4.5 Role of the State in the Macroeconomy Flashcards
What are the main types of expenditure
- Capital Expenditure
- Current Expenditure
- Transfer Payments
What is capital expenditure
This is government spending that increases the capital stock of the economy (Increasing LRAS)
What is current expenditure
This is government spending on items that are recurring and only lasts a limited time e.g. spending on public sector wages
What are transfer payments
payments from the government to individuals, represents a redistribution of income in society
e.g. pensions, welfare payments
What are the 2 key measures of government spending
- Real government spending – Spending levels adjusted for inflation.
-
Government spending as a % of GDP – Government spending, as a
share of national income.
How has UK public spending as a % of GDP changed over time
Government spending as a % of GDP rose sharply from 2000 to 2022, with a
peak in 2020/21 due to the Covid Pandemic.
How has UK public sector reciepts changed as % of GDP
government spending also correlates to UK public sector receipts (mostly tax revenue). There was a prolonged fall in tax revenues as a % of GDP from 1981 to 1993, which has since been reversed.
What is the impact of higher government spending
- More investment in education and infastructure
- Redistribution
- Fiscal Policy - in rrecession can be effective to stimulate economy
- Crowding in
Evaluate the effects of higher government spending
- Higher taxes create disincentives for work/investment
- Public Sector lacks efficiency from no profit motive
- Crowding out resources from the private sector
- Vested interests push governments to inefficiency e.g. lobbying
- Kind of Spending- welfare payments may be detrimental to efficiency
- Spending doesn’t have to be inefficient if it utilises the private sector
What is UK government spending in 2023 by size
- Healthcare (20%)
- Pensions (17%)
- Welfare (13%)
- Education (10%)
- Interest (8%)
- Defence (6%)
- Transport (4%)
What influences the size and composition of public spending
- Incomes
- Demographics
- Expectations - esp in democracy
- Business Cycle
- Interest on debt
- Inflation- raise MNW, UE Benefits, Pensions
- Political Priorities -political churn, election
- State of Global Economy
How does the stage of development influence public expenditure
- Developing: low tax revenue due to avoidance, inefficiency and little wealth to tax–> Can’t provide much through spending
- Developed: demand more services frrom governments ( income elastic )
How did the 2008 Global Financial Crisis influence public expenditure
- Huge increases for welfare payments + Bailouts
- but induced 2010 austerity to rweduce debt
How will ageing populations affect public expenditure
Europe and Japan will see pressure on government spending due to aging populations meaning larger pension bills and higher levels of care
needed.
What is the effect of public expenditure on productivity and growth
- infrastructure reduces costs for businesses
- Education increases human capital –> increased productivity
- Healthcare reduces the number of days sick
- Crowding in on frontier
- Free Market argues gov. spending is wasteful
What is the government multiplier of spending according to the OECDs
Gov. fiscal multiplier of 1.5-8 according to IMF
What is the effect of government spending on living standards
- Improve social welfare (correcting mkt failure + providing public goods)
- Reduce absolute poverty through benefits + Healthcare
but needs funding by higher tax - debt so crowding out
Evaluate the effect of government spending on living standards
government 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 principal agent problem since they make decisions on behalf of the people who may have spent that money differently. As a result, there is a loss in welfare and so a fall in living standards.
What is crowding out
a process where an increase in government spending
leads to a fall in private sector spending.
What is financial crowding out
If the government increases it’s spending – say through selling bonds – The demand for money will increase, which, ceteris paribus, raises interest rates.
At higher interest rates, both consumer spending and investment spending are likely to fall.
The aggregate effect on the economy is that financial resources are diverted from private firms to be used by the public sector.
How does financial crowding out lead to a fall in GDP
Initially, via a multiplier effect, national income increases, but as a result of the government selling securities in the financial markets, the demand for scarce loanable funds increases.
This drives up interest rates, which causes a contraction in the demand by the
private sector for investment goods (capital) as well as reducing the demand for
consumer goods. This, in turn, leads to a fall in GDP.
