4.13.1 - Fiscal Policy

Question 1

What is fiscal policy?

Answer 1

The use by the government of government spending and taxation to try to achieve the government’s policy objectives.

Question 2

What is fiscal policy often associated with?

Answer 2

Keynesian macroeconomic theory and policy.

Associated with the 1950s to 1970s.

Question 3

What affect does fiscal policy have on microeconomics?

Answer 3

Government uses taxation and subsidies to influence consumer behaviour.

Uses income taax and the welfare system to create incentives in the labour market.

Question 4

What is a balanced budget?

Answer 4

When gov. spending = gov. taxation.

Question 5

What is a budget deficit?

Answer 5

When gov. spending > gov. taxation.

Question 6

What is a budget surplus?

Answer 6

When gov. spending < gov. taxation.

Question 7

What did fiscal policy attempt to do?

Answer 7

Manage the level of AD in the economy.

Question 8

What is demand-side fiscal policy?

Answer 8

Used to increase or decrease the level of AD through changes in gov. spending, gov. taxation and the budget balance.

Question 9

What is deficit financing?

Answer 9

Deliberately running a budget deficit and borrowing to finance the debt.

Question 10

What was the central assumption to Keynesian fiscal policy?

And what is the main issue with this assumption?

Answer 10

The assumption that the government spending multiplier is high. i.e. increasing gov. spending by £10 billion would increase AD and national income by £30 billion.

It is now generally assumed that government multiplier effects are not this high. Many being closer to a multiplier of 1 (i.e. no multiplier).

Question 11

What Keynesian views led to fiscal policy being implemented?

Answer 11

• An unregulated market economy results in unnecessarily low econ. growth and high unemployment.
• A lack of AD (the private sector saves too much and spends too little) can lead the economy to settle into an under-full employment equilibrium.
• Deficit financing can allow the gvoernment to achieve full employment.

Question 12

What is sound finance?

aka fiscal orthodoxy

Answer 12

The belief that governments had a moral duty to balance the budget.

Question 13

When was fiscal orthodoxy overturned?

Answer 13

When Keynesian economics legitimised deficit financing.

Question 14

What is expansionary fiscal policy?

Answer 14

Uses fiscal policy to increase AD and shift the AD curve to the right.

Question 15

Draw a graph of the effects of expansionary fiscal policy.

Answer 15

Question 16

Why does expansionary fiscal policy work (according to Keynesians)?

Answer 16

The equation for AD is:
AD = C + I + G + (X - M).

Increasing government spending will increase AD as there is an injection into the circular flow of income.

Question 17

How do Keynesians look to remove cyclical unemployment?

Answer 17

Increasing the budget deficit by raising levels of government spending and/or cutting taxes.

This expansionary fiscal policy shifts the AD curve rightwards, and a higher equilibrium national income is achieved.

Question 18

What is the free-market argument against Keynesian methods to remove cyclical unemployment?

Answer 18

• The price level will increase, possibly leading to demand-pull inflation.
• Improvements to equilibrium national income are highly dependent on the shape of the SRAS curve.
• The nearer the economy gets to it’s “normal output”, the greater the inflationary effect and the smaller the reflationary effect.
• Once the “normal output” is reached, the effects are purely inflationary.

Question 19

What is contractionary fiscal policy?

Answer 19

Uses fiscal policy to decrease AD and shift AD to the left.

Question 20

Draw a graph demonstrating contractionary fiscal policy.

Answer 20

Question 21

What is discretionary fiscal policy?

Answer 21

Involves making intentional goverment policies to change G, T and the budget deficit to manage levels of AD.

Question 22

Why was discretionary fiscal policy used?

Answer 22

To ‘fine-tune’ the level of AD in the economy.

Gov. taxation, gov. spending and/or the budget deficit were changed to stabilise fluctuations in the economic cycle.

Question 23

Why is a larger government spending multiplier/tax multiplier desirable?

Answer 23

The smaller the increase in public spending needed to bring about a desired increase in national income.

