13.1 Fiscal Policy Flashcards
What is fiscal policy ?
Use by thr gov of gov spending and taxation to try and achieve the govs policy objectives
Fiscal policy at a macro level:
Taxation
Public spending
And the govs budgetary position
Fiscal at a micro level
Taxation and subsides used to influence consumer behaviour and income tax and welfare benefits to create labour market incentives
What is a balanced budget?
Gov spending=gov revenue
What is budget deficit?
Gov spending> gov revenue
Why is a budget deficit expansionary?
Represents a net injection of demand into the circular flow of income
What is budget surplus?
When gov spending is less than gov revenue
Why is budget surplus contractionary?
Represents a net withdrawal from the circular flow of income
What is the main way a gov deficit is eliminated
Cut public spending or increase tax
What is done when taxes and cuts can’t fix a deficit?
Public sector borrowing
What is deficit financing?
Deliberately running in a budget deficit and borrowing to finance it
What is demand side fiscal policy?
Used to increase or decrease the level of AD through changes in gov spending, taxation and budget balance
What is the aim of deficit financing?
Stabilise economic cycle to achieve full employment without creating excessive inflationary pressures
What are the key 6 Keynesian views on fiscal policy?
-left to itself unregulated market economy leads to little economic growth, high unemployment and volatile business cycles
-a lack of AD caused by private sector tendency to save much and invest little can mean economy settles into under-full employment characteristics by demand-deficient unemployment
-by deliberate deficit financing the gov can use fiscal policy as a demand management instrument, inject demand and spending power into the economy to eliminate deficient AD and achieve full employment
-having met full employment gov can use fiscal policy in a discretionary way to fine tune level of AD
-fiscal policy orientated towards demand side of the economy, supply side treated as subordinate
-assumption gov spending has a high multiplier value.
What does a discretionary way mean?
Changing taxes and levels of public spending to meet new circumstances
Describe the Keynesian view that the gov spending multiplier has a high value?
If the national income multiplier is quite large with a respect to output an increase in gov spending (e.g 10 bill) increase real national income by 30 bill
-changing levels of gov spending, taxation and the budget deficit can be quite effective in managing AD(however real world multipliers are seen to be small)
What is fiscal orthodoxy?
Traditional view gov should balance their budgets
Who first legitimised deficit financing?
Keynes
What is expansionary fiscal policy?
Uses fiscal policy to increase AD and shift the AD curve to the right
AD equation
C-G+I+(X-M)
What does an increase in gov spending or cut in taxation to do AD
Increases size of budget deficit
-injection into the circular flow or income occurs and the effect on AD is expansionary
Diagram for expansionary or reflationary fiscal policy
Describe the diagram
Equilibrium at X
To increase demand-deficient(cyclical) unemployment gov increases spending or cuts taxes to increase the budget deficit
Shifts AD curve to the right new equilibrium of point Z
-however this creates excess demand that leads to demand pull inflation (p1-p2), the extent of which depends on the SRAS curve which itself depends on how close the economy was to its normal capacity level of output(y3)
The nearer the economy is to normal capacity of output, the greater the inflationary effect
What is contractionary fiscal policy?
Fiscal policy used to decrease AD and shift it to the left
How can this diagram show contractionary fiscal policy?
Cut in gov spending or increase in tax shifts AD to the left resulting in demand deflation and the price level falling
(The extent of which being dependent on the shape and slope of the SRAS)
What is discretionary fiscal policy?
Macroeconomic policy of fiscal policy used to manage the level of AD
What is a way govs can achieve full employment
Budget deficit, expands AD bit risks overheating economy and inflation
The larger the gov spending multiplier….
The smaller the increase in public spending ended to bring about a desired increase in national income
The larger the tax multiplier..
The smaller the required tax cut
Real world multiples are unlikely to be….
Much larger than 1 or unity
What do small multipliers mean?
Demand-side fiscal policy has relatively little effect on the level of AD and hence the economy
Process of crowding out:
Need to check this one
private and public spending is a trade off with the factors of production and available resources
(Increased gov spending decreases private spending)
What is the reason for the small gov spending multiplier
Process of crowding out
Diagram for the crowding out process
Describe this diagram
What is discretionary fiscal policy?
