fiscal policy

Fiscal Policy Economics – Some Key Terms Bond Yield The rate of interest paid on government debt

The budget deficit is the difference between what the Budget (Fiscal) Deficit government receives in revenue and what it spends withing a year The size of the deficit is influenced by the state of the Cyclical Fiscal Deficit economy: in a boom, tax receipts are relatively high and spending on unemployment benefit is low Taxes on income, profits and wealth, paid directly by the Direct Taxation bearer to the tax authorities. Taxation and spending measures that allow the Fiscal Policy government to guide the economy. Taxes on expenditure (e.g. VAT). They are paid to the tax Indirect Taxation authorities, not by the consumer, but indirectly by the suppliers of the goods or services.

The structural deficit is that part of the deficit which is Structural Fiscal Deficit not related to the state of the economy. This part of the deficit will not disappear when the economy recovers.  What is Fiscal Policy? • Fiscal policy involves the use of government spending, direct and indirect taxation and government borrowing to affect the level and growth of aggregate demand, output and jobs • Fiscal policy is also used to change the pattern of spending on goods and services e.g. spending on health care and scarce resources allocated to renewable energy • Fiscal policy is also a means by which a redistribution of income & wealth can be achieved for example by changing tax rates on different levels of income or wealth • It is an instrument of micro-economic government intervention to correct for market failures such as pollution or the sub-optimal provision of public and merit goods • It is important to be aware that changes in fiscal policy affect both aggregate demand (AD) and aggregate supply (AS)  Taxation - why Why do we tax? • To pay for government spending: – Goods and services provided by the state such as merit goods and public goods, capital spending and transfers • As part of fiscal policy to manage the economy • To correct market failure – For example externalities – tax activities or goods with negative externalities (tobacco, alcohol, sugar?) • To redistribute income – Collect proportionately more tax from richer and wealthier – Use some of the tax revenue to transfer to less well off Fiscal Policy The Government Budget

The Government Budget – Surpluses and Deficits In a particular year, a government’s budget can either be balanced, in surplus or in deficit. The net effect on aggregate demand depends on the government’s budget balance.

A balanced budget: A government’s budget is in balance if its expenditures in a year equals its tax revenues for that year. A balanced budget will have no net effect on aggregate demand since the leakages (taxes collected) equal the injection (expenditures made).

A budget surplus: If, in a year, the government collects MORE in taxes than it spends, the budget is in surplus. A surplus may sound like a good thing, but in fact the net effect of a budget surplus on AD is negative, since leakages exceed injections. A budget surplus will reduce the national debt.

A budget deficit: If a government’s expenditure in a year a greater than the tax revenue it collects, the government’s budget is in deficit. A deficit has a positive net effect on AD, since injections exceed leakages from the government sector. A budget deficit will add to the national debt.

The national debt: A nation’s debt is the sum of all its past deficit minus its past surpluses. If this number is negative, then it means the government has borrowed money over the years to finance its deficits that it has not paid back through accumulated surpluses

Direct Indirect A tax on income or on A tax on expenditure (spending) corporations. Paid by taxpayer directly to govt.

Flat (Specific) Ad- Valorem An indirect tax of an absolute (Percentage) (constant) amount levied per An indirect tax, which is unit of a commodity ex: a tax of expressed as a proportion $5 per unit. (percentage) of the price

The Public and the Private Sector of the Economy Public sector businesses are owned and operated by the government, whilst the private sector is privately owned

Introduction to Fiscal Policy In an effort to promote the macroeconomic objective (price level stability, economic growth and full employment) policy-makers have a variety of tools at their disposal. One set of tools is known as fiscal policy.

\ \ \ \ Fiscal Policy: Changes in the level of government spending and taxation aimed at either increasing or decreasing the level of aggregate demand in an economy to promote the macroeconomic objectives. Fiscal policy• Economy A) An economy producing at full-employment isnot in need of any fiscal policy actions• Economy B) An economy in a recession could benefit from expansionary demand-side policies that increase AD andemployment level. • If AD is too high and has high inflation an economy could

benefit from contractionary demand-side policies that

reduce AD.

The Government Budget – Sources of Revenue Fiscal policy puts the government’s budget into action to stimulate or contract AD as needed. The budget is simply the combination of revenues earned from taxes and expenditures made by all goods and services by nation’s government in a year.

Tax revenues: A government’s primary source of revenues is through the collection of taxes. • Direct taxes: Taxes on incomes earned by households and firms. These are usually progressive in nature, meaning that the percentage paid increases as income increases, or proportional, meaning that all individuals (or firms) pay the same percentage no matter what their income. • Indirect taxes: Taxes on consumption are indirect, meaning they are actually paid by the sellers goods, but they are born by both producers and consumers.

