4.2.5 Fiscal policy and supply-side policies

Question 1

What is fiscal policy?

Answer 1

It involves the manipulation of government spending, taxation and the budget balance in order to manage the economy.

Question 2

What is the aim of fiscal policy?

Answer 2

To stimulate economic growth and stabilise the economy.

Question 3

What does the UK government spend the majority of their budget on?

Answer 3

Pensions and welfare benefits, followed by health and education.

Question 4

What is the biggest source of tax revenue in the UK?

Answer 4

Income tax.

Question 5

What is expansionary fiscal policy?

Answer 5

Fiscal policy aimed at increasing AD, by increasing spending or reducing taxes, leading to a worsening budget deficit

Question 6

What is contractionary/deflationary fiscal policy?

Answer 6

• Fiscal policy aimed at decreasing AD, by cutting spending or raising taxes, reducing consumer spending
• Leads to an improvement of the government budget deficit

Question 7

How can fiscal policy be used to manage AD?

Answer 7

Expansionary or contractionary fiscal policy.

Question 8

What are the consequences of expansionary fiscal policy?

Answer 8

• Cutting taxes can potentially result in a very low multiplier, due to leakages from increased savings (but UK is a spending economy)
• Short term increased budget deficit results in a greater need to issue bonds, potentially needing to raise interest rates to attract investors, increasing debt interest spending, resulting in an opportunity cost of government spending
• Time lags can result in the impact of policy not having the intended effect, such as an increase in exports in a now improved economy potentially becoming inflationary
• Ricardian equivalence means that more government spending today may lead to some citizens realising taxes will increase in the LR, increasing savings, a leakage, but this depends on the quantity of people

Question 9

What does the result of fiscal policy to manage AD depend on?

Answer 9

• The current state of the economy
• What is being spent/cut in terms of taxes
• The current debt to GDP ratio, as cutting taxes is unlikely to be an issue if debt is less than GDP, as GDP will increase from the policy more than the debt from newly issued bonds
• If the deficit is cyclical, as it will sort itself over the economic cycle, or structural, like in the UK

Question 10

What are the consequences of contractionary fiscal policy?

Answer 10

• Increasing taxes can potentially result in a high multiplier, due to spending, and could cause demand-pull inflation
• Short term improved budget deficit results in less need to issue bonds, decreasing debt interest spending, so revenue can be spent elsewhere

Question 11

What would be the Keynesian argument for expansionary fiscal policy?

Answer 11

It will increase AD, leading to more employment and growth, increasing tax revenue and decreasing government spending.

Question 12

How can fiscal policy be used to manage AS?

Answer 12

Supply-side fiscal policy.

Question 13

What is supply-side fiscal policy?

Answer 13

Fiscal policy aiming to boost AS and potential output of the economy.

Question 14

What are examples of supply-side fiscal policy?

Answer 14

• Reducing income and corporation tax to encourage spending and investment
• Subsidising training or spend more on education, lowering costs for firms as they will have to train fewer workers
• Spending on healthcare, which can improve the quality of the labour force, contributing towards higher productivity
• Increasing spending on infrastructure, such as improving roads and schools

Question 15

What is the government debt?

Answer 15

The accumulation of the government deficit over time, and the amount they owe.

Question 16

Why does the government tax?

Answer 16

• To create revenue to provide public goods and services, and merit goods to increase consumption
• To decrease consumption of demerit goods
• To redistribute income/wealth
• To manage the economy using AD
• To attempt to balance the budget

Question 17

What are direct taxes?

Answer 17

• Taxes imposed on income and are paid directly to the government from the tax payer, so it cannot be passed on
• Examples include income tax, corporation tax, NICs and inheritance tax

Question 18

What are indirect taxes?

Answer 18

Taxes imposed on expenditure on goods and services, increasing production costs for producers, increasing market prices.

Question 19

What are the two types of indirect taxes?

Answer 19

• Ad valorem taxes are percentages, such as VAT, adding 20% of the unit price, and is the main indirect tax in the UK
• Specific taxes are a set tax per unit, such as the 58p per litre fuel duty on unleaded petrol

Question 20

What are proportional taxes?

Answer 20

• Taxes with a fixed rate for all tax payers, so the marginal rate of tax is constant, which could encourage people to earn higher incomes
• The incidence of taxes is equal, regardless of the ability of the taxpayer to pay

Question 21

What are progressive taxes?

Answer 21

• Taxes that increase in the average rate as income increases, so as income increases, the proportion of income taxed increases, such as income tax in the UK
• Help to reduce inequality as those on lower incomes pay less, as it is based on the payer’s ability to pay

Question 22

What are regressive taxes?

Answer 22

• Taxes unrelated to income, but mean that those on lowest incomes have a higher average rate of tax, so the proportion of income paid as tax is higher for those on lower incomes than those on higher incomes
• Lead to a less equitable distribution of income

Question 23

What would be an example of a proportional tax?

Answer 23

A constant income tax rate of 20% for all taxpayers.

Question 24

What would be an example of a progressive tax?

Answer 24

Direct taxes, such as income and corporation tax.

Question 25

What would be an example of a regressive tax?

Answer 25

Indirect taxes, such as VAT or council tax.

Question 26

Describe the Laffer curve.

Answer 26

As the tax rate increases from 0%, tax revenue increases up to the tax rate t*, then tax revenue decreases as tax rate increases further to 100%.

Question 27

What are the reasons for tax revenue falling when tax rate increases shown by the Laffer curve?

Answer 27

- Increased tax avoidance/evasion - Disincentives to work - ‘Brain drain’, as high income earners leave the country

Question 28

What are the principles of taxation?

Answer 28

- Economical - the cost of collecting the tax must be low relative to the yield - Clear - the timing and quantity paid must be obvious to the tax payer - Convenient - the timing and way of paying must be convenient for the tax payer - Equitable - taxes should be imposed depending on the ability to pay - Efficient - the tax should not limit efficiency and there should only be a minimum loss of efficiency - Compatible - tax should be compatible with tax systems of other countries, such as the UK and the rest of Europe - Flexible - taxes should adjust with inflation and be easy to change

Question 29

What are limitations of fiscal policy?

Answer 29

- Governments may have imperfect information about the economy, leading to inefficient spending - Significant time lags involved with employing fiscal policy can lead to unintended effects - Crowding out resulting from borrowing from the private sector leaving fewer funds available for the public sector, as interest rates increase to attract buyers, decreasing private investment - The bigger the size of the multiplier, the bigger the effect on AD and the more effective the policy - If interest rates are high, fiscal policy might not be effective for increasing demand, as saving might increase - There could be difficulties paying back the debt if the government spends too much, making it difficult to borrow in the future