3.1 Fiscal Policy Flashcards
Define and Explain Fiscal policy?
Fiscal Policy - involves the manipulation of the overall level of Government spending (G) and/or overall level of Taxation (T) in an economy over a given period of time.
It is a demand side policy but is used to affect supply side policies.
The Government announces its tax and spending decisions in the** annual budget**. Budget is in October and the Economic/ Fiscal forecast issued in November
Define Fiscal Stance and explain the different types?
Fiscal stance - refers to how the Governments’ level of spending and taxation affect AD and short run economic growth.
Expansionary stance: G>T (Budget deficit)
Deflationary stance: G<T (Budget surplus)
Balanced Budget: G=T
Budget deficit is also known as public sector net borrowing.
Explain Government spending and its role in the circular flow of income.
-Injection into circular flow of income
In Circular flow of income: Gov spending is all the flows to Households/ Firms.
In calculations for AD: Gov spending is the purchase of goods and services by the government over a period of time.
Gov Spending on transfer payments. e.g. benefits is accounted for by their effect through consumption and investment.
What are the classifications of spending and expenditure by the government?
Exhaustive spending - Public sector spending on Goods and services
Non-Exhaustive spending - Public sector spending on transfer payments.
Current Expenditure - acquisitions by the government of goods and services for current use, to directly satisfy the individual or collective needs of the community.
Current expenditure is spending on G/S required to run public services (maintain physical capital)
Capital expenditure - Gov spending on **G/S intended to create future benefits **e.g. infrastructure investment
Transfer payments - Money transferred by** Gov to individuals in terms of benefits** e.g. JSA
Debt interest payments - These are made to the government creditors (holders of the government debt).
What are the 7 reasons why the Government spend money?
1 - influence economic activity to meet objectives
2- encourage consumption of merit goods
3- redistribute income
4-Fund social security/ welfare state
5- Provide essential services
6- encourage exports
7-encourage domestic production of goods that cause +ve externalities
What are the main types of taxation and how taxation relates to the circular flow of income?
-** Leakage** from the circular flow of income
- Income tax
- National insurance contributions
- Excise duties
- Corporation tax
Other taxes:
- Business rates - local authority taxes on property
- Council tax - local tax based on domestic property
- Inheritance tax - tax based on value of assets left by an individual after their death.
- Stamp duty - tax on purchase of assets
- Capital Gains tax - tax on profits made from sale of assets
What are the classifications of taxes?
Direct taxes - taxes imposed on income of individuals and firms
Indirect taxes - taxes imposed on expenditure of individuals and firms on G/S
Progressive tax - takes higher proportion of tax as income increases
Proportional tax - takes same proportion of income in tax at all income levels
Regressive tax - takes lower proportion of income in tax as income increases.
What is the difference between average tax rate and marginal tax rate?
average tax rate is the proportion of total taxable income paid in tax.
Avg tax rate: 100 x (total tax paid / total income)
maginal tax rate is the proportion of tax payed on an additional pound of income e.g if someone earns £20,000 then the marginal tax rate is 20%
Explain the theory of theLaffer curve why it is thought to be so and any negatives of the theory?
Tax revenue at 0% and 100% is £0.00
The reason why tax revenue is not proportional to tax rate is:
- tax avoidance
- tax evasion
- disincentive to work
- emigration of skilled workers
negatives:
- limited evidence of optimum tax rate
- is it bell-shaped or lopsided or has multiple peaks
- does it change over time ?
What is the Budget deficit? How does it relate to government debt?
Budget deficit- represents the difference between government expenditure (G) and taxation revenue (T) over a period of time (usually a year) .
The Government finances the budget deficit through borrowing.
Gov debt- represents the total amount of money owned by the government at a given point in time, this is the stock of total public debt.
Debt = sum of all past deficits
How does the government finance a budget deficit? Explain with all key terminology.
Gov borrows money to finance a budget deficit, by selling bonds (Gilts in UK/ Treasury bills in US)
Bond - Financial asset to the bond holder (creditor) as it is a promise to repay borrowed money. It is a financial liability to the bond issuer (debtor) as it is outstanding debt to be paid.
How to Gov bonds work and what are some of the characteristics of bonds?
Gov bonds pay fixed interest payments to the bond holder known as coupons.
Coupon rate = % of face value (maturity value) of bond
Creditor receives regular interest payments (1 year/ 6 months) and on maturity date, will receive face value.
Short term bonds < 1 year
Long term bonds > 30 years
Existing Gov bonds are traded on secondary markets and the price of these bonds are usually below face value
These bonds are relatively low risk as the Government is unlikely to default.
What is the bond yield ?
The current yield on bond is annual interest payment as a percentage of current market price of the bond
(interest payment/ market price)x100
Inverse relationship between bond yield and market price since annual coupon rate is constant.
What are automatic stabilizers and how do they work?
Automatic stabilizers - when revenue from some taxes and some forms of government expenditure change automatically to help stabilize fluctuations in economic activity.
As economic activity increases automatic stabilizers tend to dampen down increases in aggregate demand. As tax revenue increases and Gov spending decreases.
As economic activity decreases automatic stabilizers reduce decline in AD stabilizing the economy. Tax revenue decreases and Government spending increases.
What is the extent to which automatic stabilizers are effective? (EVAL points)
- specific gov decisions on taxes and spending
- flexibility when overall economic activity changes
- specific tax thresholds and tax rates
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 a structural and cyclical budget deficit?
Structural - fundamental imbalance in total government receipts and expenditures. (G>T). This is not affected by the economic cycle and remains even when the economy is operating at full employment.
Cyclical - part of budget deficit related to size of output gap. It is the part that falls in the boom phase and increases in the slowdown/ recession phase of an economic cycle
structural + cyclical = overall budget balance
Eval points of whether structural budget deficit is a problem.
how fast economy is growing relative to structural budget deficit. If GPD growth rate is faster than structural budget deficit, national debt will be falling as a proportion of GDP
People’s confidence in the government to pay back for bond purchases. Since government needs to finance its deficit.
What are the advantages of Fiscal Policy
- Automatic stabilizers - this is incorporated in Fiscal policy and helps achieve greater macro economic stability.
- Dealing with recessions - Gov can borrow significant sums to spend to offset a significant fall in spending by Households and Firms
- Direct Impact of Gov spending - directly impact AD and may impact greater than monetary policy. Leading to larger multiplier effect
- Ability to target sectors/ regions
- Supply side effects if government spends on capital expenditure it could increase economy’s productive capacity over time.
What are the disadvantages of Fiscal policy?
- Crowding out - When gov has to sell more bonds. S ↑. P ↓. Therefore bond yields start to rise. Upward pressure on general market rates. Lower consumption and investment. Reduces overall effectiveness of the policy
- Time lags - time to recognize the problem (information/ data doesn’t become immediately available). Time taken to identify and agree on appropriate response. Time taken for the policy to actually start affecting economic variables.
- Public debt constraints
If Gov debt is too large interest on repayments may become too large for bonds . This may become unsustainable. Thus spending may be restricted - Overcoming lack of confidence
Tax cuts may not boost AD if confidence is low
Multiplier effect will also be lower.
Willingness to purchase bonds may also decrease.
Reducing effectiveness of Expansionary fiscal policy
What are the evaluation points of the effectiveness of fiscal policy?
- size of tax cut/ spending
- Whether the economy is operating at full capacity.
- Depends on multiplier effect
- Time lags it may take years to deliver the projects
- Conflict of objectives e.g. Economic growth vs Price stability
- Confidence
- Level of automatic stabilizers
- Other policies (demand/ supply-side)