Other sources of revenue: To a lesser extent, a government may earn revenue from: • The sale of goods and services, • The sale of government property, • The privatization of state-owned enterprises to private sector investors  Some Key Roles for Fiscal Policy Fiscal policy decisions have an impact on millions of consumers and businesses – in both the short and the long term

\ The Government Budget – Types of Expenditures While a government’s revenues come from the taxes it collects. its expenditure depend on the goods and services the government provides the nation. Government expenditures include:

• Current Expenditures: This is the day to day cost of running the government. The wages and salaries of public employees, including in local, state and national government, such as police, teachers, legislatures, military servicemen, judges, etc…

• Capital Expenditures: These are investments made by the government in capital equipment and infrastructure, such as money spent on roads, bridges, schools, hospitals, military equipment, courthouses, etc…

• Transfer payments: This type of government spending does not contribute to GDP (unlike those above), because income is only transferred from one group of people to another in the nation. Includes welfare and unemployment benefits, subsidies to producers and consumers, etc… Money transferred by the government from one group to another, without going towards the provision of an actual good or service.  Government Current and Capital Spending Current spending – on Capital spending – new public providing public services infrastructure

Salaries of NHS Drugs used in Construction of New equipment employees health care new motorways in the NHS

Road Army logistics Flood defence Extra defence maintenance supplies schemes equipment  Fiscal Policy Expansionary Fiscal Policy

The Role of Fiscal Policy – During a Recession If an economy has experienced a fall in aggregate demand, it might be in a demand-deficient recession. To combat such a slump in economic activity, a government can use expansionary fiscal policies Assume an economy is experiencing a recessionary gap as seen here: Explain what you would do • Private spending in the economy has fall • To make up the gap, the government can attempt to use expansionary fiscal policies. These include:  A reduction in taxes, and / or  An increase in government spending • The size of the tax cut or increase in government spending needed depends on two factors:  The size of the recessionary gap, and  The size of the spending multiplier  Contractionary Fiscal Policy

The Role of Fiscal Policy – To Combat Inflation If an economy is experiencing abnormally high inflation as a result of an increase in AD beyond the full employment level, contractionary fiscal policy can be used to reduce AD and bring inflation under control. The economy to the left is experiencing an LRAS SRAS inflationary gap of $100 billion. Describe PL what the government should do. P2 • Inflation is higher than desired and output is AD1 beyond the full employment level • The government can bring AD down by Pfe using contractionary fiscal policy.  An increase in taxes on households and AD2 firms, or  A decrease in government expenditures • Either of these policies will reduce total Yfe Y2 real GDP spending, income and employment, and the average price level. $100 million Fiscal Policy Expansionary Fiscal Policy

Expansionary Fiscal Policy – When the Economy’s at Full Employment What if a government implements an expansionary fiscal policy when the economy is already producing at its full employment level? LRAS PL SRAS An increase in AD when the economy is already at full employment will cause: P2 • Only a slight increase in total output:  The nation’s resources are already fully AD2 employed Pfe  Firms are unable to hire the workers they need to meet growing demand • A significant increase in the average price AD1 level:  The economy is now producing beyond full employment  Demand-pull inflation results Yfe Y2 real GDP

Fiscal policy alone cannot lead to long-run economic growth, since it is first and foremost a ‘demand-side’ policy. Growth requires an increase in AS and AD. Fiscal Policy Expansionary Fiscal Policy

Expansionary Fiscal Policy – Illustrating the effect Describe the impact of a tax cut or increase in government on 1)AD, 2) Real RDP, 3)Employment, 4) Price level • On AD: AD increases by an amount determined LRAS by the initial change in spending from AD1 to PL AD2, and then ultimately to AD3 depending on SRAS the size of the multiplier • On real GDP (output): Output increases as the total demand in the economy increases. Firms P fe respond to growing demand by producing more output. P2 AD3 • On employment: In order to increase their output in the short-run, firms must hire more AD2 workers, reducing unemployment in the AD1 economy • On the price level: The increase in total Y2 Yfe real GDP spending increases the scarcity of output and resources, causing demand-pull inflation.  Lower Taxes and Components of Demand

Cut in personal Boost to disposable Adds to consumer income tax rates income demand

Cut in indirect Lower prices – Adds to consumer taxes e.g. VAT leads to higher demand Expansionary real incomes Fiscal Policy

Cut in corporation Higher “post tax” Adds to business tax profits for capital spending businesses

Cut in tax on Boost to disposable Adds to consumer interest from income of people with demand saving net savings  Impact of a rise in indirect taxes on the UK Economy All other things being equal, an increase in indirect taxes by the government is most likely to …..

