13.1 - Fiscal policy

What is fiscal policy?

The use by the government of government spending and taxation to try to achieve the governments policy objectives

What are the three possible budgetary positions a government can be in?

G=T: balanced budget

G>T: Budget deficit

G

What is a balanced budget

Occurs when government spending equals government revenue

What is a budget deficit

Occurs when government spending exceeds government revenue. This represents a net injection of demand into the circular flow of income and hence a budget deficit is expansionary.

What is a budget surplus

Occurs when government spending is less than government revenue. This represents net withdrawal from the circular flow of income and hence a budget surplus is contractionary.

What is demand side fiscal policy?

Used to increase or decrease the level of aggregate demand (and to shift the AD curve right or left) through changes in government spending, taxation and the budget balance

What is deficit financing?

Deliberately running a budget deficit and then borrowing to finance the deficit

What are some of the Keynesian points of view on fiscal policy?

- Left to itself, an unregulated market economy results in unnecessarily low economic growth, high unemployment and volatile business cycles

- A lack of AD, caused by a tendency for the private sector to save too much and invest too little, can mean that the economy settles into an under full-employment equilibrium characterised by demand deficient unemployment

- By deliberate deficit financing, the gov can, using fiscal policy as a demand management instrument, inject demand and spending power into the economy to eliminate deficient AD and achieve full employment

- Having achieved full employment, the gov can using fiscal policy in a discretionary way to fine tune the level of AD.

What is expansionary fiscal policy?

This aims to increase AD. Governments increase spending or reduce taxes to do this. It leads to a worsening of the government budget deficit, and it may mean governments have to borrow more to finance this.

What is contractionary fiscal policy?

This aims to decrease AD. Governments cut spending or raise taxes, which reduces consumer spending. It leads to an improvement of the government budget deficit.

How is expansionary fiscal policy used to eliminate demand deficient unemployment?

The government increases the budget deficit by raising the level of government spending and/or by cutting taxes. The expansionary fiscal policy shifts the AD curve right, from AD1 to AD2, and the economy moves to a new equilibrium national income where PL2 meets Y2.

What does the impact of expansionary fiscal policy depend on?

(page 452) The extent to which expansionary fiscal policy reflations real output or creates excess demand that leads to demand pull inflation depends on the shape of the SRAS curve, which depends on how close, initially, the economy was to its 'normal capacity' level of output. The nearer the economy gets to its 'normal capacity' level of output, depicted by the position of the LRAS curve, the greater the inflationary effect and the smaller the reflationary effect. Once the normal capacity output is reached, a further increase in gov spending or a tax cuts solely inflates the price level. In this situation, real output cannot grow because there is no spare capacity. The economy is production on its PPF.

How is contractionary fiscal policy explained?

A cut in government spending and/or an increase in taxation shifts the AD curve to the left. The extent to which the demand deflation results in the price level or real income falling again depends on the shape and slope of the SRAS curve.

What is supply side fiscal policy?

Used to increase the economy's ability to produce and supply goods, through creating incentives to work, save, invest and be entrepreneurial. Interventionist supply side fiscal policies, such as financing of retraining schemes for unemployed workers, are also designed to improve supply side performance.

What is the difference between demand side and supply side fiscal policy?

In demand side, income tax cuts stimulate aggregate demand through shifting the AD curve to the right. In supply side, by contrast, income tax cuts increase aggregate supply via their effects on economic incentives.

How is supply side fiscal policy shown on an AD/AS diagram?

(page 454) The effect of successful supply side fiscal policy is shown by a rightward shift from LRAS1 to LRAS2, which means the normal capacity level of output has increased from Y1 to Y2. The diagram also shows a right shift in the SRAS curve, reflecting the improvement in productivity and falling unit costs. However, in normal circumstances, the improvements in the supply side performance of the economy and accompanied by rising AD, which means the effect is to moderate inflation rather than lead to deflation.

How can gov spending and taxation affect the pattern of economic activity?

