4.5 Role of the State in the Macroeconomy Flashcards
Types of Expenditure
Capital Government Expenditure
General Government Final Consumption
Transfer Payments
Current Government Expenditure
Capital Government Expenditure
Spending on investment goods such as new roads, schools and hospitals which will be consumed in over a year
General Government Final Consumption
Spending on goods and services that will be consumed within the next year
Public sector salaries
Transfer Payments
Government payments for which there is no corresponding output, where money is taken from one group and given to another
Benefits and pensions
Current Government Expenditure
Government also has to spend money on interest payments for national debt
General government final consumption plus transfer payments plus interest payments
Composition and Size of Public Expenditure
In most mixed and free economies, lower average income of country, lower is likely to be percentage of GDP spent by government
Poor countries have low tax revenue due to avoidance, inefficiency at collecting and a smaller amount of wealth to tax
People in high income countries demand more services from governments
Government Expenditure Impacts
Productivity and Growth
Free Market Economists=> Wasteful and causes inefficiency
Government is able to enjoy economies of scale => increased productivity
Government can create multiplier effect
Government Expenditure Impacts
Living Standards
Government spending can cause improvements
Corrects market failure and provides public goods => improves social welfare
Reduce absolute poverty => provides benefits
Government suffers from principal agent problem since they make decisions on behalf of people who may have spent money differently => loss in welfare
Government Expenditure Impacts
Crowding Out
Government has to borrow
Amount of money in economy available to borrow does not increase
Government competes with private sector for finance => higher interest rates => discourages firms from investing and buying on credit
Limited number of resources in economy => less available for private sector
Free market economists: investment more efficient by private sector
Government Expenditure Impacts
Level of Taxation
When government spending is high, levels of tax must be high in order for spending to be sustainable
High levels of tax may have disincentive effect
Government Expenditure Impacts
Equality
Spending should increase equality as it leads to redistribution and helps to provide a minimum standard of living for poorest in society
Ensures everyone has access to basic goods
Taxation
Tax is used to pay for goods and services provided by the government
Tax can be used to correct market failure at a microeconomic level and to manage economy and redistribute income at macroeconomic
UK government’s current aims include keeping burden of tax low, improving incentives, using equitable taxes, correcting market failure and taxing spending rather than income
Progressive Tax
Where those who are on higher incomes pay a higher marginal rate of tax
Pay a higher percentage of their income on tax
Direct taxes tend to be progressive
Regressive Tax
Proportion of income paid in tax falls as income of the taxpayer rises
Those in higher incomes pay smaller percentage of income on tax
Most indirect taxes are regressive
Proportional Tax
Proportion of income paid on tax remains same whilst income of taxpayer changes
Everyone pays same percentage of income on tax
Impacts of Tax Changes
Incentives to Work
Argued higher marginal rates of tax discourage individuals from working
Argued supply of labour is relatively elastic and reduction in marginal taxes lead to sign I can’t increase in work
High taxes on high income earners encourage them to move broad and taxes on poor may lead to poverty trap
Switch from direct to indirect taxes may increase incentives
Argued higher taxes means people work longer to maintain income so incentive to work increases
Impacts of Tax Changes
Tax Revenues
Laffer curve shows rise in tax rate does not always increase tax revenue
If people taxed at 100%, they would do no work meaning tax revenue is 0 at both 0% and 100%
Tax revenue initially rises as tax increase but after a point where revenue is maximised, it falls
Impacts of Tax Changes
Income Distribution
Progressive tax systems increase equality of income distribution as more money is proportionally taken from rich than poor
Regressive system decreases income equality
Move from indirect to direct tax improves equality
Impacts of Tax Changes
Real Output and Employment
Some taxes AD whilst others AS
Rise in direct taxes reduce disposable income => AD falls
Also cause fall in leftover profits for businesses => fall in investment
Higher indirect taxes and NICs increase costs for firms => decrease SRAS
Impact depends on where economy is producing
Argued income taxes cause disincentive to work => reduce LRAS as most skilled workers go overseas
Impacts of Tax Changes
Price Level
Taxes can impact LRAS, SRAS and AD => changes will impact price depending on where economy is producing
Indirect taxes cause cost push inflation
Impacts of Tax Changes
Trade Balance
Rise in taxes decrease incomes => decrease consumption => consumers spend less on imports
Imports in UK are highly income elastic => trade balance will improve in SR
However in LR, lower AD reduces businesses’ need to invest => reduce competitiveness => exports decreases
Impacts of Tax Changes
FDI Flows
Low taxes on profit and investment encourage businesses to invest in a country since it will help them to see a higher level of return
Problem with his is that it can be a race to the bottom where countries have to continue to lower their taxes in order to make them the lowest to encourage investment => fall in revenue for all countries
Automatic Stabilisers
Mechanisms which reduce impact of changes in economy on national income
GI and tax are automatic stabilisers
Benefits increase in a recession as more people are unemployed so benefits are a stabiliser => fall in AD is reduced preventing too much damage in economy
During boom, tax increases as people have higher incomes
Cannot prevent fluctuations, just reduce size
Can be negative aspects
Benefits may act as disincentive to work => high unemployment
High tax decrease incentive to work