Macroeconomic Objective Comment on the Effect

Inflation Higher in short run as business pass on tax

Economic growth Slower as real incomes and demand falls

Unemployment Higher if aggregate demand weakens

Improved – falling incomes may cause Balance of trade in goods & services demand for imports to contract

Spare capacity in the economy Rising spare capacity from weaker demand

Decline if businesses are hit by lower profits Business investment and weaker consumer spending Short run improvement from higher taxes Government fiscal balance but risk of falling revenues in medium term • What are the economic arguments of having: – Increased taxation – Decreased taxation

• In what situation should a government run a budget deficit/Surplus?

• Is a high level of public debt damaging for an economy? Discuss  Evaluating the Arguments for a Low Tax Economy

Lower Stimulates work incentives and productivity Taxes Helps to create more jobs because businesses have less tax to pay Encourages an inflow of FDI from businesses looking for low tax country 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)  Evaluating the Arguments for a Low Tax Economy

Taxation is a key instrument for changing the final Higher distribution of income and wealth. It is equitable Taxes 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

Consider the relative success of countries such as Denmark, Norway and Sweden who have higher tax burdens

Taxes are needed to fund high quality public services How Could Tax Cuts Stimulate Economic Recovery?

Consumer spending Low confidence – tax • Cuts in VAT or income tax to boost cuts likely to be saved demand for goods and services rather than spent

Business investment Businesses might • Lower corporation tax to increase choose to invest investment and tax incentives for R&D overseas instead

Lower employment taxes Skills shortages might • Reduced national insurance so that limit new job creation businesses create more jobs

Lower fuel / carbon taxes Possible conflicts with • Lower costs for businesses, less environmental policies inflation and higher profits  Effect of a Lower Corporation Tax on Businesses

Businesses get to Evaluation points Government cuts the keep a larger rate of corporation 1. Effect depends on the percentage of their tax scale of the tax cut profits 2. Many factors affect capital investment e.g. the pace of technological change Increase in post-tax and strength of Investment can be by market competition profitability may lead both domestic and 3. There will be time to a rise in planned overseas businesses lags between change investment in corporation tax and increased flow of actual investment 4. Some extra Increased capital Creates a multiplier investment may lead to a loss of jobs spending is an effect on demand, through capital- injection into the output and labour substitution circular flow model employment effects. Economic Importance of Education & Health Spending Education and health are regarded by economists as merit goods. An increase in funding of both can affect the macro-economy Why? Evaluation Arguments Education spending 1. Effectiveness of • May increase the skills and education spending has productivity of workers been questioned 2. Money might be better • Improvement in human capital will spent targeting certain lower structural unemployment groups or ages • More innovation / competitiveness Evaluation Arguments Health care spending 1. Better health results can be achieved without • Improved health outcomes will boost increase in health active labour supply funding • Will also increase productivity 2. Will lower income • Lessens risks of relative poverty families get the improved access  Taxation and Aggregate Supply Changes in tax rates and tax allowances can have a direct and indirect effect on both short-run and long-run aggregate supply

Work incentives / Inward migration of Capital investment active labour supply key workers e.g. FDI projects

Enterprise / Taxation and Tariffs affect import Entrepreneurship incentives to study costs  Economic Justifications for Budget Deficits Since 1970, the government has had a surplus in only six years – it is normal for government to have to borrow money

 1. A rise in borrowing to fund extra government spending can have     powerful effects on AD, output and employment when an     economy is operating below full capacity output  2. There is an automatic rise in the budget deficit to cushion the fall     in AD caused by an external economic shock. A higher fiscal deficit     is needed to lift AD back towards pre-recession levels  3. If a fiscal stimulus works the budget deficit will improve as a result     of higher tax revenues and reductions in welfare spending. A     growing economy helps to shrink debt as a percentage of GDP  4. It makes sense for a government to borrow money if interest rates     are low and if the deficit is being used for investment      Is a High Level of Public Debt Bad for the Economy?     Public debt is the total stock of debt issued by a government that has     yet to be re-paid – it is also known as the National Debt     • High deficits cause rising debt interest payments which UK Debt Data     in 2015-16 are are forecast to be £47 billion or £700 UK government     per head of population debt is forecast     to reach 100% of     • This interest burden has an opportunity cost for less GDP in the next     interest on debt could free up extra spending on health few years. This is     and education. Borrowing of £70 billion is equivalent to lower than the     £1,100 per head of the UK population average of     • An increase in the national debt is likely to cause higher advanced     taxes in the future. This will cut the disposable incomes economies.     of tax payers and reduce growth in the private sector     Japan’s gross     • It might be unfair if the rising tax burden falls more debt is 245% of     heavily on future generations of tax payers rather than GDP in 2013,     people who benefit from government spending now. while Greece’s is     179% of GDP.      UK Government’s Fiscal Austerity Policies     • In 2010 UK government had a fiscal deficit-reduction policy with the emphasis on     cutting government spending in some areas in real terms and a series of direct     and indirect tax increases: Where did/could it save, generate money?     • Key policies for deficit reduction:  5. Rise in standard rate of VAT to 20% (from 17.5%)  6. Rise in employee national insurance contributions (13%)  7. Deep cuts in real government spending e.g. for local authorities  8. Welfare caps including £26k pa cap on welfare for each family     Some taxes have been cut  9. A series of cuts to corporation tax (main rate is now 21%)

