4.5 Role Of The State In Macroeconomy

Question 1

What are the different types of expenditure?

Answer 1

Capital government expenditure- long term gov spending- Investments in infrastructure and capital equipment E.G new roads, schools, hospital’s

Current government expenditure- These include the daily payments required to run the government & public sector. E.g. The wages & salaries of public employees such as teachers, police, members of parliament, military personnel, judges, dentists etc. It also includes payments for goods/services such as medicines for the NH

Transfer Payments- Payments made by the government for which no goods/services are exchanged. E.g. Unemployment benefits, disability payments, subsidies to producers & consumers etc. This type of government spending does not contribute to GDP as income is only transferred from one group of people to another

Question 2

What are the factors affecting the size & composition of public expenditure?

Answer 2

CHANGING INCOMES-

Countries with low incomes have low tax revenue leading to low government expenditure. As incomes in an economy increase, government tax revenues increase which allows them to increase their expenditure

As incomes increase, citizens demand a higher quantity & quality of government services (which are very income elastic) - e.g. library services, cleaner coastal waters, better recycling facilities

CHANGING AGE DISTRIBUTIONS-

Many developed countries have had lower birth rates for decades creating a situation where there is now a large & growing ageing population

Life expectancy has also increased due to advances in medicine & nutrition

This means that government spending on pension payments & healthcare will increase to support this elderly population

CHANGING EXPECTATIONS-

As societal norms change, expectations change & this puts pressure on governments to change the substance & delivery mechanism of many of their services. This often results in increased spending e.g. NHS patients wanted online access to their medical records & the Government had to spend significant sums on creating the platform to do that

GLOBAL FINANCIAL CRISIS OF 2008-

UK Government borrowing increased significantly in order to facilitate the government spending required to avoid a long-lasting depression

This borrowing had to be repaid (with interest) & in the years following the crisis, the UK government cut their expenditure & raised taxes (austerity)

Question 3

What is the significance of the level of public expenditure as a proportion of GDP?

Answer 3

The size of gov spending as a proportion of GDP varies:

2020, it accounted for 51.44% of Sweden’s GDP, 40% of the UK’s GDP, & 25.37% of Thailand’s GDP

PUBLIC EXPENDITURE BENEFITS:

Improvements to the supply-side of the economy through expenditure on infrastructure, health, education etc.

It improves the equality of opportunity e.g. education for all children

It raises the standards of living for all e.g. development of parks, libraries etc

It reduces poverty & decreases inequality in the distribution of income

It increases economic growth

It drives innovation by providing long-term seed funding for firms & investing in applied research (some estimates say that global innovation has in the majority been created by public sector funding e.g. the mission to put a man on the moon or the need to keep a soldier safe in a particular scenario)

DRAWBACKS:

It can have a negative impact on productivity & long-term growth as without a profit incentive the urgency of labour diminishes & resources are used more inefficiently

It creates opportunity for corruption which can actually decrease the standard of living

If the government is running a budget deficit they will need to borrow funds from the private sector. This can create a crowding out

It may require taxation levels to increase in order to pay for the expenditure

If the spending is not spread evenly throughout different regions of the country, it can create inequality of opportunity e.g. the North/South divide in the UK

Question 4

What is the impact of public expenditure on productivity and growth?

Answer 4

Free market economists- gov spending is wasteful and cause inefficiency. FM= profit motive whereas Gov has a social welfare. However, the government is able to enjoy EOS when it provides goods= improves productivity. Gov provide the, roads, necessary for the economy to run efficiently.

Education creates human capital necessary for growth whilst healthcare system reduces number of days workers lose from serious illness. Spending on research and development may not be done by the private sector and the government will undertake it to give businesses a long term competitive edge.

Keynesians- for gov intervention- multiplier effect. Higher growth and lower unemployment

Question 5

What is the impact of public expenditure on living standards?

Answer 5

Government spending can cause large improvements in living standards- GOV corrects market failure -provides public goods =improves social welfare.

