4-5 The role of the state in the macroeconomy

Question 1

What is current government expenditure?

Answer 1

• Current government expenditure is spending which recurs.
• This is on goods and services which are consumed and last for a short period of time.
• For example, it could be on drugs for the health service.

Question 2

What is capital government expenditure?

Answer 2

• Capital government expenditure is spent on assets, which can be used multiple times.
• For example, it could be government expenditure on roads or building a school.

Question 3

What are transfer payments?

Answer 3

• Transfer payments are welfare payments from the government.
• They aim to provide a minimum standard of living for those on low incomes.
• No goods or services are exchanged for transfer payments.
• Examples of transfer payments in the UK include: JSA, income support, child benefits and the state pension.
• These are in place to ensure people have a basic standard of living and to help reduce the level on inequality in society.
• Transfer payments are a means for the government to redistribute income from the rich to the poor.

Question 4

What are the reasons for the changing size and composition of public expenditure in a global context?

Answer 4

• In the UK, the government spends most of their budget on pensions and welfare benefits, followed by health and education. Education spending has remained relatively constant since it is protected.
• In developed economies, the population tends to demand more from their government and so spending tends to increase.
• The Global Financial Crisis led to an increase in government spending in order to bail out the banks.

Question 5

What effect do differing levels of public expenditure as a proportion of GDP have on GDP?

Answer 5

• Productivity and growth
  o Spending on human capital.
  o Invest in young apprentice schemes.
• Living standards
  o Increased provision of public goods
  o Some argue that the government’s inefficiency will reduce overall output and thus reduce living standards.
• Crowding out
  o If a bank has a choice between a risk free government bond or a risky private loan, they are more likely to choose the government bond. Therefore, the private firms will have less money to invest since they get less loans.
• Level of taxation
  o If government debt gets too high, the government might increase tax.
  o If confidence is lost in the government’s ability to repay the debt, governments might have to raise interest rates to encourage investors to buy bonds, so that they can finance the debt.
  o In some country’s the government is able to finance spending through other means, for example oil revenues in Norway.
• Equality
  o Government spending on welfare payments.
  o Government spending on public goods.

Question 6

What is a proportional tax?

Answer 6

• A proportional tax has a fixed rate for all tax payers.

Question 7

What is a progressive tax?

Answer 7

• A progressive tax has an increase in the average rate of tax as income increases.

Question 8

What is a regressive tax?

Answer 8

• A regressive tax does not relate to income, but means those on lowest incomes have a higher average rate of tax.

Question 9

What are the economic effects of changes in direct and indirect tax rates on other variables?

Answer 9

• Incentives to work
  o High marginal rates of tax may discourage people from working as they will gain less of what they have earned.
  o Higher taxes will encourage top earners to move abroad.
• Tax revenues (the Laffer curve)
  o The Laffer curve shows how much tax revenue the government receives at each level of tax.
  o Up until the point ‘T’, as tax rates increases, government tax revenue increases.
  o After point ‘T’, people do not think it is as worthwhile working, and the lack of incentive to work leads to falling tax revenue.
  o ‘T’ is the optimum tax rate where the government can maximise their revenue.
  o Laffer argued that if tax rates are too high, they provide a disincentive to work.
• Income redistribution
  o A progressive tax system will increase equality.
• Real output and employment
  o A fall in direct taxes will cause a rise in AD.
  o A fall in indirect taxes will increase SRAS.
• The price level
  o Indirect taxes could cause cost push inflation.
• The trade balance
  o Taxes could be imposed on impots into a country.
  o These are tariffs and they make it more expensive to import goods which should in theory improve the trade balance.
  o However, other countries might retaliate, so exports might decrease as well.
• FDI flows
  o Governments can provide a competitive tax environment to encourage FDI, so that the market is profitable, fair and has macroeconomic stability.
  o Taxes should also be consistent and predictable, so they are business friendly.
  o This would encourage FDI flows.
  o High taxes are likely to discourage FDI flows, since investors will choose to invest elsewhere.

Question 10

What is a discretionary fiscal policy?

Answer 10

• Discretionary fiscal policy is a policy which is implemented through one-off policy change.
• Discretionary fiscal policy involves deliberate changes in government expenditure and taxes with the intention of influencing aggregate demand.
• Keynes believed that during recessions, governments should increase their spending, and finance this with more borrowing.

Question 11

What are automatic stabilisers?

Answer 11

• Automatic stabilisers are policies which offset fluctuations in the economy.
• These include transfer payments and taxes.
• They are triggered without government intervention.

Question 12

What is a fiscal deficit?

Answer 12

• A government has a fiscal (budget) deficit when expenditure exceeds tax receipts in a financial year.

Question 13

What is the national debt?

Answer 13

• The national debt is the amount of money the government has borrowed at one time through issuing securities by the Treasury.

Question 14

What is a cyclical deficit?

Answer 14

• This is a temporary deficit, which is related to the business cycle.
• A deficit might occur during recessions, when governments increase spending to stimulate the economy.

