2.4 Fiscal Policy

Question 1

What is fiscal policy?

Answer 1

Use of taxation and government expenditure policies to influence level of economic activity and macroeconomic objectives.

Question 2

How can taxation be used?

Answer 2

Redistribute income and wealth to benefit less wealthy members of society, help control rate of inflation in economy.

Question 3

How can government spending be used?

Answer 3

Improve standards of living, key component of AD so increase in government spending helps boost national output, jobs and economic growth.

Question 4

What are examples of direct tax?

Answer 4

Income tax - on personal income
Corporation tax - on profits of business
Capital gain tax - on earnings made from investments
Inheritance tax - on transfer of income and wealth
Windfall tax - on individuals and firms the gain one off amount go money.

Question 5

What are examples of indirect tax?

Answer 5

Sales tax - VAT or GST, charged on manufacturing, sale and consumption of goods
Excise duties - inland taxes imposed on certain produces
Customs duties - cross border taxes on foreign imports
Stamp duty -progressive tax paid on sale of commercial or residential property.
Carbon tax - on vehicle manufacturers producing excessive carbon emissions.

Question 6

What are other sources of government revenue?

Answer 6

Sale of goods and services - come from state owned enterprises.
Sale of state owned enterprises - privatisation proceeds can be earned by selling government owned assets and enterprises, short term policy as state owned assets can only be sold one to the private sector.
Sovereign wealth funds - sate owned investment finds such as stock and shares, bonds of other governments, investment in property, gold resources,
Public sector borrowing - used when sources of revenue do not meet its spending needs.

Question 7

What is government current expenditure?

Answer 7

Spending on goods and services consumed within the current year.

Question 8

What is government capital expenditure?

Answer 8

Long tem items of government spending that boost economy productive capacity

Question 9

What is government expenditure on transfer payments?

Answer 9

welfare payments form government to third parties without any corresponding return.

Question 10

What is a budget deficit?

Answer 10

If government spending is greater than government revenue. May occur during recession when welfare payments rise whilst tax revenues fall due to sign unemployment.

Question 11

What is a budget surplus?

Answer 11

If government revenues exceeds public sector expenditure. May occur during a boom when tax payment will be higher whilst spending on transfer payments will tend to fall.

Question 12

What is a balanced budget?

Answer 12

Amount of government spending equals the value of its revenues.

Question 13

What are the problems with budget surpluses?

Answer 13

Politically unpopular with taxpayers.

Question 14

What are the problems with budget deficit?

Answer 14

Require government borrowing which can be expensive due to interest charges on the loans.

Question 15

Why is there a negative correlation between government debt and the budget?

Answer 15

The more money a government owes the more likely that its budget will be in deficit.

Question 16

How can a budget surplus reduce debt?

Answer 16

It can often help to reduce public sector debt caused by budget deficits in previous years, whereas budget deficit tend to increase government debt.

Question 17

Why will changes in taxes and government spending change the level of AD in the economy?

Answer 17

Government spending is a component of AD. Changes in taxes will change the level of consumption which is a component of AD.

Question 18

What is expansionary fiscal policy?

Answer 18

Used to stimulate the economy, increasing government spending and lowering taxes. Can boost consumption during a recession and close a deflationary gap.

Question 19

What is contractionary fiscal policy?

Answer 19

Used to reduce level of economic activity, decreasing government spending and raising taxes. Can reduce inflationary pressure during economic boom and close an inflationary gap.

Question 20

Why does the potential effects of expansionary or contractionary fiscal policy depend on the shape of the AS curve?

Answer 20

On the flat part of the AS curve an increase in demand has no impact on the price level as there is spare capacity. Expansionary policy is effective in increasing real national output only.
On the sloping part of the AS curve an increase in AD causes an increase in both national output and general price level.
On the vertical part of the AS curve is expansionary fiscal play is used when the economy is at full capacity when AD increases it will cause inflation without any correspondence in national output.
The opposite outcomes apply when analysing contractionary fiscal policy.

Question 21

What is an automatic stabiliser?

Answer 21

Part of fiscal policy that automatically influences national income, helping to even out short term fluctuations in the level of economic activity.

Question 22

What are examples of automatic fiscal stabilisers?

Answer 22

Progressive tax system and welfare benefits for the unemployed.

Question 23

How do progressive taxes and welfare benefits help during an economic boom?

Answer 23

A progressive tax system means the government automatically receive more tax revenue from increased tax revenue on income and spending. Government spending on welfare benefits falls due to rising levels of economic activity thus dampening the increase in consumption expenditure. Automatic stabiliser help to reduce growth rate avoiding the risk of uncontrollable inflation.

Question 24

How can automatic stabilisers help limit the fall in economic growth during a recession?

Answer 24

Helps to inject some money into the circular flow of income to boost AD.

Question 25

What is the effectiveness of automatic stabiliser in reducing fluctuations in economic activity dependent on?

Answer 25

Size of the government sector - the greater the level of government involvement the more effective automatic stabilisers.
The degree of progressivity of the tax system - the more progressive the tax system of the country the more effective automatic stabiliser are.
The scope of the welfare benefits system - automatic stabiliser will be more effective in countries like Australia and the UK with wide reaching welfare systems.

Question 26

What are the two components of AD directly affected by fiscal policy?

Answer 26

Consumption and government spending.

Question 27

What are the three ways fiscal policy can be used to directly promote long term economic growth?

Answer 27

Government spending on physical and capital goods
Government spending on human capital formation - process of using education to create knowledge and skills to create a more skilled labour force.
Provision of incentives for firms to invest - government provision of tax breaks and tax incentives helps to create an economic environment that is conducive to investment. Government spending on infrastructure can also help to encourage FDI.

Question 28

How can fiscal police be used indirectly to promote long term economic growth?

Answer 28

By creating an environment of low taxation that is favourable to private sector investment by domestic and foreign firms.

Question 29

How can expansionary fiscal policy be used to help increase confidence levels?

Answer 29

Can be used to increase consumer and business confidence levels, creates further incentives for firms to invest in their labour force and in the economy.

Question 30

What are the downsides of expansionary fiscal policy?

Answer 30

Depends on the shape of the AS curve.

Debatable whether demand side policies alone are sufficient to achieve long term economic growth.

Question 31

What are some negatives of using fiscal policy?

Answer 31

Has a greater impact on some areas of the country than others due to regional disparities in income and spending habits.
Effectiveness of fiscal policy is hindered by the severity of the recession.
Effectiveness of policy will depend on the extent to which the government can afford to sustain a budget deficit.
The political cycle of re electing new leaders can cause artificial shocks to the business cycle.
Financial crowding out occurs when increased government borrowing causes interest rates to rise thereby reducing private sector investment expenditure due to the higher costs.
Fiscal policy is unable to deal with supply side shocks.

Question 32

What are some negatives of using expansionary fiscal policy?

Answer 32

Expansionary fiscal policy can help to achieve economic growth but tax cuts and increased government spending can fuel demand pull inflation.

Question 33

What are some negatives of using contractionary fiscal policy?

Answer 33

Can cause disincentives to work, lower productivity and unemployment.
Contractionary fiscal policy via reduced public sector spending can have detrimental effects on public transportation which can lead to economic inefficiencies and market failures.

Question 34

Why are there issues with time lags when implementing fiscal policy?

Answer 34

Recognition time lags - time lag before recognising that government intervention is needed to affect level of economic activity because government do not know if the economy is growing too fast of declining too quickly.
Administrative time lags - time delay between recognising need for fiscal policy intervention and time to actually implement an appropriate action.
Impact time lags - time lag from implementation of fiscal policy to seeing the effects on the economy.