In a similar vein, the larger the tax mulitplier, the smaller the required tax cut to bring about a desired increase in national income.

Question 24

What is crowding out?

Answer 24

A situation in which an increase in government or public-sector spending displaces private-sector spending, with little or no increase in AD.

Question 25

Why does crowding out lead to a small government spending multiplier?

Answer 25

Assuming an economy is producing on it’s PPF, increasing public-sector spending will reduce private-sector spending with little to no improvement in AD.

Question 26

What is the argument against crowding out?

Answer 26

It is almost safe to assume an economy is never producing on it’s PPF as that needs such high levels of productivity.

As a result, crowding out will not occur and the government spending multiplier will be large enough to make an improvement.

Question 27

What is supply-side fiscal policy?

Answer 27

Policies to increase the economy’s ability to produce and supply goods.

Question 28

What are supply-side policies?

Answer 28

Government economic policies which aim to make markets more competitive and efficient.

Question 29

When did demand-side fiscal policy become unfavoured?

Answer 29

Mostly following 1979.

(Revived briefly in 2008 to 2010 to ‘spend the economy out of recession’.)

Question 30

What are the effects of income tax cuts according to demand-side fiscal policy?

Answer 30

Shift the AD curve to the right as there is more money available for people to spend.

Question 31

What are the effects of income tax cuts according to supply-side fiscal policy?

Answer 31

AS is increased as economic incentives are changed.

Question 32

What are the effects of supply-side fiscal policy from an AD AS perspective?

Answer 32

The LRAS will shift rightwards meaning the normal capacity level of output has risen.

Alongside this, supply-side fiscal policy can also cause the SRAS to shift rightwards.

Question 33

Draw the effects of supply-side fiscal policy on LRAS.

Answer 33

Question 33

What are the main types of public expenditure?

Answer 33

• Investment (i.e. new schools, hospital renovations etc.)
• Annual running costs (teacher salaries, electricity in hospitals etc.)
• Transfers (state pension, unemployment benefits)
• Interest payments on national debt.

Question 34

What sector is the biggest portion of total government expenditure?

Answer 34

Social protection, followed by health.

Question 34

What is total managed expenditure?

Answer 34

The total amount that the government spends.

Question 35

Why will the costs of social protection continuously increase?

Answer 35

The number of pensioners is increasing steadily, and the ‘triple lock’ protects pensioners.

Question 36

Why may social protection spending fall or increase?

Answer 36

In economic booms, there are less unemployed so less spending on unemployment related benefits.

In economic recessions, there are more unemployed so more spending on unemployment related benefits.

Question 37

What are transfer payments?

Answer 37

Taxation of one group to redistribute to another.

Question 38

What makes up the majority of social protection?

Answer 38

Transfer payments.

Question 39

What are interest payments directly affected by?

Answer 39

Interest rates set by the BoE.

Question 40

Where does the UK government generate the majority of it’s revenue from?

Answer 40

Income tax, closely followed by VAT and NI contributions.

Question 41

What is income tax?

Answer 41

The UK’s most direct tax, paid on earnings, pensions, benefits, savings and investment income and rents.

Question 42

What is national insurance?

Answer 42

Was started as a rainy-day fund that people could claim from.

It’s now used to finance the NHS and welfare benefits.

Question 43

What type of tax is NI?

Answer 43

A regressive tax.

Question 44

What is a corporation tax?

Answer 44

A tax levied on company profits.

Question 45

What is the rate of corporation tax?

Answer 45

25%.

Question 46

What are the rates of income tax?

Answer 46

20% (~£12.5k to ~£50k)
40% (~£50k to ~£125k)
45% (>~£125k)

Question 47

What are excise duties?

Answer 47

Indirect taxes on the sale and consumption of goods such as alcohol, tobacco and energy.

Question 48

What is stamp duty?

Answer 48

A tax paid on the purchase of a property.

Question 49

What is inheritance tax?

Answer 49

A tax on the wealth of someone who dies at 40%.