Involves making discrete changes to Gov spending and tax and budget deficit to manage AD
What is crowding out?
Situation where increase in gov or public sector spending displaces private sector spending with little or no increase in AD
What is supply-side fiscal policy?
Used to increase economy’s ability to produce and supply goods through creating incentives to work, save,invest and be entrepreneurial.
Interventionist supply side policies such as financing of retraining or schemes for unemployed workers are also designed to improve supply-side performance
What are supply side policies?
Gov economic policies which aim to make markets more competitive and efficient increase production potential and shift the LRAS to the right.
(Supply-side fiscal policy is the most important type of supply side policy but there is also non-fiscal supply-side policies )
Why to tax cuts increase AS?
Due to their effects on economic incentives
What is the aim of supply side fiscal policy?
Increase economy’s ability to produce and supply goods through creating incentives to work, save, invest and be entrepreneurial
What do supply side fiscal oldies do on a graph?
Try and shift LRAS to the right to increase the real national output of the economy
Diagram for affect of fiscal supply side policies
Good deflation here
But usually increases in LRAS are partnered with increase in AD leading to inflation most of the time
What does taxation actually do?
Raises revenue required to finance gov spending
Taxes and subsides can be used to alter relative prices of goods in order to change consumption patterns and promote investment by firms into new capital goods
What takes up most of gov expenditure?
Transfers(state pension and unemployment related benefits)
-interest payments and national debt
Total managed expenditure?
Total amount the gov spends-splits the amount that gov departments such as defence that have been allocated to spend and spending that is not controlled by a gov department, including welfare, pensions, national debt and interest payments.
Who are the office for budget responsibility?
Advisory public body that provides independent economic forecast and analysis of the public finances as background for the preparation of the uk budget
What takes the most gov spending
Social security(half of which on pensions-Triple lock)
What does the triple lock do?
Protect those receiving a pension from the effect of spending cuts
(Pensions rise with what is highest out of wages cpi or 2.5%
What happens to spending on social security when the economy boombs
Decreases as unemployment falls
What is an example of demand led spending?
Unemployment benefit (literally reliant on demand)
Expamples of transfer payments (gov expenditure)
State pension
Unemployment related benefits
What is debt interest made out of?
Payments from the gov to people who have lent to the state (rises when interest rates rise and vice versa)
If the national debt relative to gdp can be reduced what happens to debt interest as a fraction of nominal gdp?
It also falls(providing interest rates don’t rise)
What happens to debt interest as a fraction of real gdp when the national debt rises faster then nominal gdp
It rises
What are the two main indirect taxes?
VAT and exercise duties (goods such as motor fuels)
What is a tax?
Compulsory levy made by a gov to pay for its activities-used to fund public expenditures
How much of UK tax is collected by local gov for the central gov?
92.5%
What non tax income does the gov receive?
Dividends and interests
What makes up exercise duties?
Tobacco
Alcohol
Fuel
Vehicle exercise duty
Describe income tax?
Biggest direct tax-paid on earnings, benefits, savings, investment incomes and rents
Personal allowance 12750
20% up to 50k
40% 50k-150k
45% 150k
Brackets based on incomes
What is cooperation tax?
Tax on company profits
Currently 25%
What is VAT?
Indirect tax 20% on most goods and services
5% on gas and electricity
0 books children’s clothes and food
What is natural insurance
Technically not a tax used to help Finance NHS and welfare benefits(unemployment)
-supplementary form of income tax
What is stamp duty?
Paid on the purchase of property
First-time buyers will pay no Stamp duty land tax on properties worth up to £425,000. On any property purchase price of up to £625,000, you will pay no Stamp Duty on the first £425,000. After this first-time buyers will pay 5% on the remaining amount, up to £200,000.
Inheritance tax
No tax up to £325,000 amount over that 40% rate
What are the key types of tax(9)
Income
National insurance
VAT
Stamp duty
Inheritance
Excise duties
Corporation
Capital gains
Council
What are excise duties?
Indirect tax
Tobacco, alcohol, petrol and dispel fuel unlike VAT is an ad velorum tax percentage tax levied on physical quantities of a good
What is capital gains tax?