Discretionary Fiscal Policy
Deliberate manipulation of government expenditure and taxes to influence economt
Expansionary and deflationary policies
Fiscal Deficit and National Debt
National debt is sum of all government debts built yp over many years
Fiscal deficit is when government spends more than it receives that year
Distinction between Structural and Cyclical Deficits
Cyclic deficit is part of deficit that occurs due to government spending and tax fluctuates around trade cycle
When in recession, tax revenue is low and spending is high creating larger deficit
At peak of boom, there structural deficit => fiscal deficit occurring when cyclic deficit is 0, long term and not relate to state of economy
Actual deficit = structural + fiscal
Distinction between Structural and Cyclical Deficits
Governments
Have structural deficits, structural surpluses or structural balances
Surplus occurs at peak of boom, there is an actual fiscal surplus whilst a balance occurs when at peak of boom, actual fiscal balance is 0
If government has deficit, national debt will grow over time as government has to borrow
Factors Influencing Size of Fiscal Deficit
Trade Cycle Unforeseen Events Interest Rates Privatisation Government Aims High Revenue from Oil Number of Dependents
Factors Influencing Size of Fiscal Deficit
Trade Cycle
During a downturn, government tax revenue decreases while spending increases and so deficit increases
Factors Influencing Size of Fiscal Deficit
Unforeseen Events
Lead to huge increases in spending which increase deficit
Factors Influencing Size of Fiscal Deficit
Interest Rates
If rates on government debt increase, amount government pays in interest repayments increases => increases deficit
Impact will depend on how significant interest repayments are in size of deficit
Interest rates depend on market rates and credit ratings of government
Factors Influencing Size of Fiscal Deficit
Privatisation
Provide one-off payments to government which will decrease deficit in short term
Depends on value of company sold
Factors Influencing Size of Fiscal Deficit
Government Aims
Influences government’s fiscal policy
E.g. austerity aim helped decrease size of deficit but attempting to increase AD would increase spending
Factors Influencing Size of Fiscal Deficit
High Revenues from Oil
Many countries with high revenues from oil run a budget surplus and so government revenue is important in the size of the deficit
Factors Influencing Size of Fiscal Deficit
Number of Dependents
Number of dependents in a country affect both spending and tax revenues so influence deficit
Factors Influencing Size of National Debts
If government is continuously running a deficit, then national debt will increase overtime
There is a consensus view that fiscal deficits over 3% lead to growing national debt as a proportion of GDP
It is only when government runs a budget surplus that size of national debt decreases
Ageing populations contribute to high national debt since government runs a structural deficit in order to fund pensions and care and this leads to high national debt
Significance of Fiscal Deficits and National Debts
Interest Rates Servicing National Debt Intergenerational Inequality Inflation Reduced Credit Rating for Government Foreign Currency Benefit Growth
Significance of Fiscal Deficits and National Debts
Interest Rates
High levels of borrowing may raise interest rates in economy since an increase in demand for money will increase price of money
Could cause crowding out of the economy
However this may not always be the case as the government may borrow from overseas during a recession, private sector investment falls which means interest rates may remain unchanged
Significance of Fiscal Deficits and National Debts
Servicing National Debt
Countries have to spend large amounts of money on servicing national debt through interest repayments which occur an opportunity cost
Primary budget deficit is actual budget deficit but does not include interest rates and size of primary deficit compared to interested repayments
In a liquidity trap (interest rates low), government can borrow at low rates for long periods of time
Significance of Fiscal Deficits and National Debts
Intergenerational Inequality
Argued that high fiscal deficits and national debts benefit citizens for future and cause Intergenerational inequality
Concerns over deficit depend on whether deficit is caused by current or capital expenditure
Current budget deficit = government revenue < current expenditure, government has to borrow money
Argued government should run current budget surplus to enable it to invest in future
Current = future generations pay bill for today’s expenditure
Capital = todays generation pay bill for future’s expenditure
Significance of Fiscal Deficits and National Debts
Inflation
High fiscal deficits cause inflation
If government increases spending and there is no similar fall in private sector spending, AD rises => inflationary
If government is unable to borrow money, they will print more causing hyperinflation => depends on how much is printed and where economy is producing on the LRAS
Significance of Fiscal Deficits and National Debts
Reduced Credit Rating for Government
Caused by high levels of debt
Private sector companies estimate likelihood that government will default on its debt and give it a rating from AAA to D
Lower rating means lending is risky so high interest rates are demanded
However, it is not the size of the debt that influence level of risk involved, it is whether country has ever defaulted on loans before and their current economic/political climate
Significance of Fiscal Deficits and National Debts
Foreign Currency
If government has borrow from abroad, it may have difficulties getting enough foreign currency to make repayments on its debt
Could cause problems for consumers as if there is not enough foreign currency, they will be unable to import goods
Significance of Fiscal Deficits and National Debts
Benefit Growth
Government borrowing can benefit growth if used for capital spending since this will improve supply side of economy => reducing deficit in long term
Budget deficit can be used as tool for short term demand management
Keynesians argue deficit is acceptable to use as a stimulus in demand during recessions