Taxation raise the revenue required to finance government spending. Taxes and subsidies can also be used to alter the relative price of goods and services in order to change consumption patterns and promote investment by firms in new capital goods.

What are the types of and reasons for public expenditure?

Current government expenditure is spending which recurs. This is on goods and services which are consumed and last for a short period of time. For example, it could be on drugs for the health service.

Capital government expenditure is spent on assets, which can be used multiple times. For example, it could be government expenditure on roads or building a school.

Transfer payments are welfare payments from the government. They aim to provide a minimum standard of living for those on low incomes. No goods or services are exchanged for transfer payments.

What is demand led spending and how does it influence public spending?

The pattern of public spending and also the extent to which certain types of public spending increase while others fall, depends in part on the extent to which spending is demand led. Demand led spending is literally led by demand, increases when unemployment grows and falls when unemployment drops.

What is a direct tax?

A tax that cannot be shifted by the person legally liable to pay the tax onto someone else. They are levied on income and wealth.

What is indirect tax?

A tax that can be shifted by the person legally liable to pay the tax onto someone else e.g. through raising the price of a good being sold by the taxpayer. They are levied on spending.

Example of direct tax

Corporation tax and national insurance contributions

Examples of indirect tax

VAT

What is a progressive tax?

A progressive tax has an increase in the average rate of tax as income increases. As income increases, the proportion of income taxed increases.

Example of progressive tax?

Income tax is progressive. People have a personal allowance of £10,600 where tax is not paid. For incomes below £31,785, people only pay the basic rate of 20%. For incomes between £31,786 and £150,000, people pay the higher rate of 40%. Above this, a 45% rate is paid.

Why do progressive taxes help reduce inequality?

This should help reduce inequality, because those on lower

incomes pay less tax. The tax is based on the payer's ability to pay. Higher income households are more able to pay higher rates of tax than lower income households. Generally, direct taxes are more progressive.

What is regressive taxation?

A regressive tax does not relate to income, but means those on lowest incomes have a higher average rate of tax. In other words, the proportion of income paid as tax is higher for those on lower incomes than those on higher incomes.

Example of regressive taxation?

For example, as a percentage of income, the London Congestion Charge and Council Taxes are higher for those on lower incomes. This leads to a less equitable distribution of income. Generally, indirect taxes are more regressive.

What is proportional taxation?

A proportional tax has a fixed rate for all tax payers, regardless of income. It is also called a flat tax.

Example of proportional taxation?

For example, all tax payers might have to pay 20% income tax rate. The incidence of taxes is equal, regardless of the ability of the taxpayer to pay

What are the principles of taxation?

1) The cost of collecting the tax must be low relative to the yield

2) The timing and quantity paid must be obvious to the tax payer

3) The timing and way of paying should be convenient for the tax payer

4) Taxes should be imposed depending on the ability to pay. axes should also be equitable.

5) The tax should not limit efficiency, and there should only be a minimum loss

of efficiency.

6) Tax should be compatible with tax systems of other countries. For the UK, taxes should be compatible with the rest of Europe.

7) Taxes should adjust with inflation.

How do the principles of taxations decide if a tax is good or bad?

A good tax meets as many of these principles as possible, although because of conflicts and trade offs, it is usually impossible for a tax to meet them all at the same time. A bad tax meets few if any of the principles.

What are the limitations of fiscal policy?

o Governments might have imperfect information about the economy. It could lead to inefficient spending.

o There is a significant time lag involved with employing fiscal policy. It could take months or years to have an effect.

o If the government borrows from the private sector, there are fewer funds available for the private sector, which could lead to crowding out.

o The bigger the size of the multiplier, the bigger the effect on AD and the more effective the policy.

o If interest rates are high, fiscal policy might not be effective for increasing demand.

o If the government spends too much, there could be difficulties paying back the debt, which could make it difficult to borrow in the future

What are the reasons for the changing size and composition of public expenditure in a global context?

In the UK, the government spends most of their budget on pensions and welfare benefits, followed by health and education. Income tax is the biggest source of tax revenue in the UK.

