AS Macro Revision: Fiscal Policy

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Information about AS Macro Revision: Fiscal Policy

Published on February 21, 2014

Author: tutor2u


AS Macro Revision Fiscal Policy Spring 2014

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What is Fiscal Policy? • Fiscal policy involves the use of government spending, taxation and 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. Health care and 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 • Changes in fiscal policy affect both aggregate demand (AD) and aggregate supply (AS) (build this into your analysis)

Some Key Roles for Fiscal Policy Fiscal policy decisions have a large impact on millions of consumers and businesses – in both the short and the long term Financing government spending Altering distribution of income and wealth Providing a welfare state safety-net Managing the economic cycle Improving competitiveness Tackle market failures

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 • The public sector is not profit-driven, while this is usually (but not always) the case with the private sector. • In terms September 2013, there were 5.7 million people working in the UK public sector (18.8% of people in employment). The National Health Service (NHS) employs over 1.5 million people • Public sector businesses include the following: • Met Office and Ordnance Survey • Channel 4, National Nuclear Laboratories • Eurostar, NATS (National Air-Traffic Control Services) • Network Rail • The Royal Mail was part privatised in 2013

Direct and Indirect Taxation • Direct taxation is levied on income, wealth and profit • Direct taxes include income tax, inheritance tax, national insurance contributions, capital gains tax, and corporation tax • The burden of a direct tax cannot be passed on • Indirect taxes are taxes on spending • Examples of indirect taxes include excise duties on fuel, cigarettes and alcohol and Value Added Tax (VAT) on many different goods and services • Producers may be able to pass on an indirect tax – depending on price elasticity of demand and supply

Progressive, Proportional and Regressive Taxes • With a progressive tax, the marginal rate of tax rises as income rises. I.e. as people earn more income, the rate of tax on each extra pound goes up. This causes a rise in the average rate of tax • Examples: Income tax (basic and higher rates) • With a proportional tax, the marginal rate of tax is constant leading to a constant average rate of tax • Examples: National insurance contributions • With a regressive tax, the rate of tax falls as incomes rise – I.e. the average rate of tax is lower for people of higher incomes • Examples: Excise duties on tobacco and alcohol

Taxation and Aggregate Demand Changes in tax rates and tax allowances can have a direct and indirect effect on the level of aggregate demand Income tax and disposable income Corporation taxes and business investment Taxation of imports National insurance and labour demand VAT and consumer spending Taxation and business R&D spending

Lower Taxes and Components of Demand Cut in personal income tax rates Boost to disposable income Adds to consumer demand Cut in indirect taxes e.g. VAT Lower prices – leads to higher real incomes Adds to consumer demand Cut in corporation tax Higher “post tax” profits for businesses Adds to business capital spending Cut in tax on interest from saving Boost to disposable income of people with net savings Adds to consumer demand Expansionary Fiscal Policy

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 / active labour supply Inward migration of key workers Capital investment e.g. FDI projects Enterprise / Entrepreneurship Human capital spending Tariffs affect import costs

How Could Tax Cuts Stimulate Economic Recovery? Consumer spending • Cuts in VAT or income tax to boost demand for goods and services Business investment • Lower corporation tax to increase investment and tax incentives for R&D Lower employment taxes • Reduced national insurance so that businesses create more jobs Lower fuel / carbon taxes • Lower costs for businesses, less inflation and higher profits Low confidence – tax cuts likely to be saved rather than spent Businesses might choose to invest overseas instead Skills shortages might limit new job creation Possible conflicts with environmental policies

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Government Spending Government spending is spending by the public sector on goods and services such as education, health care and defence Transfer Payments Recurring spending Investment Projects Welfare Spending Public Services State Investment Total UK government spending is forecast to be £745 billion in 2015 This is 43.1% of GDP. £50 billion or 7% will be on capital spending Spending on public services such as education & health is 22% of GDP

Economic Importance of Government Spending Key Component of Aggregate Demand Providing Public & Merit Goods Regional Economic Impact Achieving greater Equity in Society

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 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 Evaluation Arguments 1. Effectiveness of education spending has been questioned 2. Money might be better spent targeting certain groups or ages Evaluation Arguments 1. Better health results can be achieved without increase in health funding 2. Will lower income families get the improved access

How Government Spending can affect Incomes Welfare state transfers • Universal child benefits / unemployment benefit • Public (state) pensions • Conditional welfare transfers e.g. Conditional on attending unemployment programmes • Targeted welfare payments- linked to income State-provided services (in-kind benefits) • Education - reduces inequality of market incomes • Health care – state provided health services • Social housing e.g. Provided by local authorities • Employment training

The Fiscal (Budget) Balance When tax revenues are insufficient to pay for state spending then a government must borrow, this is known as a budget deficit The last year that the UK ran a budget surplus was in 2000. There has been a deficit in every year since with the fiscal deficit peaking at 11% of GDP in 2009 – which was also a year of deep recession. The deficit has gradually fallen in recent years

Government Spending and Taxation as % of GDP The scale of state spending and total tax revenues is usually measured as a % of national GDP – data for the UK is below The recession from 2008-2010 caused a steep rise in state spending and a fall in tax revenues. The government is now seeking to reduce government spending as a share of GDP to help cut the fiscal deficit.

Government Borrowing and Bond Interest Rates When a government borrows it issues debt in the form of bonds. The yield on a bond is the interest rate paid on state borrowing In recent years there has been a large fall in the interest rate paid on 10 year UK government loans. This is good news for the government as the interest payments on each bond will be lower.

Economic Arguments for Budget Deficits A budget deficit is a net injection of aggregate demand into the circular flow since G > T 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 – also known as the National Debt • The Government may have to offer higher interest rates on new debt – increasing the cost of servicing debt • This interest burden has an opportunity cost for less spent on interest payments could free up extra spending on services such as health and education • A sizeable increase in the national debt is likely to cause higher taxes in the future. This will cut the disposable incomes of tax payers and leave less money for private sector expansion • It might be considered unfair if the rising tax burden falls more heavily on future generations of tax payers rather than people who benefit from government spending now. UK Debt Data UK government debt is forecast to reach 94% of GDP in 2013. This is lower than the average of advanced economies (109.3%). Japan’s gross debt is 245% of GDP in 2013, while Greece’s is 179% of GDP.

Supply-Side Economic Policies

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