to be the same as if the 2 parties were independent of each other

 

Why is it difficult for govt to control TNCs

• EU suffer from legal tax avoidance schemes e.g. "Dutch sandwich" and the "Double Irish", where costs, revenues and profits are routed through Ireland, the Netherlands or Luxemburg and then sent to a tax haven like the Bahamas

• Solutions to taxation require worldwide agreement, any solution that benefits a coutnry like UK would lead to great losses to countries like Bahamas and Luxembourg

Problems facing policy makers for controlling TNCs

• Inaccurate information

• Risks and uncertainties

• External shocks

Inaccurate information

• short term information e.g. GDP figure are unreliable

• Cutting down tax avoidance is difficult as govt does not know the full level and who is avoiding the tax

• BofE makes decisions based on past data but trends can change

Risks and uncertainties

• Future is unpredictable so difficult to know if extra spending is necessary etc

• Can't know the full impact of decisions and consumer react unexpectedly

External shocks

• Govt is unable to control and prepare for these

• Only can hope to lessen their impact

• Policies may not have intended impacts or undermine current policies e.g. Brexit has delayed govt plans to balance the budget