3.1 - Fiscal Policy

Question 1

What is Fiscal Policy?

Answer 1

Fiscal Policy is the changes in government spending and taxation to influence aggregate demand in an economy.

Question 2

Why do governments levy taxes?

Answer 2

Governments levy taxes for five main reasons: to raise revenue to fund essential public expenditure and transfer payments, to redistribute income, to correct market failures, to manage the macroeconomy, and for protectionism.

Question 3

How do governments use taxes to raise revenue?

Answer 3

Governments use taxes to raise revenue for their expenditure programmes because they need to finance their essential public expenditure and transfer payments. They can borrow some money for this, but most of it must come from taxation to avoid inflation and excessive increases in national debt over time.

Question 4

How can governments use taxes to redistribute income?

Answer 4

Governments can use progressive taxation to reduce the income of some groups in society and use the money collected to increase the income of other groups. This is done to address the argument that the distribution of income is inequitable.

Question 5

How can governments use taxes to correct market failures?

Answer 5

Governments can intervene in markets by introducing or raising taxes such as cigarette taxes, carbon taxes, and alcohol taxes to reduce consumption and production. This way, taxation can be used to reach allocatively efficient outcomes in failing markets.

Question 6

How can governments use taxes to manage the macroeconomy?

Answer 6

Taxation can have an important influence on the macroeconomic performance of the economy. Governments may change tax rates to influence variables such as growth, inflation, unemployment, and the current account.

Question 7

How can governments use taxes for protectionism?

Answer 7

Governments can use tariffs, a tax on imports, to reduce the quantity of imports into a country, thus protecting domestic producers from foreign competition by increasing the price of imports, promoting more domestic supply and employment, and depressing domestic demand.

Question 8

What is the purpose of government spending in the economy?

Answer 8

Governments spend money in the economy to influence the level of economic activity, correct market failures, reduce inequality and promote equity, and improve social welfare.

Question 9

How can government spending influence the level of economic activity?

Answer 9

When there is high unemployment and sluggish economic growth in a recession, the government can raise its spending to increase aggregate demand. Conversely, if there is a boom in the economy with high inflation, the government may decide to reduce spending to reduce aggregate demand.

Question 10

How can government spending correct market failures?

Answer 10

Governments can provide subsidies or publicly provide merit/public goods such as schools, hospitals, and transport infrastructure where underproduction or a lack of supply exists. By correcting such market failures, socially optimum outcomes and thus allocative efficiency can be reached.

Question 11

How can government spending reduce inequality and promote equity?

Answer 11

Governments can spend on transfer payments and social housing, as well as education and healthcare to improve the skills and productivity of the poor in a bid to increase their incomes and reduce the income gap.

Question 12

What is Expansionary Fiscal Policy?

Answer 12

Expansionary Fiscal Policy is a type of fiscal policy that involves increasing government spending or reducing taxes to boost aggregate demand in the economy, resulting in higher economic growth and lower unemployment.

Question 13

How can governments reduce the marginal rate of income tax for those in lower income tax bands to stimulate the economy?

Answer 13

Governments can reduce the marginal rate of income tax for those in lower income tax bands or increase the income tax-free allowance. This would increase the disposable income for those on lower incomes. As these consumers have a high marginal propensity to consume, consumption would increase in the economy, increasing aggregate demand from AD1 to AD2.

Question 14

How can governments reduce the marginal rate of income tax on the rich to stimulate the economy?

Answer 14

Governments can reduce the marginal rate of income tax on the rich, reducing the tax rate on the highest income tax bands. This would increase the disposable income for the rich significantly, given the proportion of income that is taxed in these tax bands. Consequently, more income will be disposable to spend in the economy, increasing aggregate demand from AD1 to AD2 and generating a large multiplier effect.

Question 15

How can governments reduce regressive taxes to stimulate the economy?

Answer 15

Governments can reduce the level of regressive taxes in the economy, such as VAT and fuel duty. Regressive taxes take a greater proportion of the poor’s income than they do of the rich, reducing disposable income. Reducing regressive taxes will free up more disposable income for the poor to spend on goods and services in the economy, and as the poor have a high marginal propensity to consume, consumption will increase, boosting aggregate demand from AD1 to AD2.

Question 16

How can governments reduce the level of corporation tax to stimulate the economy?