They reduce absolute poverty - providing benefits and basic goods - education and healthcare. In developing countries, GOV do not have the resources = leads to malnutrition, poor water etc.

There is some debate about how much the government can contribute to improved living standards. It is argued gov will be inefficient at providing goods and services and will have a negative disincentive impact on workers, meaning that output overall is reduced and so living standards fall.

Government suffers from the principal agent problem since they make decisions on behalf of the people and individuals may have spent that money differently= there is a loss in welfare =fall in living standards. However, the political system means that society decides the government and so therefore decides to an extent where it would like money to be spent.

Question 6

What is crowding out with evaluation?

Answer 6

Crowding out is a classical economist theory- good eval point for gov spending

DEF- When increased public sector spending leads to less private sector spending

If the government borrows from the private sector, there are fewer funds available for the private sector, which could lead to crowding out- excessive gov borrowing increases the demand for loanable funds in the market - pushing up equilibrium I/R making it more £££ for firms finance investment projects and reach their hurdle= reduce investment in the economy harming both s/r and l/r econ growth

For Gov to spend money above their tax rev- gov has to borrow from individuals and businesses. However the amount of money in the economy available to borrow doesn’t increase. Gov will thus be competing with private sector for finance= higher I/R= discourage firms from investing and individuals from buying on credit. This therefore will reduce both short run econ growth and Long run- reducing AD, LRAS, Productive potential

Limited number of resources in the economy = every resource used in gov spending- less resources available for private sector – the result is that gov borrowing crowds out private sector- may lead to no increases in AD

FM economists- investment is more efficient If done by the private sector- gov targets investment poorly

Crowding out is felt most at full employment but not always the case. Transfer payments may have no impact on output – wouldn’t cause crowding out as resources are taken from one group and given to another. When U/E is high – extra gov spending could lead to crowding in where it encourages investment through the multiplier

Keynesians don’t agree with crowding out

Incomes inc proportion of gov spending inc

EVAL:

Bond yield at all time low- crowding out is unlikely

Depends on degree of spare capacity. Well targeted, timely stimulus spending can absorb under-utilised capacitycrowding in- Keynesian multiplier

Future tax payers burdened with tax in l/r. May reduce incentives to work

Demand pull inflation and overheating- depends upon spare capacity, inelastic or elastic

Bond yields are low- reality and likelihood of crowding out is slim

Just a theory may not work in presence

Probability of crowding out is low with lots of spare capacity

Keynesian economists counter that well-targeted and timely stimulus spending helps to support growth, output, jobs and competitiveness. Indeed higher government spending can be partially self-financing and an important policy option when private demand is depressed

Question 7

What is the Laffer Curve?

Answer 7

It shows that if you raise taxes on the rich to the point where total revenue decreases as tax rate increases.

higher income tax = disincentive for workers to work for higher incomes as heavily taxed. The income effect becomes negative whereby workers work -earn less to reach satisfactory income = reducing income tax revenue. Higher taxes promotes tax evasion/ avoidance and incentivising the highly skilled workers/entrepreneurs to emigrate to countries where tax rates are lower. Not only will this reduce expected tax revenue for gov to use in redistributing income - dampen productive potential as innovation/ entrepreneurial spirit decreases. Free market

Example – France raised income tax around 2015- Brain drain

Lower tax rates – substitution effect > income effect- substitute leisure for more work- hence tax rev increases

DIAGRAM: Tax rate increases up to point A, will result in an increase of tax revenue. Further tax rate increases from A to B result in a loss of tax revenue from C to D

Question 8

What is the difference between progressive, regressive and proportional tax?

Answer 8

Progressive tax - those who are on higher incomes pay a higher marginal rate of tax; pay a higher % of their income on tax. Direct taxes tend to be progressive, for example income tax.

Regressive tax - the proportion of income paid in tax falls as the income of the taxpayer rises. Higher incomes pay a smaller percentage of their income on the tax. Most indirect taxes are regressive, for example everyone pays same VAT -those on higher wages = represents a small proportion of their earnings compared to those on low wages.

