3.1 Fiscal Policy Flashcards
What is fiscal policy?
The manipulation of the overall level of government spending (G) and/or the overall level of taxation (T) in an economy, over a given period of time
What is fiscal stance?
Refers to how a government’s level of spending and taxation affect aggregate demand and short run economic growth
What is an expansionary stance and what does it mean?
- Government spending is higher than tax revenues
- Means the government is running a budget deficit (G>T)
- Budget deficit also known as “public sector net borrowing” (PSNB)
What is a deflationary stance and what does it mean?
- Government spending is lower than tax revenue
- Means the government is running a budget surplus (G<T)
What is a neutral stance and what does it mean?
- Government spending is equal to tax revenues
- Means the government is running a balanced budget (G=T)
What is exhaustive spending?
Public sector spending on goods and services - directly affects AD
What is non-exhaustive spending?
Public sector spending on transfer payments - indirectly affects AD
What is current expenditure?
The acquisition by the government of goods and services for current use to directly satisfy the individual or collective needs of the community
Spending on goods and services to run public services and to maintain physical capital
Eg. Salaries of public employees, purchase of medicines,
What is capital expenditure?
Government spending on goods and services intended to create future benefits
Eg. Infrastructure investment in transport
What are direct taxes?
Taxes imposed on the income of individuals and firms
Includes income tax and corporation tax
What are indirect taxes?
Taxes imposed on the expenditure of individuals and firms on goods and services
Includes excise duty (tax on specific products) and VAT
What is a progressive tax?
A tax which takes a higher proportion of income in tax as income increases
What is a proportional tax?
A tax which takes the same proportion of income in tax at all income levels
What is a regressive tax?
A tax which takes a lower proportion of income in tax as income increases
What are transfer payments?
Money transferred by the government to individuals in the form of benefits
Eg. JSA and state pensions
What are debt interest payments?
Payments made to the government’s creditors (holders of the government debt)
Eg. Interest paid on government bonds
Why does the government spend public money?
- To influence economic activity to meet its major economic objectives (aggregate demand)
- To encourage consumption of merit goods and those with positive externalities (subsidies and state provision)
- To provide essential services (public goods)
- To redistribute income within the economy (tax system and benefits)
What does the Laffer Curve show?
A relationship between the rate of taxation and the tax revenue collected
- At a rate of 0% or 100%, tax revenue will be zero
- Suggests there is an optimum tax rate (t*) in between, where tax revenue is maximised
What is the average tax rate?
The proportion of total taxable income paid in tax:
(Total tax paid/total income) x 100
What is the marginal tax rate?
The proportion of tax paid on each additional £ earned
What are criticisms of the Laffer curve?
- There is limited empirical evidence about whether an optimal tax rate actually exists
- It is unclear what the shape of the Laffer curve is
- Cuts in tax rates may cause people to opt more for leisure rather than increase hours of work
- A tax cut for the rich has implications for inequality
What is the budget deficit?
The budget deficit represents the difference between government expenditure (G) and taxation revenue (T) over a period of time (usually a year)
What is government debt?
The total amount of money owed by the government at a given point in time - the stock of total public debt
What is the bond yield?
(Annual coupon payment / current market price) x 100
What are automatic stabilisers?
When the revenues from some taxes and some forms of government expenditure change automatically to help stabilise fluctuations in economic activity / real GDP
What do automatic stabilisers do when economic activity increases?
Automatic stabilisers tend to dampen down increases in AD; tax revenue increases and government expenditure falls as a proportion of GDP
What do automatic stabilisers do when economic activity falls?
Automatic stabilisers tend to reduce the decline in AD; tax revenue falls and government expenditure increases as a proportion of GDP
What is discretionary fiscal policy?
Changes to taxes and spending that may be implemented by the government in response to changing economic activity, to help achieve a specific policy objective
What is the structural budget deficit?
The underlying fundamental imbalance in total government receipts and expenditures, where government expenditure (G) is greater than taxation revenue (T). It is NOT affected by the economic cycle.
- Remains even at full employment/full capacity
What is the cyclical budget deficit?
The part of the budget deficit that falls in the boom phase of the economic cycle and rises in the slowdown/recession phase. Is related to the size of the output gap.
What is the overall budget balance?
The sum of the structural and cyclical parts
What does the extent to which we should worry about a structural budget deficit depend on?
- How fast the economy is growing relative to the structural budget deficit -> if real GDP is growing faster than the structural budget deficit, the national debt will be falling as a proportion of GDP
- If people have confidence in the government’s ability to repay their debt, then a deficit is unlikely to be a problem
- If the structural budget deficit is growing faster than the economy, the debt to GDP ratio increases -> issuing more bonds -> higher yields which pushes up other interest rates (also means higher debt repayment) -> investment falls - called “crowding out” of private investment
What are the advantages of fiscal policy?
- Automatic stabilisers
- Dealing with deep recessions - fiscal policy can overcome a lack of AD through directly spending on goods and services
- Direct impact of government spending - may have a greater impact on AD than monetary policy
- Ability to target sectors/regions - can be more specific than monetary policy
- Supply side effects - capital expenditure may increase the productive capacity of the economy over time
What are the disadvantages of fiscal policy?
- Crowding out - if government pursues expansionary fiscal policy with a large budget deficit it will have to sell more government bonds -> can crowd out investment by private firms (think through chain of reasoning)
- Time lags (discretionary fiscal policy - some months may pass before the effect of a change is felt
- Public debt constraints - additional borrowing required to finance an increased budget deficit will force up the interest on debt -> may restrict additional levels of spending in the economy
- Overcoming a lack of confidence - in a deep recession tax cuts may not be effective in increasing AD as it may not necessarily increase spending (MPC may fall and the multiplier effect will be smaller)