Profit a person makes when selling possessions or investments
CGT is charged at the rate of either 10% or 18% for basic rate taxpayers. For higher or additional rate taxpayers, the rate is either 20% or 28%.
What is an ad velorum tax
tax whose amount is based on the value of a transaction or of a property. It is typically imposed at the time of a transaction, as in the case of a sales tax or value-added tax
What is council tax?
Charged by local authorities on the value of houses and flats to the people who live in the properties -become a highly regressive tax
Up to £40,000 £1,106.83
B £40,001 to £52,000 £1,291.30
C £52,001 to £68,000 £1,475.77
D £68,001 to £88,000 £1,660.24
What is a direct tax?
Cannot be shifted by a person legally liable to pay the tax to someone els.
Levied on income and wealth
What does levied mean?
Impose
What is an indirect tax?
A tax that can be shifted by the person liable to pay the tax into somebody els through raising the price of the good being sold to the taxpayer
Indirect taxes are levied on spending
2 eg of direct taxes
National insurance
Cooperation tax
2 eg of indirect taxes
VAT
Excise duties
What can a gov do if it thinks the distributions on income and wealth produced by free market is undesirable?
Taxes and transfers in its public spending programme can be used to modify these distributions to try to reduce this market failure resulting from inequity.
Progressive taxation
It imposes a lower tax rate on low-income earners and a higher tax rate on those with a higher income
Reduce income and wealth inequalities
Why are some taxes are more regressive
Designed to reduce consumption of demerit goods such as alcohol and tobacco
Regressive taxation?
When the protection of income paid in tax falls as income increases
(tax imposed by a government which takes a higher percentage of someone’s income from those on low income)
E.g cigarette duty and VAT
Diagram for proportional, regressive and progressive taxes
Put in later
What is proportional taxation?
When the proportion of income paid in tax stays the same as income increases
Who advocates for the introduction of proportional taxation and why
Free market economists -benefits high income groups
Average tax rate equation
Tax paid/income
Marginal tax rate
Change in tax paid/change income
What is the principle of taxation?
Judging if a tax is good or bad, often known as cannon of taxation
What are Adam Smith’s 4 principles of taxation known as?
Canons of taxation
Adam smith said a tax should be.
Equitable
Economical
Convenient
Certain
Plus textbook adds or incomes of efficiency and flexibility
-good tax meets many as possible
A tax should be economical?
Cheap to collect in relation to the rev it yields
A tax should be equitable?
Tax system should be fair (although different conflicting interpretations on what is equitable)
-tax based on the tax payers ability to pay-justifies progressive taxation
A tax should be convenient and certain?
Should be easy to pay and tax payers should know exactly how much tax they are liable to pay
Tax should be flexible?
East to change to new circumstances
A tax should be efficient?
Should achieve its desired objective with minimum unintended consequences
(The disincentive effect on effort can be thought of as an unintended consequence of high rates of income tax)
On average how much of incomes do people pay in tax
1/3
What taxes are on income?
Cooperation
National insurance
Personal income tax
(All direct taxes)
What is tax evasion (illegal)
Failure to declare income
How do people avoid tax
Dealing in cash
and setting up tax efficient schemes produced by financial advisors-exploit unintended loopholes in the tax system
How could a highly progressive income tax lead to unintended consequences?
Disincentivises hard work, risk taking and entrepreneurial effort
Taxes on wealth and capital are ..
Direct taxes
Why do many supply some economists argue that income tax rates and benefit rates should be reduced?
They believe tax and benefit cuts would alter the work/leisure choice in favour of supplying labour
What is the trickle down effect?
Poor eventually end up better off in absolute terms but inequality’s increase
The merits and demerits of different taxes depend on…
The principles of a “good tax”
What is national debt?
Stock of all past gov borrowing that has not been paid back
Who are in favour of gov running a balanced budget
Free market economists
A budget deficit is an example of an economic flow, what does this mean?
Even when the deficit is falling provided is still positive(not a budget surplus), the flow of net borrowing that fiancés the budget deficit adds to the stock of the national debt
What does the debt to GDP indicate?
