4.2.5.1 fiscal policy

Question 1

what is fiscal policy?

Answer 1

any policy relating to the manipulation of government spending, taxation and the budget balance/borrowing

• government-led
• it can have both macroeconomic and microeconomic functions
  -> can be used to influence both AD and AS

Question 2

what does fiscal policy aim to do?

Answer 2

to stimulate economic growth and stabilise the economy

Question 3

what does the government spend their budget on in the UK?
and what is the biggest source of tax revenue in the UK?

Answer 3

most of their budget is spent on pensions and welfare benefits
- followed by health and education

• income tax is the biggest source of tax revenue in the UK

Question 4

what does expansionary fiscal policy do?

Answer 4

• this aims to increase AD
• governments increase spending or reduce taxes to do this
• leads to a worsening of the government budget deficit
• may mean governments have to borrow more to finance this
• borrowing

Question 5

what is the diagram for expansionary fiscal policy?

Answer 5

Question 6

what does deflationary fiscal policy do?

Answer 6

• aims to decrease aggregate demand
• governments cut spending or raise taxes which reduces consumer spending
• leads to an improvement of the government budget deficit
• reducing borrowing

Question 7

what are the fiscal policy goals?

Answer 7

• keep inflation on target (2%)
• stimulate economic growth and employment whilst maintaining a stable economic cycle
• tackle market failure
• provide a welfare state
  -> everyone has access, ie) NHS
• improve competitiveness
• redistribute income and wealth

Question 8

how do you show deflationary fiscal policy on a diagram?

Answer 8

Question 9

how can fiscal policy be used to influence AS?

Answer 9

the gov could:
- reduce income and corporation tax to encourage spending and investment
- subsidise training or spend more on eduction
-> this lowers the costs for firms, as they have to train less workers
-> more ££ on healthcare helps improve the quality of the labour force and contributes towards higher productivity
- spend more on infrastructure like improving roads / schools

Question 10

when does the government have a budget deficit?

Answer 10

when expenditure exceeds tax receipts in a financial year

Question 11

when does the government have a budget surplus?

Answer 11

when tax receipts exceed expenditure

Question 12

what is the difference between the government debt and the government deficit?

Answer 12

debt
= the accumulation of the government deficit over time
-> is the amount the government owes

deficit or surplus
= the difference between expenditure and revenue at any one point

Question 13

what are direct taxes?

Answer 13

• imposed on income and are paid directly to the government from the tax payer
• consumers and firms are responsible for paying the whole tax to the government
  eg) income tax, corporation tax, NICs, inheritance tax

Question 14

what are indirect taxes?

Answer 14

• imposed on expenditure on goods and services
• they increase production costs for producers
• this increases market price and demand contracts

Question 15

there are two types of indirect tax
what are they?

Answer 15

1) ad valorem
- taxes are percentages
-> such as VAT, adds 20% of the unit price (main indirect tax in UK)

2) specific taxes
- a set tax per unit
-> such as the 58p per litre fuel duty on unleaded petrol

Question 16

what is a proportional tax?

Answer 16

• has a fixed rate for all tax payers, regardless of income
• also called a flat tax
• eg) all tax payers might have to pay 20% income tax rate
• incidence of taxes is equal regardless of the ability of the taxpayer to pay
• could encourage people to earn higher incomes because the rate of tax paid does not increase

Question 17

what is a progressive tax?

Answer 17

• has an increase in the average rate of tax as income increases
• as income increases, the proportion of income taxed increases
  eg) in the UK income tax is progressive
• ppl have a personal allowance of £10,600 where tax isn’t paid
• for incomes below £31,785 people only pay the basic rate of 20%
• for incomes £31,786 to £150,000 people pay the higher rate of 40%
• above this, a 45% rate is paid
• this should help reduce inequality, because those on lower incomes pay less tax
• the tax is based on payer’s ability to pay
• higher income households are more able to pay higher rates of tax than lower income households
• so generally, direct taxes are more progressive

Question 18

what’s a regressive tax?

Answer 18

• doesn’t relate to income
• means those on lowest incomes have a higher average rate of tax
• ie) the proportion of income paid as tax is higher for those on lower incomes than those on higher incomes

eg) as a % of income, the London Congestion Charge and Council Taxes are higher for those on lower incomes
- this leads to a less equitable distribution of income
- generally, indirect taxes are more regressive

Question 19

what are some limitations of fiscal policy?

Answer 19

• governments might have imperfect info about the economy
  -> could lead to inefficient spending
• there’s a significant time lag involved with employing fiscal policy
  -> could take months/years to have an effect
• if the government borrows from the private sector
  -> there are fewer funds available for the private sector, which could lead to crowding out
• if 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
• if the gov spends too much, there could be difficulties paying back the debt, which could make it difficult to borrow in the future

Question 20

what is the current government expenditure?

Answer 20

• is spending which recurs
• this is on goods and services which are consumed and last for a short period of time
  eg) could be on drugs for the health service

Question 21

what is capital government expenditure?

Answer 21

• spent on assets
• can be used multiple times
  eg) could be government expenditure on roads or building a school

Question 22

what are transfer payments?