Proportional tax - the proportion of income paid on tax remains the same whilst the income of the taxpayer changes e.g. 10% of income is spent on tax, regardless of income. Everyone pays the same percentage of their income on the tax.

Progressive tax system will inc the equality of income distribution as more money is proportionately taken from the rich than from the poor. A regressive one will decrease income equality. Inheritance taxes= most progressive form of taxation.

Ev:

Using tax to redistribute income – doesn’t given poor anything- systems needs to be supported with benefits

Question 9

What are the economic effects of changes in tax?

INCENTIVES TO WORK

Answer 9

High marginal rates of tax = discourage individuals from working. free market economists argue - the supply of labour is relatively elastic and a reduction in marginal taxes on income will lead to a significant increase in work as individuals work longer hours, accept promotions and more people join the workforce.

§ High taxes on high income earners could encourage them to move abroad and taxes on the poor may lead to a poverty trap.

§ high income tax reduces incentives more than high vat. thus, a switch from direct to indirect taxes may increase incentives.

§ However-no hard evidence for the link between income tax and incentives. Nordic countries have high taxes and welfare benefits but have similar rates of growth compared to lower tax and gov spending countries like US and UK.

§ It can be argued that higher taxes mean people have to work longer hours in order to maintain their income and so even increases the incentive work

In 2022, the Adam Smith Institute calculated that average earners in the UK work from the 1st January to the 8th June (Freedom Day) to pay their taxes - all income after that point belongs to them

Question 10

What are the economic effects of changes in tax?

Real output and employment

Answer 10

Some taxes affect AD whilst others affect AS. A rise in direct taxes will reduce the level of disposable income =fall in their spending = fall in AD. It could also cause a fall in leftover profits for businesses and therefore a fall in investment. The effect this has on output will depend on where the economy is: whether it is at full employment or not.

Higher indirect taxes and NICs increase costs for firms = decrease SRAS. Depend on where the economy is producing.

Income taxes cause a disincentive to work and therefore reduce LRAS as the most skilled workers go overseas and more people become inactive.

Question 11

What are the economic effects of changes in tax?

PRICE LEVEL, FDI FLOWS, TRADE BALANCE

Answer 11

PRICE LEVEL- An increase in indirect taxes reduces disposable income & so workers may petition their employer for a salary increase
If they receive the increase the economy may face a wage-price spiral
Indirect taxes also increase costs of production for firms possibly leading to cost-push inflation

FDI FLOWS- If the rate of corporation tax increases relative to other countries, it may result in less inward foreign direct investment

TRADE BALANCE- An increase in taxes can reduce disposable income which is likely to reduce the level of imports
This may improve the trade balance (exports - imports)

Question 12

What is the distinction between automatic stabilisers and discretionary fiscal policy?

Answer 12

Automatic stabilisers- these are automatic fiscal changes as the economy moves through stages of the business/trade cycle
E.g. A fall in tax revenues during a recession or an increase in state welfare benefits paid out when unemployment is rising
They do not require active intervention from the government but happen automatically in the background

Discretionary fiscal policy- a demand-side policy that uses government spending & taxation policy to influence aggregate demand (AD)

Question 13

What is the difference between structural and cyclical deficits?

Answer 13

Structural deficits- deficits are present even when an economy may be operating at the full employment level of output
These deficits are difficult to correct
These deficits may be caused by a widespread tax avoidance culture, or poor governance

Cyclical deficits- occur due to downturns in the business/trade cycle, usually as a result of a recession
Governments receive less tax revenue as profits & income fall - & government spending increases
These deficits tend to self-correct as the economy starts to grow again

If the government has a structural deficit- likely that national debt will grow over time - Gov has to consistently borrow money to finance spending. For this reason, it is argued that structural deficits need to be eliminated but this is difficult since it is impossible to know what part of the deficit is structural and what part of it is cyclical, just as it is impossible to know the size of the output gap

Question 14

What is the difference between fiscal deficit and national debt?