Answer 16

Governments can reduce the level of corporation tax, which is the tax on business profits. This will increase retained profits for businesses, making it easier for them to finance investment, thus increasing the marginal propensity to invest. As investment increases, aggregate demand will too from AD1 to AD2, as investment is a component of AD.

Question 17

How can governments boost their spending in the economy to stimulate it?

Answer 17

Governments can boost their spending in the economy, for example, by spending on infrastructure, education, healthcare, public sector wages, etc. As government spending is a core component of aggregate demand, this will significantly increase aggregate demand from AD1 to AD2 and generate a large multiplier effect in the economy, whereby an initial increase in spending (aggregate demand) will increase incomes in the economy, facilitating further rounds of spending and income generation. The end result is an even greater final increase in aggregate demand.

Question 18

What happens to growth when aggregate demand increases due to expansionary fiscal policy?

Answer 18

Actual growth increases from VI to Y2. This is because with greater demand in the economy, firms respond by increasing output exhausting spare capacity; Y2 is now closer to the full employment level of output. This increase in output is an increase in real GDP, which is an increase in economic growth.

Question 19

What happens to unemployment when aggregate demand increases due to expansionary fiscal policy?

Answer 19

Unemployment decreases. This is because labor is a derived demand, derived from the demand for goods and services. As the demand for goods and services is high, firms will need more workers to produce extra output, thus reducing unemployment.

Question 20

How can reducing the level of corporation tax shift LRAS to the right?

Answer 20

Governments can reduce the level of corporation tax, which will increase retained profits for businesses, making it easier for them to finance investment, thus increasing the marginal propensity to invest. As investment increases, the quantity and quality of the capital stock in the economy increases, shifting LRAS to the right from LRAS1 to LRAS2.

Question 21

How can government spending on infrastructure, education, and healthcare increase LAS?

Answer 21

Governments can boost their spending in the economy, for example, by spending on infrastructure, education, and healthcare. Such spending will increase both the quantity and the quality of the capital stock in the economy. Spending on education and healthcare could well increase the productivity of labor; that is, the quality of labor. Spending on transport infrastructure could increase the productive efficiency of the economy by making it quicker, easier, and cheaper to transport goods and services both nationally and internationally. All these factors can increase LAS from LRAS1 to LRAS2.

Question 22

How can inflation be a disadvantage of expansionary fiscal policy?

Answer 22

Inflation in the economy is likely to increase from P1 to P2 as spare capacity in the economy is being exhausted, therefore there is more competition for resources and pressure put on existing factors of production increasing the prices of them. This puts upward pressure on prices and causes demand-pull inflation.

Question 23

What is the potential disadvantage of expansionary fiscal policy in terms of government finances and how does it relate to income inequality?

Answer 23

The potential disadvantage of expansionary fiscal policy in terms of government finances is the deterioration of government finances. This policy would cost the UK government billions of pounds where funding would carry a severe opportunity cost. If the government has to borrow money, taxes in the future will have to rise to pay back debts gathered. This can lead to indirect, regressive taxes such as VAT or fuel duty to increase and part-fund this spending, which will lead to worsening income inequality going against the major macroeconomic objective. Furthermore, if the government funds these policies by cutting spending in other areas of the economy such as healthcare or education, once more the negative impacts will be suffered mostly by the poor. The potential problem of Ricardian Equivalence could also arise where individuals save their disposable income from tax cuts instead of spending in preparation for tax increases in the future, reducing the gains from expansionary fiscal policy and increasing aggregate demand.

Question 24

How can excessive government borrowing crowd out the private sector?

Answer 24

A large borrowing-fueled increase in government spending could crowd out the private sector. This is where excessive government borrowing increases the demand for loanable funds in the loanable funds market significantly, pushing up equilibrium interest rates, making it more expensive for firms to finance their investment projects and reach their hurdle. This can then reduce investment in the economy, harming both short-run and long-run economic growth.

Question 25

What is a potential disadvantage of expansionary fiscal policy in terms of time lags?

Answer 25

The length of time lags. As the government decides to spend money, it takes a long time for that money to actually start flowing around the economy. For example, the government spending money to build schools will see initial spending on workers (wages) and building material, but the entire budget will not be spent straight away, limiting how much AD will increase in the immediate short term.

Question 26

What is the main benefit of austerity policy?