Education spending in the UK has remained relatively constant. This is because it is protected so it does not fall, but it also does not increase much either.

Social security payments are payments from the government to assist those who have low incomes. After the war, people saw this as necessary, so there has been a general increase in spending.

Defence spending in the UK is falling. This is the area the government spends least on.

What is the significance of differing levels of public expenditure on productivity and growth?

Governments can spend money on supply-side policies to improve human capital and boost long run growth. Human capital is important for competitiveness. The government could invest in youth apprentice schemes, for example, to make people more employable and productive from a young age.

Education and training can mean higher value products can be made and productivity can be improved.

Fiscal policy aims to stimulate economic growth and stabilise the economy. The government could influence the size of the circular flow by changing the government budget, and spending and taxes can be targeted in areas which need stimulating.

What is the significance of differing levels of public expenditure on crowding out?

Governments might have to fund its spending using taxes or running a budget deficit. This leaves fewer funds in the private sector for firms to use, since the government is borrowing money, which crowds them out of the market.

When the government borrows a lot of money, interest rates might increase. This discourages spending and investment among the private sector.

This reduction in private sector investment is the 'crowding out' of investment.

Sometimes, crowding out refers to the government provision of a good or service, which would otherwise be provided by the private sector.

What is the significance of differing levels of public expenditure on the level of taxation?

The tax rate might increase if government debts get too high. If confidence is lost in the government's ability to repay the debt, governments might have to raise interest rates to encourage investors to buy bonds, so that they can finance the debt. It could lead to higher taxes and austerity measures, especially if the debt becomes uncontrollable.

In the UK, the size of government spending is about 40% of GDP. This means that citizens in the UK have a lower tax burden than in a country such as Switzerland, where government spending is 60% of GDP

What is the significance of differing levels of public expenditure on equality and living standards?

Progressive taxes could be used to reduce inequality, since the poorest in society pay the smallest proportion of their income as tax. Redistributive policies and welfare payments, such as Income Support, could be used to help those on the lowest incomes.

Also, government spending on housing and the provision of public services, such as education and healthcare, helps provide equal opportunities for people from all income backgrounds. This ensures that even those on low incomes can afford a good standard of healthcare and education.

By providing these services, the government ensures that all members of society can achieve a minimum standard of living.

What is the relationship between the budget balance and the national debt?

It is important to distinguish between the government debt and the government deficit. The national debt is the accumulation of the government deficit over time. It

is the amount the government owes. The deficit (or surplus) is the difference between expenditure and revenue at any one point.

The national debt is the accumulation of the government deficit over time. It is the total amount the government owes.

If the government is continuously running a deficit, the size of the debt increases. If the government reduces the size of their deficit, the rate of increase of the total debt is slower, but the debt is still increasing.

It is only when the government runs a budget surplus that the size of the national debt decreases. Currently, the UK government is trying to reduce the size of the deficit and eventually run a budget surplus by 2019-2020, at which point they will start paying off the debt.

What is a cyclical budget deficit?

The part of the budget deficit which rises in the downswing of the economic cycle and falls in the upswing of the cycle

What is a structural budget deficit?

The part of the budget deficit which is not affected by the economic cycle but results from structural change in the economy affecting the government's finances, and also from long term government policy decisions.

What is the significance of the size of the national debt?

- The cost of borrowing could increase, since by borrowing money, the government is increasing demand for credit in the economy.

- If confidence is lost in the government's ability to repay the debt, governments might have to raise interest rates to encourage investors to buy bonds, so that they can finance the debt.

- It could lead to higher taxes and austerity measures, especially if the debt becomes uncontrollable.

What is the role of the office for budget responsibility?

- The OBR provides analysis of the UK's finances.

- They produce 5-year forecasts for the economy, including the impact of tax and spending changes announced in the Budget.

- They judge the government's performance against its fiscal targets. These are to balance the budget 5 years ahead and have net public sector debt falling in 2015-16. They assess the likelihood of the government meeting the targets.

- They scrutinise tax and welfare spending measures.

- They also assess how sustainable public sector finances are in the long run.