Answer 22

• welfare payments from the government
• aim to provide a minimum standard of living for those on low incomes
• no goods/services are exchanged for transfer payments

eg:
- job seeker’s allowance
- income support
- child benefit
- the state pension

Question 23

why are these transfer payments in place?

Answer 23

• to ensure people have a basic standard of living and to help reduce the level of inequality in society
• they are a means for the government to redistribute income from the rich to the poor

Question 24

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

Answer 24

• in the UK the gov spends most of the budget on pensions and welfare benefits, followed by health and eduction
• income tax = biggest source of tax revenue in the UK
• eduction spending in the UK has remained relatively constant
• this is because it’s protected so doesn’t fall but doesn’t increase much either
• social security payments are payments from the government to assist those who have low incomes
• after the war, people saw this as necessary, so there’s been a general increase in spending
• defence spending in the UK is falling
• this is the area of the government spends least on

Question 25

what is the significance of differing levels of public expenditure as a proportion of GDP on productivity and growth?

Answer 25

• governments can spend money on supply-side policies to improve human capital and boost long run growth
• human capital is important for competitiveness
• the gov could invest in youth apprentice schemes
  eg) to make ppl more employable and productive from a young age
• education and training can mean higher value products can be made and productivity can be improved
• fiscal policy aims to stimulate economic growth and stabilise the economy
• the gov could influence the size of the circular flow by changing the budget, and spending and taxes can be targeted in areas which been stimulating

Question 26

what is the significance of differing levels of public expenditure as a proportion of GDP on crowding out?

Answer 26

• governments might have to fund its spending using taxes or running a budget deficit
• 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
• when the gov borrows a lot of money, interest rates might increase
  -> this discourages spending and investment among the private sector
• this reduction in private sector investment is the ‘crowding out’ of investment
• sometimes, crowding out refers to the gov provision of a good or service which would otherwise be provided by the probate sector

Question 27

what is the significance of differing levels of public expenditure as a proportion of GDP on level of taxation?

Answer 27

• the tax rate might increase if gov debt gets too high
• if confidence is lost in the gov’s ability to repay the debt, gov’s 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 uncontrollable
• in the UK the size of gov spending is about 40% of GDP
• this means that citizens in the UK have a lower tax burden than in a country such as Switzerland, where gov spending is 60% of GDP

Question 28

what is the significance of differing levels of public expenditure as a proportion of GDP on equality and living standards?

Answer 28

• progressive taxes could be used to reduce inequality, since the poorest in society pay the smallest proportion of their income as tax
• redistributive policies and welfare payments could be used to help those on lowest incomes (eg income support)
• gov spending on housing and the provision of public services helps provide equal opportunities for people from all income backgrounds
  (eg education and healthcare)
• by providing these, the gov ensures that all members of society can achieve a minimum standard of living

Question 29

what is national debt?

Answer 29

the accumulation of the government deficit over time
- amount the government owes

Question 30

what happens if the gov continuously run a deficit?

Answer 30

the size of the debt will increase

Question 31

what happens if the gov reduces the size of their deficit?

Answer 31

the rate of increase of the total debt is slower but the debt is still increasing

Question 32

what happens when the gov run a budget surplus?

Answer 32

the size of the national debt decreases

Question 33

what is a cyclical deficit?

Answer 33

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

Question 34

what is a structural deficit?

Answer 34

a deficit due to an imbalance in the revenue and expenditure of the government
- so it exists at every point in the business/economic cycle

Question 35

what are the consequences of budget deficits on surpluses for macroeconomic performance?

Answer 35

• a fiscal deficit could be inflationary if it increases AD
• more gov spending could lead to crowding out of the private sector
  -> this leaves fewer funds in the private sector for firms to use, since the gov is borrowing money, which crowds them out of the market
• could lead to increased interest rates
  -> due to the gov having to offer investors an attractive rate in order to encourage them to buy the debt

Question 36

what is the significance of the size of the national debt?

Answer 36

• the cost of borrowing could increase, since the borrowing money, the gov is increasing demand for credit in the economy
• if confidence is lost in the gov’s ability to repay the debt
  -> govs might have to raise interest rates to encourage investors to buy bonds, so they can finance the debt
• could lead to higher taxes and austerity measures, especially if the debt becomes uncontrollable

Question 37

what is the role of the Office for Budget Responsibility?

Answer 37

OBR
- provides analysis of the UK’s finances
- produce 5yr forecasts for the economy
-> including impact of tax and spending changes announced in the Budget
- judge the gov’s performance against its fiscal targets
-> to balance the budget 5yrs ahead
-> have net public sector debt falling in 2015-2016
- assess the likelihood of the gov meeting the targets

• scrutinise tax and welfare spending measures
• assess how sustainable public sector finances are in the long run

Question 38

what are some arguments for running a balanced budget?

Answer 38

• reduction of interest payments
• reduce the borrowing requirement
• high debt threatens confidence, stability and recovery
• credibility in financial markets
• avoid higher future taxes - inequitable for furniture gens
• reduction of the tax burdened in the long term once deficit paid off
• crowding out effect of large deficits

Question 39

what are the arguments for borrowing and maintaining a deficit?

Answer 39

• low interest rates mean crucial infrastructure projects can be put into place - but interest rates are rising
• the need to boost economic growth
• sensible policies are self-financing because they generate tax revenue
• improves the supply side of the economy
• external shocks