Answer 14

A fiscal deficit occurs when the level of government spending is greater than the government tax revenue in any given year

The national debt is the accumulation of all previous deficits. The deficit in one year adds to the national debt from previous years

Question 15

What are the factors influencing the size of deficits?

Answer 15

State of the economy- Government revenue often increases in a boom & decreases in a recession. Government spending often decreases in a boom & 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 & 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- Many unforeseen events occur each year which require government support e.g. The Russian war on Ukraine started in February 2022 & 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)

Question 16

What are the factors influencing the size of national debts?

Answer 16

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 polices- These directly impact tax revenue & 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 & possibly increase the deficit & national debt at a time when the deficit would naturally be decreasing due to the automatic stabilisers

Question 17

What is the significance of the size of deficits and national debts?

Answer 17

High levels of borrowing may raise interest rates in economy since an inc in demand for money will increase the price of money, i.e. interest rates= crowding out of the economy. However, this may not always be the case as the government may borrow from overseas and during a recession, private sector investment falls which means interest rates may remain unchanged.

Countries have to spend a large amount of money on servicing their national debt through interest repayments, which has a high oppourntiy cost. impact will depend on the level of interest rates and the size of the primary deficit compared to interest repayments. In a liquidity trap ( when interest rates are extremely low), the government can often borrow at very low rates for a long time.

Some economists argue- high fiscal deficits nd national debts benefit citizens today at the expense of future generations- can cause intergenerational inequality. . Concerns over a deficit depend on whether the deficit is caused by current expenditure alone or whether it is just caused by capital expenditure. A current budget deficit is one where government revenues are less than current expenditure; the GOV has to borrow money simply to finance day to day spending. It is argued that the government should run a current budget surplus to enable it to invest for the future, except in recessions when they can run a deficit to increase AD. A current budget deficit is problematic as it means that future generations are forced to pay the bill for today’s expenditure

HOWEVER-

However, if the deficit is due to capital expenditure, the future generations benefit from increased spending and so their extra tax bill to pay for today’s borrowing can be justified. The value of debt tends to fall overtime because inflation erodes its value and because a country’s GDP grows meaning the debt is easier to pay off, so this limits the impact on future generations.

Monetarists argue that more money chasing same amount of goods= price increases. High deficits can cause inflation. Gov inc spending – AD will rise. if a government is unable to borrow money, they will print more money and this can cause hyperinflation. Printing money will not necessarily cause hyperinflation, it depends on how much is printed and where the economy is producing on the LRAS

High levels of debt tend to result in reduced credit rating for GOV. Private sector companies estimate likelihood that gov will default on its debt and give it a rating from AAA to D. Lower credit ratings mean that lending to the government is riskier and so higher interest rates are demanded from lenders. E.G. Greece.

However, in reality, 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.

EV; government borrowing can benefit growth if it used for capital spending since this will improve the supply side of the economy = reduce the deficit in l/t. 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.

Question 18

How can we use policies to reduce fiscal deficits and national debts?

Answer 18

To decrease the national debt= UK- policy of austerity since 2010, where they attempt to decrease spending. It would also be possible to increase taxes. Both of these are unpopular, could limit growth, and reduce living standards and income equality. Free market economists say that spending can be reduced by cutting out waste, but it is highly unlikely that these efficiency savings will make a significant difference. Sweden used spending cuts and tax increases to balance their budget in the 1990

Demand stimulus = high spending = economic growth = higher tax revenues= budget surpluses and eventually a reduction of national debt.

§ Rely on automatic stabilisers to allow the economy to grow so national debt/fiscal deficit will reduce as a percentage of GDP= mainly the approach that the US took after the GFC and economy recovered fairly quickly.

§ One way to reduce national debt would be for government to default on their loans but the economic cost of this is so large that governments only default if it is the only option

Question 19

What policies can we use to reduce poverty and inequality?