Question 50

What is capital gains tax?

Answer 50

A tax levied on the profit a person makes when selling possessions or investments.

Question 51

What is council tax?

Answer 51

A tax charged by local authorities on the value of houses and flats to the people who live in the properties.

Question 52

What is a direct tax?

Answer 52

A tax that cannot be shifted by the person legally liable to pay the tax onto someone else.

Question 53

What is an indirect tax?

Answer 53

A tax that can be shifted by the person legally liable to pay the tax onto someone else.

Question 54

Why was progressive taxation employed?

Answer 54

Mostly under the guise of reducing income inequalities.

Question 55

What is regressive taxation?

Answer 55

When the proportion of income paid in tax falls as income increases.

Question 56

What is proportional taxation?

Answer 56

When the proportion of income paid in tax stays the same as income increases.

Question 57

How, mathematically, can you tell if a tax is regressive, progressive or proportional?

Answer 57

You can examine the relationship between the average rate at which the tax is levied and the marginal rate.

Question 58

What makes a progressive tax, progressive?

Answer 58

The marginal tax rate is higher than the average tax rate.

(i.e. the average rate rises as income increases)

Question 59

What makes a regressive tax, regressive?

Answer 59

The marginal rate of tax is less than the average rate.

(i.e. the average rate falls as income increases)

Question 60

Which of the average tax rate or marginal tax rate have a bigger impact on economic choices?

Answer 60

The marginal tax rate.

Question 61

What are the canons of taxation?

Answer 61

• Economy (a tax should be cheap to collect in relation to revenue gained)
• Convenience and certainty (it should be easy to pay, and taxpayers should roughly know how much they are going to pay)
• Equity (tax system should be fair)
• Efficiency (a tax must have its desired objective(s) with minimal undesired side-effects)
• Flexibility (the tax should be easy to change to meet new circumstances)

Question 62

How is income tax relatively easy to pay (for most?)

Answer 62

Most people are on PAYE taxation.

Employers bear most of the costs as a result.

Question 63

What is an ad valorem tax?

Answer 63

A tax levied on the value of an item.

Question 64

What is the main advantage of taxes on spending?

Answer 64

It can be used to encourage people to change behaviours by making prices higher.

Question 65

Why can indirect taxes become less useful to influence consumer spending?

Answer 65

If more and more goods are taxed at the same rate, people will not have the same incentive to change behaviours as everything is taxed at the same rate.

Question 66

Which of the two canons of taxation prove to conflict?

Answer 66

Efficiency and equity.

Question 67

Why are the canons of efficiency and equity difficult to meet at the same time?

Answer 67

To have an efficient tax system, it must provide greater incentives to work in order to increase the UK’s growth rate.

If you use the taxation system to make the UK more equitable, there is less incentive to work hard and take risks by being entrepreneurial. (aka dependency culture)

Question 68

What do supply-side economists think about income tax and benefit rates?

Answer 68

Generally think they should be cut.
Income tax cuts and benefit cuts would alter the work/leisure choice in favour of supplying labour.

This view thinks increased inequality is a necessary evil to create incentives to facilitate economic growth. i.e. trickle down.
The poor will end up better in absolute terms, but worse in relative terms to the rich.

Question 69

What is the national debt?

Answer 69

The stock of all past government borrowing that has not been paid back.

Question 70

What is the difference between deficit and debt?

Answer 70

Deficits are economic flows.
Debts are economic stocks.

i.e. the deficit can fall, but the debt will continue to grow.

Question 71

What is the cyclical budget deficit?

Answer 71

The part of the budget deficit which rises in the downswing of the economic cycle and falls in the upswing.

Question 72

What is the structural budget deficit?

Answer 72

The part of the budget deficit that is not affected by the economic cycle but results from structural change in the economy.

Question 73

What is counter-cyclical demand management policy?

Answer 73

Contractionary fiscal and/or monetary policy deflated AD in the boom phase of the economic cycle.