Answer 26

Lower government borrowing and debt. This is because austerity policy consists of cuts to government spending and increases in taxation both of which reduce the need for borrowing and allow the government generate more tax revenue to service debts. As a consequence, both the budget deficit (yearly deficit) and national debt (total stock of debt) reduce promoting greater confidence in the state of government finances, attracting FDI and domestic investment whilst reducing the cost of borrowing and increasing the ease of raising finance for the government over time.

Question 27

How does austerity policy allow for flexibility in government spending?

Answer 27

The government can save any surplus revenue from austerity policies to keep aside for emergency use or to improve the state of the economy. As a consequence, there is room for expansionary fiscal policy (Keynesian stimulus) in a recession to move the economy back to full employment avoiding large negative impacts on growth and employment whilst keeping inflation at the target rate. Once more for public services or infrastructure, there will be funds available to make necessary improvements.

Question 28

How does austerity policy reduce crowding out and X-inefficiency?

Answer 28

Reducing the level of government spending automatically will decrease the size and role of government in the economy. Market economists would argue that government inefficiencies would be taken away such as crowding out private sector investment and excess costs of poorly run government organisations. As a consequence, private sector activity can flourish efficiently creating jobs whilst promoting both short run and long run growth in the economy.

Question 29

How can austerity policy help keep inflation low?

Answer 29

Austerity policy reduces AD through lower G and potentially lower C and I if taxation levels are raised. Consequently, as the level of spare capacity increases, there will be less pressure on existing factors of production reducing the rate at which their prices rise, reducing the rate of inflation resulting in disinflationary pressure. This impact could be useful if inflation is beyond target and demand pull in nature.

Question 30

What is a potential consequence of austerity policy in terms of the economy?

Answer 30

Potential shock to the economy. This is because as AD falls in the economy, growth decreases and unemployment increases potentially leading a recession. Therefore if an economy is fragile, even if government finances are in a poor state, governments must be extremely careful in deciding the timing of austerity and exactly what policies are best to use to avoid major conflict of macro objectives. If the economy does weaken significantly, this could actually increase debt to GDP ratios thus completely failing to achieve the core objective of austerity.

Question 31

How can austerity policy impact income inequalities in the economy?

Answer 31

Certain austerity policies such as raising regressive taxes like VAT and cutting spending on welfare, education and healthcare can increase income differentials in the economy. As a consequence, long term government finances can actually worsen if further spending is needed in areas such as policing, judiciary and health services to deal with problems of rising income inequality. Furthermore improvements in education, healthcare, infrastructure and public transportation generate strong returns via economic growth over time and can therefore generate tax revenues for the government whilst also boosting productivity and competitiveness. Stringent austerity policy could worsen long term economic prospects in this sense.

Question 32

How can austerity policy have unintended consequences on incentives in the economy?

Answer 32

Austerity can have the unintended impact of distorting incentives if taxes such as income tax, corporation tax and/or VAT are raised. This is because higher income taxes discourage work and entrepreneurial spirit whilst higher corporation taxes/VAT discourage FDI and domestic investment. Consequently, long run growth rates in the economy will suffer, as will productivity and competitiveness potentially worsening government finances in the long run too if lower economic activity due to these perverse incentives reduces tax revenue as Laffer suggests could occur.

Question 33

1. What is the impact of expansionary fiscal policy on an economy with large spare capacity?

Answer 33

An increase in aggregate demand in an economy with large spare capacity will lead to a larger increase in output and decrease in unemployment. There will also be limited pressure on factors of production, which will limit the rise in inflation and potentially have no demand-pull inflationary effect. This will not make exports less competitive and worsen the current account position.

Question 34

1. What is the impact of expansionary fiscal policy on an economy with low spare capacity?

Answer 34

An increase in aggregate demand in an economy with low spare capacity will result in limited increases in output and employment, as it is difficult for firms to find new workers or increase their level of capital to produce more. The enormous pressure on limited factors of production will lead to a much greater rise in inflation, potentially worsening the current account position.

Question 35

2. How does the level of consumer and business confidence impact the effectiveness of income tax reduction as a form of expansionary fiscal policy?

