4.5 - Public Sector finances

Question 1

Automatic stabilisers

Answer 1

These are automatic fiscal changes as the economy moves through stages of the business/trade cycle

Question 2

Explain how government spending and taxation are automatic
stabilisers.

Answer 2

• In a recession, benefits increase as more people are unemployed and so
  the benefits are a stabiliser as it means that the overall fall in AD is reduced, preventing too much change in the economy.
• On the other hand, during a boom, tax
  increases as people have more jobs and higher incomes, and this tax reduces disposable income so decreases consumption and AD, meaning that demand
  doesn’t grow too high.

Question 3

Evaluate automatic stabilisers

Answer 3

• These automatic stabilisers cannot prevent fluctuations; they simply reduce the
  size of these problem
• Negative aspects to automatic stabilisers:
  > Benefits may act as a disincentive to work and lead to higher unemployment
  > High levels of tax can decrease the incentive to work hard

Question 4

Discretionary fiscal policy

Answer 4

• A demand-side policy that uses government spending and taxation policy to influence aggregate demand (AD)
  and influence the economy; expansionary and deflationary
  policies.

Question 5

fiscal deficit

Answer 5

Occurs when the level of government spending is greater than the government tax revenue in any given year

Question 6

national debt

Answer 6

Accumulated budget deficits overtime. It is debt owed by the government to those who hold government bonds.

Question 7

Cyclical deficits

Answer 7

• Occur due to downturns in the business/trade cycle, usually as a result of a recession
  > Government spending
  and tax fluctuates around the trade cycle:
  > Governments receive less tax revenue as profits and income fall - and government spending increases
  > These deficits tend to self-correct as the economy starts to grow again

Question 8

Structural deficits

Answer 8

• Are long run deficits which occur regardless of the state of the economy
• they may be present even when an economy may be operating at the full employment level of output/in a boom
• These deficits are difficult to correct

Question 9

What might structural deficits be caused by?

Answer 9

These deficits may be caused by a widespread tax avoidance culture, or poor governance

Question 10

Factors influencing the size of fiscal deficits:

Answer 10

• State of the economy
  > Government revenue often increases in a boom and decreases in a recession.
  > Government spending often decreases in a boom and increases in a recession.
  > Fiscal deficits tend to increase as the state of the economy worsens
• Housing Market
  > The government receives an indirect tax from property sales (stamp duty).
  > This revenue increases when an economy is doing well and helps to reduce fiscal deficits
• Political priorities
  > If political priorities change then the size of the fiscal deficit can change e.g. after the UK Government has spent billions in rescuing the economy after the Global Financial Crisis of 2008 they prioritised austerity with the focus of eliminating the deficit
• Unforeseen events
  > such as natural disasters or recessions, lead to huge increases
  in spending which increase the deficit.
  > e.g. The Russian war on Ukraine started in February 2022 and by June 2022 the UK Government had spent £2.8 bn. in providing assistance (it is worth noting that much of this went to the UK military industry to pay for weapons which were donated to the Ukraine. This increased UK GDP)
• Interest rates
  > If interest rates on government debt
  increase, the amount the government pays in interest repayments increases and this
  is likely to increase the deficit.
  > The impact of this will depend on how significant
  interest repayments are in the size of the deficit. Interest rates depend on market rates and the credit ratings of the government.
  > 7% of all UK government spending is
  on interest repayments of loans.
• privatisation
  > provide one-off payments to the government which will
  decrease the deficit in the short term; it will depend on the value of the company sold.
• Factors such as the number of dependents in a country affect both spending and
  tax revenues so influence the deficit.
• Trade cycle
  > During a downturn, government tax
  revenue decreases whilst government spending increases and so the deficit increases

Question 11

Factors influencing the size of national debts

Answer 11

• Size of fiscal deficits
  > As national debt is the accumulation of annual fiscal deficits, the size of the fiscal deficit each year will grow by the size of the deficit
  > If the UK were to run a budget surplus in any year, this additional revenue could be used to pay back some of the debt > or it may be used to fund government spending or investment in the following year
• Government policies
  > These directly impact tax revenue and government spending which can change the level of the fiscal deficit leading to a change in the national debt level
  > E.g. Reducing corporation tax during a boom in the economy will reduce government revenue and possibly increase the deficit and national debt at a time when the deficit would naturally be decreasing due to the automatic stabilisers
• Ageing populations tend to contribute to a high national debt since the government runs a structural deficit in order to fund their pensions and care and this leads to a
  high national debt.

Question 12

The Significance of the Size of Deficits & National Debts
> The size of the deficits and national debt can influence multiple factors in an economy
> These factors tend to be more long-term in nature and can have significant repercussions should the level of national debt become unsustainable

Answer 12

• Interest rates:
  > The higher the level of a country’s Government debt as a proportion of GDP, the more concerned global lenders will be to continue lending to fund future deficits.
  > This may require the country to raise interest rates to entice lenders to make their money available to the country’s government
  > Higher risk means higher reward mecessary
• Debt servicing:
  > there is an opportunity cost to paying back debt and debt interest.
  > The higher the debt, the greater the opportunity cost
  > e.g. every £ spent on paying back interest could have been spent on education improvements instead
• Inter-generational equity: > today’s borrowing has to be paid back from tax revenue received from future generations.
  > The greater the debt, the greater the burden on the next generation of tax payers
• Rate of inflation:
  > Inflation reduces purchasing power (which is bad) but at the same time it allows the UK Government to pay back lenders with money worth less than when it was originally borrowed
• Nation’s credit rating:
  > Standard and Poor’s is a credit rating agency based in the USA who provides credit ratings for different Nations.
  > Investors use this to guide their lending.
  > Countries with a good credit rating will be able to borrow funds at a lower interest rate
  > Lower credit ratings mean that lending to the
  government is riskier and so higher interest rates are demanded from lenders.
  > However, in reality, it is not the size of the debt that influences the level of risk involved with the lending the money, it is whether that country has ever defaulted on
  their loans before and their current economic/political climate.
• Foreign direct investment (FDI):
  > the higher the level of external debt, the more foreign currency is required by the Government to pay it (e.g. UK borrowing from the USA in US$ needs to be repaid in US$).
  > Countries may run short of foreign currency and one way to obtain more is to make foreign direct investment more attractive.
  > This means more assets are being sold but it does bring in more foreign currency which can be used to facilitate repayments

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Question 13

Benefit of government borrowing

Answer 13

• On the other hand, government borrowing can benefit growth if it used for capital
  spending since this will improve the supply side of the economy and thus reduce the
  deficit in the long term.
• On top of this, the budget deficit can be used as a tool for
  short term demand management: Keynesians argue a deficit is acceptable to use as
  a stimulus in demand during recessions.