Expansionary fiscal and/or monetary policy reflated AD in the recessionary phase of the economic cycle.

This will smooth out the economic cycle had discretionary demand management not been used.

Question 74

What are automatic stabilisers?

Answer 74

Fiscal policy instruments that automatically stimulate AD in an economic upswing and depress AD in an economic downswing. Thereby ‘smoothing’ the economic cycle.

Question 75

What are some examples of automatic stabilisers?

Answer 75

Progressive taxes
Income-related welfare benefits

Question 76

What is the main benefit of automatic stabilisers? (and how does this happen)

Answer 76

It reduces the volatility of the economic cycle.

The multiplier effects within the economy are dampened. If AD falls, national income will also fall. The progressive tax system will take less money from people and the demand-led income-related welfare benefits will spend more. Increased public spending on transfers and declining tax revenues inject more money back into the economy which stabilises and dampens the deflationary impact of the initial fall in AD.

Question 77

What proof is there that automatic stabilisers contributed to milder economic cycles?

Answer 77

In the UK, economic cycles became more mild between 1945 and 1973, where discretionary fiscal policy to manage AD was applied. This also happened in Germany where discretionary fiscal policy to manage AD was not applied.

The main thing in common both countries had were automatic stabilisers.

Question 78

Why do free-market economists argue against Keynesian counter-cyclical demand mangement policies?

Answer 78

• Governments may get it wrong accidentally. (reflating when they should be deflating and vice-versa).
• Governments may also get it wrong deliberately. (in the run up to a GE to win votes)
• If governments get it wrong, the long-run trend rate of growth is likely to fall.
• Leads to a growth in ‘big government’ leading to ‘crowding out’ which stifles the private sector as the public sector grows too big.

Question 79

What is resource crowding out?

Answer 79

When resources used by the government cannot simultaeneously be employed in the private sector.

Question 80

What is financial crowding out?

Answer 80

Public spending has to be financed by either taxation or borrowing.

If the government finances by selling gilts, the annual interest rates on new gilt issues must rise, but the resulting increase in interest rates makes it more expensive to borrow. Private sector investment then falls, and financial crowding out occurs.

In a more simplistic way, by taking money from the private sector in taxation will lead to less private sector investment.

Question 81

Why do free-market economists argue against Keynesian intervention?

Answer 81

They focus on cyclical deficits, which are not all that important. These deficits can be solved by government intervention.

Structural deficits are more important, but also more difficult to solve and free-market economics strives to solve this.

Question 82

Why do some argue that a large national debt is a burden on the economy?

Answer 82

You must differentiate between reproductive national debt and deadweight national debt.

Future generations of taxpayers will have to end up paying interest to pay for borrowing of prior governments.

Long-term borrowing to finance current spending is certainly a burden, as there is no benefit to future generations, and the liability is not offset by any real asset and is therefore a deadweight national debt.

Question 83

Why do some argue that a large national debt is not a burden on the economy?

Answer 83

You must differentiate between reproductive national debt and deadweight national debt.

If a government borrows to finance a project, the liability should be matched by a wealth producing asset (i.e. a motorway, hospital etc.). This reproductive borrowing is not a burden on future generations as interest payments on the debt are basically ‘paid for’ by the motorway’s contribution to national output.

Question 84

How does inflation tie to debt?

Answer 84

If the rate of inflation is greater than the rate at which the budget deficit and borrowing requirement adds to the national debt, then the value of debt as a proportion of nominal GDP falls.

Question 85

What is ‘rolling over’ the national debt?

Answer 85

When a national debt matures, the government must sell new debt in order to raise funds with which to repay the maturing debt.

If there is a budget surplus, they don’t have to sell new debt though.

Question 86

How can rolling over the national debt lead to financial crowding out?

Answer 86

When the government rolls over the national debt, the government may be forced to pay higher nominal interest rates to provide lenders a real return on their savings.

This general rise in interest rates makes it more expensive for firms to borrow. This leads private sector investment to fall, and financial crowding out has taken place.