4.5 Role of the State in the Macroeconomy

Question 1

Types of Expenditure

Answer 1

Capital Government Expenditure
General Government Final Consumption
Transfer Payments
Current Government Expenditure

Question 2

Capital Government Expenditure

Answer 2

Spending on investment goods such as new roads, schools and hospitals which will be consumed in over a year

Question 3

General Government Final Consumption

Answer 3

Spending on goods and services that will be consumed within the next year
Public sector salaries

Question 4

Transfer Payments

Answer 4

Government payments for which there is no corresponding output, where money is taken from one group and given to another
Benefits and pensions

Question 5

Current Government Expenditure

Answer 5

Government also has to spend money on interest payments for national debt
General government final consumption plus transfer payments plus interest payments

Question 6

Composition and Size of Public Expenditure

Answer 6

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

Question 7

Government Expenditure Impacts

Productivity and Growth

Answer 7

Free Market Economists=> Wasteful and causes inefficiency
Government is able to enjoy economies of scale => increased productivity
Government can create multiplier effect

Question 8

Government Expenditure Impacts

Living Standards

Answer 8

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

Question 9

Government Expenditure Impacts

Crowding Out

Answer 9

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

Question 10

Government Expenditure Impacts

Level of Taxation

Answer 10

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

Question 11

Government Expenditure Impacts

Equality

Answer 11

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

Question 12

Taxation

Answer 12

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

Question 13

Progressive Tax

Answer 13

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

Question 14

Regressive Tax

Answer 14

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

Question 15

Proportional Tax

Answer 15

Proportion of income paid on tax remains same whilst income of taxpayer changes
Everyone pays same percentage of income on tax

Question 16

Impacts of Tax Changes

Incentives to Work

Answer 16

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

Question 17

Impacts of Tax Changes

Tax Revenues

Answer 17

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

Question 18

Impacts of Tax Changes

Income Distribution

Answer 18

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

Question 19

Impacts of Tax Changes

Real Output and Employment

Answer 19

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

Question 20

Impacts of Tax Changes

Price Level

Answer 20

Taxes can impact LRAS, SRAS and AD => changes will impact price depending on where economy is producing
Indirect taxes cause cost push inflation

Question 21

Impacts of Tax Changes

Trade Balance

Answer 21

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

Question 22

Impacts of Tax Changes

FDI Flows

Answer 22

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

Question 23

Automatic Stabilisers

Answer 23

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

Question 24

Discretionary Fiscal Policy

Answer 24

Deliberate manipulation of government expenditure and taxes to influence economt
Expansionary and deflationary policies

Question 25

Fiscal Deficit and National Debt

Answer 25

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

Question 26

Distinction between Structural and Cyclical Deficits

Answer 26

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

Question 27

Distinction between Structural and Cyclical Deficits

Governments

Answer 27

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

Question 28

Factors Influencing Size of Fiscal Deficit

Answer 28

Trade Cycle
Unforeseen Events
Interest Rates
Privatisation
Government Aims
High Revenue from Oil
Number of Dependents

Question 29

Factors Influencing Size of Fiscal Deficit

Trade Cycle

Answer 29

During a downturn, government tax revenue decreases while spending increases and so deficit increases

Question 30

Factors Influencing Size of Fiscal Deficit

Unforeseen Events

Answer 30

Lead to huge increases in spending which increase deficit

Question 31

Factors Influencing Size of Fiscal Deficit

Interest Rates

Answer 31

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

Question 32

Factors Influencing Size of Fiscal Deficit

Privatisation

Answer 32

Provide one-off payments to government which will decrease deficit in short term
Depends on value of company sold

Question 33

Factors Influencing Size of Fiscal Deficit

Government Aims

Answer 33

Influences government’s fiscal policy

E.g. austerity aim helped decrease size of deficit but attempting to increase AD would increase spending

Question 34

Factors Influencing Size of Fiscal Deficit

High Revenues from Oil

Answer 34

Many countries with high revenues from oil run a budget surplus and so government revenue is important in the size of the deficit

Question 35

Factors Influencing Size of Fiscal Deficit

Number of Dependents

Answer 35

Number of dependents in a country affect both spending and tax revenues so influence deficit

Question 36

Factors Influencing Size of National Debts

Answer 36

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

Question 37

Significance of Fiscal Deficits and National Debts

Answer 37

Interest Rates
Servicing National Debt
Intergenerational Inequality
Inflation
Reduced Credit Rating for Government
Foreign Currency
Benefit Growth

Question 38

Significance of Fiscal Deficits and National Debts

Interest Rates

Answer 38

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

Question 39

Significance of Fiscal Deficits and National Debts

Servicing National Debt

Answer 39

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

Question 40

Significance of Fiscal Deficits and National Debts

Intergenerational Inequality

Answer 40

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

Question 41

Significance of Fiscal Deficits and National Debts

Inflation

Answer 41

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

Question 42

Significance of Fiscal Deficits and National Debts

Reduced Credit Rating for Government

Answer 42

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

Question 43

Significance of Fiscal Deficits and National Debts

Foreign Currency

Answer 43

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

Question 44

Significance of Fiscal Deficits and National Debts

Benefit Growth

Answer 44

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