10. Freezing of fuel duties (meaning a cut in real terms)
11. Increases in the real value of the income tax free allowance
12. Cuts in employer national insurance for long term unemployed
13. Freezing of council tax (so that council tax falls in real terms)     The UK Government has also been helped by lower interest rates on newly issued     debt as a result of quantitative easing     Fiscal Policy Expansionary Fiscal Policy

What’s more effective? Taxes or Govt Spending? To achieve a particular increase in AD, taxes would have to be CUT by more than spending would have to INCREASE. There is a reason for this: • A tax cut is an INDIRECT injection into the nation’s economy.  A tax cut increases the disposable incomes of households  Higher disposable incomes leads to more consumption, but also increases savings and imports, both leakages.  The actual increase in spending, therefore, is less than if the government were to increase AD directly through new government spending. • Fiscal stimulus (both tax cuts and spending increases) lead to a budget deficit  Assuming a government started with a balanced budget, if it wanted to stimulate AD, the government would have to incur a deficit.  A tax cut will require the government incurs a LARGER deficit in order to stimulate AD by a certain amount than a spending increase.  Fiscal Policy Automatic Stabilizers

Automatic Stabilizers and Fiscal Policy Not all changes to fiscal policy require explicit action by the government. In most economies, some changes to the level of taxation and the level of government spending happen automatically. Study the graph below. When output falls: • Tax revenues fall automatically decreases:  Incomes and revenues decrease when AD decreases  At lower incomes levels, households pay lower tax rates (especially progressive tax) • Government spending increases automatically:  More households receive government welfare payments.  More workers receive government unemployment benefits When output increases: • Tax revenues increase because households incomes and firms revenues increase. Some households move up to higher tax brackets and pay higher rates. • Government spending decreases because fewer households depend on government support. Fiscal Policy Fiscal Policy and Long-run Growth

Fiscal Policy and Long-run Economic Growth Economic Growth, defined as an increase in total output over time, is only possible in the long- run if both AD and AS increase. Therefore, demand-side fiscal policies alone cannot produce economic growth. However, some fiscal policies can have positive supply-side effect as well. Supply-side effects of fiscal policy: Certain types of government spending and tax policies can promote increases in aggregate supply, and thereby contribute to long-run economic growth: • Infrastructure spending: When government supports a modern infrastructure, including for transportation and communications, the private sector is given the resources it needs to grow and succeed in the long-run • Education spending: Human capital is perhaps the most important resource a nation requires for long- run economic growth. Public, government funded schools and programs to improve skills in the labor can contribute to long-run growth. • Research and development: Government-funded research and development can lead to scientific, technological, and medical breakthroughs that may spur new industries and promote growth across the private sector. • Incentives for private investment: Creating a tax policy that rewards innovation and entrepreneurship, rather than punishes it by taking the ‘winners’ in an economy will encourage private businesses to invest and thereby help the economy grow. Fiscal Policy Fiscal Policy and Long-run Growth

Fiscal Policy and Long-run Economic Growth Fiscal policy is an effective tool for managing AD in the short-run to help maintain price stability and low-unemployment, but demand-side policies alone cannot produce long-run economic growth, which requires an increase in both AD and AS. However, some fiscal policies can have positive supply-side effects as well.