Answer 19

Free market forces = unlikely to create an equal society, leading to absolute or relative poverty and inequality. Some redistribution from rich to poor is necessary

Gov can use a progressive tax system - produce a more equal distribution of income after tax. Inheritance taxes – wealth inequality will be reduced. EV- unintended consequences of raising tax, for example a reduction in incentives and the impact of the Laffer Curve.

GOV EXPENDITURE IN FORM OF BENEFITS AND TRANSFER PAYMENTS:

Universal benefits are available to everyone who meet certain criteria, respective of personal income e.g. winter fuel allowance, child benefits.

§ Means tested benefits are only available to people who have sufficiently low incomes/ wealth- provide a safety net/minimum standard of living and are better at improving inequality since they directly affect the poor.

§ Government can provide goods and services - citizens equal opportunities and access to services they may not otherwise be able to afford, such as healthcare, education and housing- helps to ensure everyone is given an equal start in life

§ The problem with these is that they also benefit those on higher incomes and incur a high opportunity cost

Question 20

How do policy measures change interest rates and supply of money?

Answer 20

The central bank has the ability to change interest rates and monetary supply= control inflation, or due to global issues such as a low exchange rate or a change in world commodity prices. A fall in the bank rate is likely to increase the supply of money because it will mean there is more demand for loans- inc demand for borrowed fund

There is no simple relationship between the supply of money and inflation and it can be argued that central banks don’t have complete control over the money supply because they cannot control the ability of the financial system to create credit. The globalisation of the financial market has also made it increasingly harder to control domestic money supply.

Different views exist on the role that an increase in the money supply plays in creating inflation
Milton Friedman (a Monetarist) held the view that “Inflation is always and everywhere a monetary phenomenon in the sense that it is and can be produced only by a more rapid increase in the quantity of money than in output”
This opposes the Keynesian view that inflation is the result of a change in output

The global money supply has increased enormously since 2010 as a result of quantitative easing e.g. between March 2020 & the end of 2021 the USA had increased the money supply by $6.3 trillion
In early 2022 inflation began to spike globally confirming the fears of many monetarists

Question 21

How do policy measures increase international competitiveness?

Answer 21

These typically include protectionism, currency depreciation & the use of supply side policies

The effectiveness of these policies depends on the response of trading partners

Policies to improve international competitiveness can result in creating internal domestic conflicts which are difficult to resolve e.g. by protecting the steel manufacturing industry in the UK, the cost of steel as an input for broader industry increases

Employment gained in steel manufacturing is very likely surpassed by employment lost in steel related industries as a result of the increased costs of production.

Encourage competition, forcing firms to be efficient and thus competitive within the global market-place an emphasis on quality of products and use tax incentives to encourage incentives.

Education will improve the skills of the workforce and help improve flexibility. The UK government has established the ‘Red Tape Challenge’, which aims to simplify regulation for businesses.

Question 22

What is the use of policies in response to external shocks?

Answer 22

Due to globalisation world’s economies = increasingly interdependent. Macroeconomic policies can be used to combat the effects of negative shocks to the economy.

One example could be a commodity price shock- oil prices greatly increase. Gov could use expansionary policy to reduce impact of a fall in GDP or deflationary policy to reduce the impact on inflation.

Another example may be a financial crisis, where government can use expansionary policy to increase AD. Following Brexit, I/R were lowered = improve confidence but then raised to deal with inflation caused by the falling value of the pound.

Changes in exchange rates can cause inflation within the country or could cause a fall in growth and a poor balance of payments, both of which the government can attempt to solve through various methods. Political instability in the UK or in other countries is likely to impact the economy, and will mean the government needs to take action

Question 23

What are measures to control global companies? WITH EVAL OF TNCS

Answer 23

TNC’s - bring huge gains = creation of jobs, tax revenue, knowledge, investment

Ability to control depends on:

The absence of corruption e.g. Singapore is ruthless in stamping out corruption but Romania & Democratic Republic of Congo are well known for their high levels of corruption. The latter allow Transnational Corporations to influence legislation & to decide how the factors of productions are used/exploited

The state of development of the legal, financial, media & political institutions e.g. many of these institutions remain undeveloped in Cambodia & Transnational Corporations are stripping the country of its resources

The state of development of the economy as a whole (developing or developed)

Power of government

EVAL OF TNCS:

Can have a negative economic and social impact by destroying local culture affecting environment and withdrawing more in profits than they inject through investment- history of influencing politicians to take decisions that will favour their interests and are involved in tax avoidance.