Question 15

What is a structural deficit?

Answer 15

• This is a deficit which is due to an imbalance in the revenue and expenditure of the government, so it exists at every point in the business cycle.

Question 16

What are the factors influencing the size of fiscal deficits?

Answer 16

• The business cycle
  o Governments are likely to spend more during recessions
• Interest payments
  o If interest rates increase on government debt, the amount the government pays in interest payments increases, so a deficit might increase.
• Privatisation
  o Could improve the budget deficit as provides the government with a one off payment.

Question 17

What are the factors influencing the size of national debts?

Answer 17

• If the government is continuously running a deficit, the size of the debt increases.
• If the government reduces the size of their deficit, the rate of increase of the total debt is slower, but the debt is still increasing.
• It is only when the government runs a budget surplus that the size of the national debt decreases.
• Currently, the UK government is trying to reduce the size of the deficit and eventually run a budget surplus by 2019-2020, at which point they will start paying off the debt.

Question 18

What is the significance of the size of fiscal deficits and national debts?

Answer 18

• The cost of borrowing could increase, since by borrowing the money, the government is increasing demand for credit in the economy.
• If confidence is lost in the government’s ability to repay the debt, governments might have to raise interest rates to encourage investors to buy bonds, so that they can finance the debt.
• It could lead to higher taxes and austerity measures, especially if the debt becomes incontrollable.
• A fiscal deficit could be inflationary if it increases AD.
• More government spending could lead to crowding out of the private sector.
• This leaves fewer funds in the private sector for firms to use, since the government is borrowing money, which crowds them out of the market.

Question 19

What are the measures to reduce fiscal deficits and national debts?

Answer 19

• Budget deficits could be reduced with less government spending and higher taxes.
  o However, this could lead to lower economic growth, which might cause government finances to worsen since tax revenue falls.
  o Further, if taxes are too high people could be discouraged from working, since they are not keeping much of their income.
• Economic growth could be promoted to help reduce a deficit; this would increase revenue from taxes without needing to raise the rate of tax. For example, consumers would spend more, which raises revenue from VAT.
  o However, this is not effective is the government has a structural deficit.
• Governments can issue bonds to raise finance. This is not considered to be an effective long-term solution to eliminate the government debt.
  o However, it can help the government avoid raising taxes in the short run. The government has to pay interest to the investors who buy the debt, which has to be repaid at some point.

Question 20

What are the measures to reduce poverty and inequality?

Answer 20

• There can be income redistribution and wage equality through government intervention.
  o For example, inheritance tax means rich families cannot keep their entire wealth.
• Governments could employ progressive taxes, such as higher rates of income tax for the richest earners.
  o This puts most of the tax burden on high income earners, and it allows the government to reduce regressive taxes and raise welfare payments.
  o However, this could reduce incentives to work harder and earn more, and it could result in a fall in government revenue, as shown by the Laffer curve.
• US has a progressive tax system, but the welfare state is not effective at redistributing income.
• In countries such as Finland and Norway, the tax system is less progressive, but the government collects a lot more tax revenue, which they are effective at redistributing.
• The UK has a NMW which ensures all workers can access a minimum standard of living.
  o This aims to prevent employees exploiting their workers by paying them two wages, and it prevent people falling into extreme poverty.
• In developing countries, governments might improve human capital by making education more widely available.
  o Moreover, they might try and diversify the economy in order to stimulate economic growth and job creation.
  o For example, countries such as Sri Lanka and tried to develop their tourism industry.

Question 21

What are the measures to increase international competitiveness?

Answer 21

• Generally, the cheaper the relative unit labour costs, the more competitive the country in manufacturing.
• However, countries such as Germany are famous for producing high quality good so consumers may be willing to be pay more for them.
• China has used currency manipulation in order to increase their international competitiveness, they devalued the Renminbi in order to make their relative export price lower.
• The UK government tried to increase competitiveness by lowering corporation tax rate from 21% to 20% in 2015.
• Further, the UK government has established the ‘Red Tape Challenge’, which aims to simplify regulation for businesses.

Question 22

How have macroeconmic policys been used to respond to external shocks to the global economy?

Answer 22

• UK responded to economic decline in the Eurozone by lowering interest rates to 0.5%, In order to encourage economic growth. Further BOE used QE to further this.
• UK gov. introduced Funding for Lending Scheme, which aimed to lower costs of lending and provide cheap lending to banks.
• Post Brexit, Chancellor set aside £3bn to deal with effects of inflation.

Question 23

What are the measures to control MNC’s operations?

Answer 23

• Regulation of transfer pricing
  o MNC’s avoid tax by saying that the majority of their operations were in low tax countries.
• Limits to government ability to control global companies
  o HMRC may have high admin costs.

Question 24

What are the problems facing policymakers when applying policies?

Answer 24

• Inaccurate information
• Risks and uncertainties
• Inability to control external shocks