Answer 35

If the level of consumer and business confidence is low, an income tax reduction may have little impact on stimulating aggregate demand. Consumers may be cautious about their future employment prospects and may be more inclined to save any extra disposable income rather than spend it. Businesses may also be concerned about lower profits and may be unwilling to spend any increase in their retained profits to fund investment projects. This will leave aggregate demand unchanged and the four key macroeconomic objectives of government unaltered.

Question 36

3. What is the impact of the state of government finances on expansionary fiscal policy?

Answer 36

If the government is in a strong financial position, financing expansionary fiscal policy is not a burden as future tax rises or spending cuts will not need to take place to fund such policies. However, if budget deficits are large and unsustainable, the long-term impact of expansionary fiscal policy could be severe, with austerity being the likely result. In this sense, the long-term costs of such policies could outweigh the short-term benefits.

Question 37

6. How could expansionary fiscal policy crowd in the private sector according to Keynesian economists?

Answer 37

Keynesian economists argue that expansionary fiscal policy, particularly in the form of infrastructure spending, could crowd in the private sector. As the government spends and boosts demand in the economy, economic activity and incomes rise, promoting private sector investment as firms seek to increase profits from such activity. Infrastructure spending could also encourage more private sector investment if that infrastructure directly improves competitiveness and profitability for private sector firms that gain this advantage.

Question 38

7. How do automatic stabilizers impact the need for discretionary fiscal policy during a recession?

Answer 38

If an economy has a progressive income tax system and a welfare state, it could reduce the need for discretionary fiscal policy in a recession as the impact of the automatic stabilizers, such as greater government spending on benefits and lower taxation due to lower incomes, will cushion the negative impact on growth and employment. This means governments can limit borrowing and the size of their budget deficits, reducing the long-term impact of debt while still achieving economic recovery.

Question 39

4. How does the size of the multiplier impact expansionary fiscal policy?

Answer 39

The greater the size of the multiplier, the less the government will need to increase spending or cut taxes in order to have a large favorable impact on aggregate demand, growth, and employment in the economy; vice versa if the multiplier is small. However, calculating the multiplier is notoriously difficult and highly assumptive, so basing fiscal policy decisions on it is dangerous with no guarantee of success.

Question 40

5. How do Laffer Curve arguments impact expansionary fiscal policy through tax cuts?

Answer 40

If tax rates in the economy are beyond the efficient tax rate on the Laffer curve, expansionary fiscal policy in the form of direct tax cuts could actually raise revenue for the government. This is because tax cuts can promote entrepreneurial spirit, inward migration, and incentives to be more productive, all of which would increase tax revenues for the government, thus improving, not worsening, government finances

Question 41

1. How does fiscal policy through automatic stabilizers impact a boom in an economy?

Answer 41

In a boom, fiscal policy through automatic stabilizers has instruments to reduce fluctuations in the economic cycle. With a progressive tax system and unemployment benefits, incomes increase which increases the average tax rate for workers in the economy. This controls increases in consumer spending, reducing the rate of growth of aggregate demand, restricting the size of the boom, and thus inflationary pressure. With more individuals employed, the government will spend less on unemployment benefits and other welfare payments, helping to further restrict the increase in aggregate demand and cool excessive inflationary pressure.

Question 42

2. How does fiscal policy through automatic stabilizers impact a recession in an economy?

Answer 42

In a recession, fiscal policy through automatic stabilizers has instruments to reduce fluctuations in the economic cycle. With a progressive tax system and unemployment benefits, incomes decrease throughout the economy, which reduces the average tax rate for workers as less income is taxed. This prevents how much consumer spending falls in the economy, reducing the impact of aggregate demand decreases, limiting the size of the recession, and thus unemployment. With more individuals unemployed, the government will spend more on unemployment benefits and other welfare payments, which could limit the size of the aggregate demand reduction and prevent a deep, prolonged recession taking place with large falls in growth and very high unemployment.

Question 43

3. How do automatic stabilizers impact the need for discretionary fiscal policy in managing the macroeconomy?

Answer 43

The stronger the automatic stabilizers are in an economy, the less the need is for discretionary fiscal policy to actively manage the macroeconomy in times of recession and boom. In a recession, this is significant as it means governments can limit their borrowing and the size of their budget deficits, reducing the long-term impact of debt. In a boom, this is significant as governments can run budget surpluses to pay off debt obligations and save surplus tax revenue ready for both automatic and discretionary fiscal policy to reduce the impact of the next recession.