In the EU and the USA, it is illegal for TNCs operating in their country to use bribery or corrupt practices anywhere in the world and they can be fined for doing so.

Some developing countries don’t allow TNCs to set up in their country without first setting up a joint company with a local partner , meaning that some profits are retained within the country and knowledge/technology is transferred. Many governments use import contracts with TNCs= some part of the value of the order must be manufactured in the country.

Question 24

What does reducing the use of transfer pricing mean?

Answer 24

Transfer pricing is one way for firms to engage in tax avoidance. This can occur if a firm produces a good in one country and then transfers it to another to make it into another good which it then sells.

If taxes are higher in the first country than the second country, they can set a low price on the product made in the first country. The overall aim is to increase their profit made in the low tax country and decrease it in the high tax country and so overall reduce their tax bill.

In the UK, companies which don’t allocate sufficient profits here are challenged by HMRC and this has led to billions of pounds earnt in taxes.

Transfer Pricing Guidelines were introduced by the OECD in 1995, providing guidelines on cross-border services, intangibles, cost contribution arrangements and advance pricing guidelines; these were modified in 2010. They aim for the price to be the same as if the two parties were independent of each other; the ‘arm’s length’ principle.

Question 25

What limits the government in its ability to control global companies?

Answer 25

It is difficult for individual governments to control TNCs . Small countries may earn less in revenue than a TNC earns in profits. Highly educated, successful executives are able to use a vast number of resources to find a solution which will benefit them

EU suffers from legal tax avoidance schemes, such as the ‘Dutch sandwich’ and the ‘double Irish’, where costs, revenues and profits are routed through Ireland, the Netherlands or Luxemburg and then sent to a tax haven like the Bahamas or the Cayman Islands.

Solutions to taxation are extremely difficult as they require worldwide agreement. However, any solution which would benefit a country like UK would lead to great losses for countries like the Bahamas, Ireland and Luxembourg

Also division within countries , for example in the USA between the Democrats and Republicans. This division allows TNCs are able to prevent any agreement they do not like through immense lobbying. Any solutions are also time consuming and costly

Question 26

What are problems facing policymakers when applying policies?

Answer 26

Inaccurate information:

Data often lags reality as underlying economic conditions can change quickly .S/T information, such as GDP figures- often inaccurate - mean gov is unable to see if there are problems within the economy. Trying to cut down on tax evasion and avoidance is difficult - gov doesn’t have the full picture on level of avoidance, who it is that is avoiding the tax and best way to reduce it. The BOE makes its decisions based on past data but it is possible trends in the economy may be changing so past data gives an inaccurate picture of where the economy is currently heading. With I/R so low for such a long period, past data is unlikely to give an accurate representation of the current economic climate which makes it difficult for the Bank to know which action to take. Full cost-benefit analyses can be time consuming and costly and it is impractical for the govt to gain every single bit of information they need.

Risks and uncertainties: GOV can’t accurately predict the future - difficult for them to know whether extra spending is necessary etc. Can’t know the full impact of their decisions as consumers often react unexpectedly and this could undermine gov policy. Managing risk = essential part of good decision making.

External shocks: Gov is unable to control and prepare for these external shocks; the best they can hope to do is lessen their impact. Since every situation is different, it may be difficult to know the best method to solve the problem. Policies employed by policy makers may not have their intended impacts and it may undermine current policies in place, for example Brexit has delayed government plans to balance the budget.

IN CONCLUSION:

Monetary policy- Effectiveness is limited due to external shocks due to globalised markets and how interdependent we are