4.5

Question 1

Explain and give examples of the following types of public expenditure

Answer 1

Capital expenditure
Spending on investment goods
New motorways, schools, hospitals, street lights, etc.
Items that are consumed over a period of time longer than a year

Current expenditure
Spending on goods and services that are consumed in a short period of time
Wages, heating, road grit

Transfer payments
Payments by government for which there is no corresponding output
Welfare payments – e.g. state pensions, child benefit

Question 2

Microeconomic failure as a reason for government expenditure

Answer 2

Capital expenditure
Spending on investment goods
New motorways, schools, hospitals, street lights, etc.
Items that are consumed over a period of time longer than a year

Question 3

Macroeconomic failure as a reason for government failure

Answer 3

Economic cycle
Without government spending the effect of a recession may be longer lasting
Spending forms part of expansionary fiscal policy
Inequality
Left to the market the level of inequality may be too high
Government spending is one element (along with taxation) of redistributing income and wealth from richer to poorer

Question 4

Reasons for changing size of public expenditure
Level of GDP

Answer 4

LEDC vs. MEDC
Lower income countries lack the tax base to raise revenues to pay for government spending
Collection of taxes requires sophisticated administration by government departments
Lower income countries tend not to have as well developed government institutions

Question 5

Reasons for changing size of public expenditure
Demand for public services

Answer 5

Increases in demand for healthcare, education, etc. will increase the need for government to fund them
This may have come from increasing population sizes and ageing populations

Question 6

Reasons for changing size of public expenditure
Size and age distribution of the population

Answer 6

Ageing populations-
Greater number of dependent people puts greater strain on public finances
Greater spending on state pensions
Greater need for medical provision

Question 7

Reasons for changing size of public expenditure
Trade cycle (economic cycle)

Answer 7

Cyclical reasons
Greater need to spend on unemployment benefit during a recession
Extra spending may be automatic rather than discretionary
A discretionary fiscal stimulus (expansionary fiscal policy) might be used to help get out of recession
E.g. UK response to global financial crisis in 2008

Question 8

Reasons for changing size of public expenditure interest on the national debt

Answer 8

Historic budget deficits requires borrowing which creates debt
As the level of national debt rises, the size of interest payments will increase
Larger debt also requires higher interest rates which compounds the higher interest rate payments

Question 9

Reasons for changing size of public expenditure interest on
rate of inflation

Answer 9

High levels of inflation requires large increases in nominal spending to prevent spending from falling in real terms
Governments can cut spending in real terms by freezing spending or increasing it at a rate lower than inflation

Question 10

Reasons for changing size of public expenditure interest on
political priorities

Answer 10

Free market vs. interventionist governments
Countries that are more market oriented tend to have smaller levels of public spending
US – spending is approx. 40% of GDP
Finland – spending is approx. 60% of GDP
Changing political parties after an election may cause a change within a country
E.g. labour vs. conservative in UK

Question 11

Explain the level of public expenditure might affect the following
Productivity and growth + evaluation

Answer 11

Free market view:
Public spending is wasteful and inefficient compared to private sector spending
Cutting public spending should increase productivity and growth if it encourages private sector spending
However:
Public spending provides infrastructure for trade
High quality education improves human capital
Comprehensive healthcare reduces ill-health
Regional spending in depressed areas can boost GDP
Benefits can be used as a positive incentive to work

Question 12

Explain the level of public expenditure might affect Living standards +evaluation

Answer 12

Government spending can help avert absolute poverty, increasing living standards for the poorest in society
Spending can help redistribute resources to make the quality of life across society more evenly balanced
Provision of public sector services like refuse collection and policing may enhance living standards for all in society
However:
Government can be inefficient and wasteful due to the lack of profit incentive
Inefficiencies could reduce living standards
Disincentive effects of tax and benefits might outweigh their benefits
However, Nordic countries tax and spend more but do not have a major disincentive problem
Individuals are best placed to make decisions about how their money should be spent
But, information gaps and negative externalities may undermine this argument

Question 13

Explain the level of public expenditure might affect level of taxation + evaluation

Answer 13

High levels of government spending require high levels of taxation
High tax levels can create a disincentive effect on individuals and firms
However:
Scandinavian countries have relatively high spending and taxation without major disincentive effects
High levels of spending can be possible without high taxation – e.g. oil rich countries
ev

Question 14

Explain the level of public expenditure might affect crowding out +evaluation

Answer 14

At full employment, there is a trade off between public and private sector spending – so each £1 spent by government is £1 less that can be spent by the private sector
Greater borrowing by governments may lead to financial crowding out
The higher interest rates discourage private sector consumption and investment
However
Transfer payments – providing a state pension which is paid for by workers’ taxation just shifts spending from workers to pensioners – the total amount of private sector spending may not change
Unemployment – spending to boost aggregate demand when there is spare capacity could lead to crowding in
Government’s spending increases private sector spending through the multiplier effect
Capital spending – government spending which increases the productive capacity of an economy may increase both private and public sector spending

Question 15

Explain the level of public expenditure might affect equality

Answer 15

Government spending can be used to help redistribute income and wealth in the economy
If governments use spending to provide funds that reach poorer sections of society, then this can close the gap between rich and poor (especially if combined with taxation which is targeted more towards those better off)
E.g. spending on most social protection will be disproportionately received by poorer households

