3.1 Fiscal Policy

Fiscal policy

Decisions made by the government on its expenditure, taxation and borrowing

Government budget

The balance between government receipts and outgoings (budget surplus/deficit)

Transfer payments

Occur when the government provides benefits (in cash or in kind) to poorer households

Direct taxation

A tax levied directly on income

Indirect taxation

A tax on expenditure, e.g. VAT

Progressive taxation

A tax in which the marginal tax rate rises with income, i.e. a tax bearing most heavily on the relatively well-off members of society

Proportional taxation

Tax that is proportional to income, being neither regressive nor progressive

Regressive taxation

A tax bearing more heavily on the poorer members of society

Current government expenditure

Spending by the government on goods and services

Capital government expenditure

Spending by government on capital projects

Budget surplus

A situation in which government expenditure is less than government revenue

Budget deficit

A situation in which government expenditure exceeds government revenue

Balanced budget

A situation in which government expenditure equals government revenue

Cyclical budget position

A government budget deficit that occurs during the downturn of the business cycle, but disappears in the upturn

Structural budget position

A government budget deficit that persists even when the economy is at full employment

Bond Yield

The rate of interest paid on government debt

National Debt

Total amount owed by the government which has accumulated over the years.

Government Debt

Incurred when countries borrow funds to pay for more public services and projects than they raise in taxes.

Roles of fiscal policy

Financing government spending

Changing final income and wealth

Providing a welfare state safety-net

Managing the economic cycle

Improving long run competitiveness

Tackle important market failures

Economic Importance of Education & Health Spending

Education spending: May increase the skills and productivity of workers, improvement in human capital will lower structural unemployment, more innovation / competitiveness

Health care spending: Improved health outcomes will boost active labour supply, will also increase productivity, lessens risks of relative poverty

Expansionary fiscal policy

To stimulate economic growth by increasing spending/lowering taxes/both

This leads to a rightward shift of AD

Used when there is not enough AD, such as during a recession when output is low and unemployment is high

Contractionary fiscal policy

To slow the economic growth by decreasing spending/increasing taxes/both

This leads to a leftward shift of AD, leading to downward multiplier effect

Used when AD is too high, for example during a boom when the economy is near full employment output and inflation is too high

Effect of lower corporation tax on businesses

Increase in post-tax profitability may lead to a rise in planned investment - this increased capital spending is an injection into the circular flow, which creates a multiplier effect on demand, output and employment

Effect depends on the scale of the tax cut

Many factors affect capital investment so multiplier effect not guaranteed e.g. the pace of technological change and strength of market competition

There will be time lags between change in corporation tax and increased flow of actual investment

Some extra investment may lead to a loss of jobs through capital labour substitution effects

Impact of a rise in indirect taxes on the UK Economy

Effects of taxation on AS

Work incentives / active labour supply

Inward migration of key workers

Capital investment e.g. FDI projects

Enterprise / Entrepreneurship

Taxation and incentives to study

Tariffs affect import costs

Arguments for a low tax economy

Stimulates work incentives and productivity

Helps to create more jobs because businesses have less tax to pay

Encourages an inflow of FDI from businesses looking for low tax countries

Incentivizes enterprise and start-ups – a source of long term wealth and jobs

Lower tax rates might end up increasing total tax revenues (Laffer Curve concept)

Arguments for a high tax economy

Taxation is a key instrument for changing the final distribution of income and wealth. It is equitable for those with the greatest resources to pay more

Tax cuts don’t necessarily lead to an increase in total tax revenues for the government

Taxes are needed to fund high quality public services

Calculating average tax rate

Total taxes divided by total taxable income

Calculating the average tax rate involves adding all of the taxes paid under each bracket and dividing it by total income

Calculating marginal tax rates

The marginal tax rate is the extra tax paid on incremental income

Marginal tax rate = Change in tax paid / Change in income x 100

Laffer Curve

Illustrates that sometimes cutting tax rates can increase total tax revenue

When tax revenues increase beyond a certain level, people will avoid paying them or lose incentives to work/be productive, so tax revenue will fall

Tax revenue cannot be increased indefinitely by increasing taxes

Limitations of Fiscal Policy

Lack of data can hinder it. Data takes time to compile and governments may not be aware how much intervention is needed

Crowding out effect

Suggests rising public sector spending drives down private sector spending

This is when government spending fails to increase overall aggregate demand because higher government spending causes an equivalent fall in private sector spending and investment