Fiscal Policy’s positive supply-side effects When government supports a modern infrastructure, including for transportation and Infrastructure communications, the private sector is given the resources it needs to grow and succeed in the spending: long-run Human capital is perhaps the most important resource a nation requires for long-run economic Education spending: growth. Public, government funded schools and programs to improve skills in the labor can contribute to long-run growth. Research and Government-funded research and development can lead to scientific, technological, and medical development: breakthroughs that may spur new industries and promote growth across the private sector. Creating a tax policy that rewards innovation and entrepreneurship, rather than punishes it by Incentives for private taking the ‘winners’ in an economy will encourage private businesses to invest and thereby help investment: the economy grow. Fiscal Policy The Crowding-out effect

Fiscal Policy and the Crowding-out Effect The use of fiscal policy in times of recession is highly controversial. Opponents argue that an increase in the size of the government during recessions will crowd-out private spending in the economy, reducing an economy’s ability to self-correct from the recession, and potentially reducing the economy’s long-run economic growth rate. Expansionary fiscal policy’s effect on the interest rate: Fiscal stimulus requires that a government increases its deficit. This means the government must borrow money in order to stimulate AD. Government borrowing is done using government bonds. • Government bonds: These are certificates of debt that a government sells in order to borrow money to finance an expansionary fiscal policy. • The cost of borrowing: When a government has a history of balanced budgets, investors will be willing to lend it money at very low interest rates, therefore the government does not need to offer a high rate of interest on its bonds. Fiscally responsible nations can borrow money cheaply. But if a government has a history of large deficits, investors will demand a higher rate of interest in order to lend it money. • Crowding-out: The increase in interest rates that often accompany a deficit-financed fiscal stimulus may cause private investment and consumption in the economy to decrease. Therefore, any increase in AD from new government spending may be off-set by a decrease in private spending, which is crowded-out by higher borrowing costs. Fiscal Policy The Crowding-out effect

Illustrating the Crowding-out Effect Interest rates paid by private borrowers in a nation are a primary determinant of the levels of savings, investment, and consumption. The market in which private interest rates is illustrated is called the loanable funds market. The Loanable Funds Market: A nation's loanable funds market represents the money in commercial banks that is available to be loaned out to firms and households to finance private investment and consumption. • The price of loanable funds is the real interest rate • The market shows relationships between real returns on savings and real price of borrowing and the private sector's willingness to save and invest. • The supply curve represents household savings  At higher interest rates, households save more  At lower rates, households save less • The demand curve represents investment  At higher interest rates, firms invest less  At lower interest rates, firms invest more Fiscal Policy The Crowding-out effect

Illustrating the Crowding-out Effect in the Loanable Funds Market (Th 4) When a government borrows in order to finance a budget deficit, it must increase the interest rates on its bonds in order to attract more lenders. • Higher rates on government debt will lead households to take their savings out of private banks and lend it to government instead • This causes the supply of loanable funds to decrease, leading to higher borrowing costs in the private sector.  Before the expansionary fiscal policy, the level investment was Qpr.  Higher interest rates on government bonds cause the supply of loanable funds to decrease to S1.  Less money in banks leads to higher interest rates. The quantity funds demanded for private investment falls to Qp.  Overall spending increases to Qg, but there is a decrease in private investment of Qp-Qpr Private sector spending is ‘crowded-out’ by the government’s deficit spending. This means AD will not increase by as much as the spending multiplier would predict. Fiscal Policy The Crowding-out effect

Illustrating the Crowding-out Effect in the AD/AS Model (Theme 4) Say a government increases spending by $100 million, without raising taxes. This money must be borrowed. Assume the multiplier is 4. The fiscal policy should lead to an increase in AD of $400 million. However… • If the government’s borrowing reduces the supply of funds available to the private sector, then higher interest rates might cause private investment to fall, therefore, • The total increase in AD will be less than that which was predicted by the multiplier.  To reach full employment, AD would have to increase to AD1.  But due to crowding-out, it only increases to AD2. A much larger stimulus would be needed than the multiplier predicts, further increasing national debt! Fiscal Policy The Crowding-out effect

Evaluating the Crowding-out Effect (Theme 4) Whether crowding-out will actually occur depends primarily on the depth of the recession the economy was in when the government undertook its expansionary fiscal policy.

During deep recessions: Crowding-out is unlikely to During mild recessions: Crowding-out is more likely occur; private sector investment is already deeply to occur; resources are close to being fully-employed, depressed. There is very little spending to crowd and private sector spending is relatively high. out, and government should be able to borrow Government will have to offer higher rates to attract without raising interest rates by much lenders, which could cause private investment to fall  UK Government’s New Fiscal Rule (2015)

In the July 2015 Budget, the Chancellor George Osborne announced a new fiscal rule.

The government’s fiscal rules now Balanced budget include a target for a budget when G= T surplus by 2019/20 and for all subsequent years when in ‘normal times’.

The economy will be viewed as being in ‘normal times’ if real annual growth is above 1% Normal times – a full economic recovery