Question 16

4 reasons for taxation

Answer 16

To pay for government expenditure
In the short run, borrowing can pay for expenditure, but in the long run taxation must cover spending
To correct market failure
Increasing resource allocation through taxation of, e.g., tobacco, alcohol, etc.
To manage the economy
Tax rates can be used to influence unemployment, inflation, etc.
To redistribute income
Taxing different groups of people at different rates may redistribute income in the economy

Question 17

Explain the impact of progressive taxation on equality

Answer 17

Increased income equality
Greater redistribution effect - especially if used to target higher earners
Can be combined with spending policies that target the poorer in society
Evaluation
Depends on how tax revenues are used and whether other fiscal changes offset the impact of the higher marginal tax rate.

Question 18

Explain the impact of progressive taxation on incentives to work

Answer 18

Could act as a disincentive to take higher paid jobs
Negative impact on the supply-side of the economy
Evaluation - Workers may work harder to maintain standard of living - higher paid jobs need to work more hours to protect net income levels
Lower taxation on the poorest may increase the incentive to take paid jobs for the unemployed

Question 19

Explain the impact of progressive taxation on tax revenues

Answer 19

Raising of tax should raise the tax rev
could be used as a part of an objective of reducing the budget deficit
Evaluation - Depends on at what rate tax revs are maximised
Laffer curve analysis - depend on the position along the curve
Also depends on overall impact to AD and growth

Question 20

Explain the impact of progressive taxation on AD

Answer 20

Stimulus to aggregate demand
Redistribution from rich to poor could lead to greater spending due to higher marginal propensity to consume for poorer households
Evaluation
Impact may be undermined by tax avoidance/evasion
If greater progressive taxation is associated with greater tax levels generally then this creates a larger withdrawal from the circular flow - i.e. reducing AD

Question 21

Impact of taxation on the trade balance

Answer 21

A rise in taxes on households will reduce disposable income and therefore levels of consumption
This means less spending on imports, improving the balance of trade
Evaluation
If the drop in aggregate demand leads to spare capacity, there may be a subsequent fall in investment
This could harm the long run competitiveness of domestic firms which could worsen the trade balance

Question 22

Impact of taxation on FDI

Answer 22

FDI is investment by a foreign company where they acquire an interest in a domestic company
Countries compete to attract FDI because of its positive impact on employment and output
One way to attract FDI is to lower corporation tax
Evaluation
Can lead to a race to the bottom – if all countries lower their corporation taxes then it simply leads to a lowering of tax revenues

Question 23

What is the impact of taxes on aggregate supply?

Answer 23

A rise in taxes like VAT, excise duties and Employers’ National Insurance contributions raise costs to firms
The rise in costs leads to a fall in SRAS
A fall in real output, fall in employment (rise in unemployment), rise in the price level
Increase in UK VAT from 15% to 17.5% in 2010 helps to explain significant rise in UK inflation rate at this time
Evaluation
Economic impact may be offset by tax cuts elsewhere or spending by government
Impact on inflation rate will be temporary – after 12 months it will have worked its way through

Question 24

Define cyclical and structural deficit

Answer 24

Cyclical Deficit
Occurs because government spending and revenues fluctuate through the economic cycle
In a boom a surplus should be seen – greater tax receipts and fewer benefits paid out as more are employed
In a recession this is reversed, creating a deficit
Structural Deficit
Occurs when the cyclical deficit is zero at the top of a boom
If an economy goes through a full economic cycle and stays in deficit throughout, then it has a structural deficit

Actual deficit = cyclical deficit + structural deficit

Question 25

Factors Influencing The Size of Fiscal Deficits - Cyclical reasons

Answer 25

Cyclical Reasons
As the economy moves into a recession tax receipts decline as the number of people employed falls and government spending rises to pay for their benefits
These changes happen automatically without the government making passing new laws or budgets – referred to as automatic stabilisers
Other factors associated with recessions, like falling levels of house sales, may reduce other forms of tax revenue (e.g. stamp duty)

Question 26

Factors Influencing The Size of Fiscal Deficits - structural reasons

Answer 26

High levels of tax avoidance/evasion (Greece), demographic pressures eg aging population, government inefficiency, high levels of subsidies/financial support

Question 27

Factors Influencing The Size of Fiscal Deficits - exogenous shocks

Answer 27

unforeseen, external shocks may cause a deficit

Question 28

Factors Influencing The Size of Fiscal Deficits-
Debt interest

Answer 28

Larger the debt interest, more that must be paid

Question 29

Factors Influencing The Size of Fiscal Deficits -
Keynesian fiscal deficits

Answer 29

Gov may choose to conduct expansionary fiscal policy to boost the economy. This is discretionary spending- choice not automatic

Question 30

3 possible measures that might reduce fiscal deficits and national debts

Answer 30

Austerity measures - Reduce gov spending, increase tax rates
But will cause a withdrawal (reduction of AD) which could worsen the budget balance

Grow the economy, using expansionary policy (monetary or fiscal)
But depends which one - fiscal will originally worsen budget balance

Debt reduction by paying it back
But decrease in gov spending and increase taxes to do so - withdrawal evaluation