Lecture 3 - Fiscal Policy

Fiscal Policy

Learning Outcomes

• Explain the meaning of macroeconomics

• Identify typical government economic objectives

• Explain government policy instruments

• Identify possible conflicts of government economic objectives

Macroeconomics

Government Economic Objectives

• Economic growth

• Stable prices

• Low levels of unemployment

• A favorable balance of trade

Policy Instruments

Types of Economic Tools

• Fiscal Policy:

  • Involves changing government spending and taxation rates

• Monetary Policy:

  • Controls the money supply and interest rates

Key Policy Instruments

• Government Spending

• Taxation and Benefits

• Interest Rates

• Control of the Money Supply

Examples of Government Policy Changes

• Cut income tax rates, increasing consumer spending (affecting aggregate demand)

• Increase spending in sectors like health and defense (affecting aggregate demand)

• Lower interest rates to stimulate borrowing (monetary policy affecting aggregate demand)

• Make borrowing easier for investments (monetary policy affecting aggregate supply)

• Reduce unemployment benefits to incentivize work (fiscal policy affecting aggregate supply)

Fiscal Policy Explained

• Defined as the government's decisions regarding taxation and spending

• It encompasses various taxes, benefits, and public services

• A significant tool for modifying economic performance and resource distribution

Government Spending Includes:

• Defense

• Social Security Benefits

• Education

• Repayments on Previous Borrowing

UK Public Sector Spending (2018-19)

• Social Protection: £252bn

• Health: £155bn

• Education: £102bn

• Defence: £49bn

• Other Sectors: Various allocations including transport, housing, and personal social services

Public Sector Receipts (2018-19)

• Income Tax: £185bn

• VAT: £145bn

• National Insurance Contributions: £134bn

• Total Revenue Sources include various other taxes and non-tax revenues

Government Revenue

Sources of Government Funding

• Tax Revenue

• Borrowing

Taxation Types

Direct Taxes

• Paid on income and profits

• Examples:

• Income Tax

• Corporation Tax

• Capital Gains Tax

• Inheritance Tax

Indirect Taxes

• Incurred during purchases

• Examples:

  • VAT

  • Excise Duties

  • Customs Duties

Taxation Systems

Types of Taxation

• Progressive: Average tax rate increases with income

• Regressive: Average tax rate decreases as income increases

• Proportional: Constant percentage paid regardless of income

Effective Taxation System

Features

• Understandable

• Cost-effective to administer

• Difficult to evade

• Non-distortionary

Fairness of Taxation

• Horizontal Equity: Similar taxpayers pay similar amounts

• Vertical Equity: Taxpayers with greater ability to pay owe more

Using Taxation as a Policy Instrument

• Higher tax rates may disincentivize work (poverty trap)

• Tax cuts can incentivize labor and potentially increase overall tax revenue

The Laffer Curve

• Illustrates the relationship between tax rates and tax revenue

• Initially, increasing tax rates boost revenue

• Eventually, higher rates can reduce revenue due to disincentives

Types of Benefits

• Means-Tested Benefits

• Universal Benefits

• Benefits in Kind

Government Borrowing and Deficits

Understanding Borrowing Needs

• Government deficits arise when spending exceeds revenue

• Deficits measured in monetary terms and as a percentage of national income

Public Sector Net Borrowing (PSNB)

• Represents the annual difference between government spending and income

• Government finances deficits via borrowing or selling securities

UK Government Deficit

Data Overview

• Shows annual deficit as a percentage of GDP from 2009-2017

Government Budgets and Deficits

• Explains the relationship between government budget position and national income

Budget Changes

Automatic and Discretionary Changes

• Automatic Stabilizers: Taxes and expenditures that change with national income

• Discretionary Policies: Changes enacted in response to economic conditions

Types of Fiscal Policies

Reflationary Fiscal Policies

• Aim to increase aggregate demand

• Actions include increasing spending or reducing taxes

Contractionary Fiscal Policies

• Aim to decrease aggregate demand

• Actions include decreasing spending or increasing taxes

Issues with Fiscal Policy

• Problems include fiscal drag, public cash requirements, and national debt

Summary

• Fiscal policy involves changes in taxation and spending to meet macroeconomic objectives, including both expansionary and contractionary policies

Conclusion

• Overview of macroeconomics

• Discussion on policy instruments, particularly fiscal policy, and the role of taxation systems.