The burden of debt on the national economy
When does the nominal national debt rise but the national debt as a % of nominal gdp may be falling
When nominal GDP rises faster than gov debt either because of economic growth or inflation
Because it increases Debt what does a budget deficit do to interest payments
Increases them
How does a budget surplus allow a gov to reduce national debt?
By paying back a fraction of the past borrowing
Cyclical budget deficit
Part of the budget deficit which results in the downswing of the economic cycle and falls in the upswing of the cycle
Structural budget deficit
Part of the budget deficit which is not affected by the economic cycle but resulted from structural changes in the economy affecting the govs finances and also from long term policy decisions
What is the cyclical budget deficit related to?
Level of AD in the economy at the different phases of the economic cycle
In a boom:tax is low and spending on unemployment is low
Downswing: opposite to a boom-gov spending increases and cyclical deficit gets larger
Can the structural budget deficit be measured?
No must be estimated
What does a growing structural deficit imply?
Gov wants more public sector finances(paid for by higher taxes)
Diagram for smooth economic cycle
What is counter cyclical demand management policy?
In boom phase: contractionary monetary and fiscal policy to declare demand
Downswing: expansionary fiscal or monetary policy to make cycle more smooth and less violate
What are automatic stabilisers?
Fiscal policy instruments such as progressive taxes and income related welfare benefits, that automatically stimulate AD in an economic downswing and depress AD in an upswing, thereby “smoothing” the economic cycle
What do automatic stabilisers do?
Reduce the effects of multipliers resulting in a change of Ad in the economy, thereby reducing the ups and downs of the economic cycle
(Lies between balancing budget and and discretionary demand management)
-upper part(no stabilisers lower part they are in action
What reduces contractionary multiplier effect?
Demand lead spending as AD falls
What are free market economists against the use of Keynesian counter-cyclical demand management policies?
-argue govs can get timing wrong with discretionary demand management
-lags between policy and its effect can also be a problem
-market forces will drive economy to normal level of output
-gov intervention lead to greater cyclical instability rather than reducing it
-excuse for more gov intervention leading to crowding out
What causes financial crowding out?
Method of financing an increase in public spending
What analysing the costs and benefits of a budget deficit what do Keynesian and free market economists focus on
Free market: structural deficits
Keynesian: deficits
Why is gov intervention effective for correcting fiscal fluctuations?
When based on discretionary demand management or automatic fiscal stabilisers
The resulting debt is also eaten up by inflation means the cyclical deficit will dial but structural deficit remains an issue
This is an issue because the mismatch between gov spending and tax revs is unaffected by the phase of the economic cycle, this is only manageable as long as the resulting growth of national debt is equal to or less than rate of gdp growth
What do budget surpluses do to national debt?
Enable it to fall
Why are excessive budget surpluses bad?
Taxes higher than necessary and harm euro deflation caused by excessive depression in AD
-reduces potential growth but damaging the supply side performance of the economy
What are gilts
bonds issued by the UK Government.
Is reproductive national debt an issue?
No deadweight national debt is
What is reproductive debt?
expected to create asset that will yield sufficient income to pay off the principal as well as the interest on loan
What is deadweight debt?
debt that does not increase the productive capacity of the economy because it is not backed by any existing asset
-can be put on future generations as a burden
What is the significance of national debt dependent on?(2)
-debt as a % of GDP
-wether the national debt can be ‘rolled over’
Why Is debt as a % of gdp important?
If inflation rate is greater than the rate at which the budget deficit and borrowing requirement add to the nominal national debt, the money value of the debt as a proportion of money or nominal gdp falls
If inflation rate if greater than nominal interest rates gov wins out
What does ‘rolling over’ the national debt mean?
When loans are taken out(more debt) to pay back loans
-if govs are forced to pay higher nominal interest rates it can lead to ‘crowding out’
(Servicing national debt becomes more of a problem when debt is held external in other countries)
Who are the OBR and when were they created
2010
Office for budget responsibility
What do the OBR do?
Independent analysis of UK’s public-sector fiancés
Produces medium term forecasts for Uk economy twice a year in its ‘economic and fiscal outlook’
Treasury complies a list of external economic forces monthly and compares to OBR
OBR rules if gov policy has more than a 50% change in meeting treasury’s fiscal targets