What is crowding out in relation to the labour market
a relative increase in the public sector may push up wages in order to attract workers from the private sector.
The increased demand for labour reduces unemployment and ‘tightens’ the labour market, leading to possible shortages of labour available for the private sector use as well causing upward pressure on wage levels across the economy.
What fundamental financial fact drives crowding out
that financial and real resources are ultimately scarce, and if one sector of the economy increases its use of these resources, fewer are available for use in other sectors.
What is the Ricardian Equivalence
This means that attempts to stimulate an economy by increasing debt-financed government spending will not be effective because investors and consumers understand that the debt will eventually have to be paid for in the form of future taxes.
The theory argues that people will save based on their expectation of
increased future taxes to be levied in order to pay off the debt, and that this will offset the increase in aggregate demand from the increased government spending.
What did Barro say to support the Ricardian Equivalence
an increase in government spending will lead individuals and organisations to expect interest rates to rise in the future, they will save more in order to pay higher interest rates.
What is the evaluation of crowding out
it may be a weak effect, this depends on the various elasticities that exist in the relevant markets.
if the supply of loanable funds is elastic and the demand for capital is inelastic, the impact of higher interest will be relatively small.
What evidence did Enrice Moretti from MIT find about federal spending to oppose the ‘crowding out’ theory
Government spending leads to an increase in private spending; a ‘crowding in’ effect
What are 3 reasons for the crowding in effect
- Frontier technology projects have extremely high fixed costs so by letting the public
sector fund the research, it allows the private sector to realise higher
profits. -
“Spillover effects”, where new technologies find different applications
in the private sector. GPS, for instance, was first developed to help
missiles find their targets -
Credit constraints on the private sector, where a project is difficult to
fund without government support due to, say, an economic downturn.
Why does frontier/speculative funding have a crowding in effect
the potential outcomes from speculative research and development are inherently unknowable, which makes a new project impossible to justify commercially.
What is crowding out
a process where an increase in government spending
leads to a fall in private sector spending.
What is financial crowding out
If the government increases it’s spending – say through selling bonds – The demand for money will increase, which, ceteris paribus, raises interest rates.
At higher interest rates, both consumer spending and investment spending are likely to fall.
The aggregate effect on the economy is that financial resources are diverted from private firms to be used by the public sector.
How does financial crowding out lead to a fall in GDP
Initially, via a multiplier effect, national income increases, but as a result of the government selling securities in the financial markets, the demand for scarce loanable funds increases.
This drives up interest rates, which causes a contraction in the demand by the
private sector for investment goods (capital) as well as reducing the demand for
consumer goods. This, in turn, leads to a fall in GDP.
What is crowding out in relation to the labour market
a relative increase in the public sector may push up wages in order to attract workers from the private sector.
The increased demand for labour reduces unemployment and ‘tightens’ the labour market, leading to possible shortages of labour available for the private sector use as well causing upward pressure on wage levels across the economy.
What fundamental financial fact drives crowding out
that financial and real resources are ultimately scarce, and if one sector of the economy increases its use of these resources, fewer are available for use in other sectors.
What is the Ricardian Equivalence
This means that attempts to stimulate an economy by increasing debt-financed government spending will not be effective because investors and consumers understand that the debt will eventually have to be paid for in the form of future taxes.
The theory argues that people will save based on their expectation of
increased future taxes to be levied in order to pay off the debt, and that this will offset the increase in aggregate demand from the increased government spending.
What did Barro say to support the Ricardian Equivalence
an increase in government spending will lead individuals and organisations to expect interest rates to rise in the future, they will save more in order to pay higher interest rates.
What is the evaluation of crowding out
it may be a weak effect, this depends on the various elasticities that exist in the relevant markets.
if the supply of loanable funds is elastic and the demand for capital is inelastic, the impact of higher interest will be relatively small.
What evidence did Enrice Moretti from MIT find about federal spending to oppose the ‘crowding out’ theory
Government spending leads to an increase in private spending; a ‘crowding in’ effect
Why does frontier/speculative funding have a crowding in effect
the potential outcomes from speculative research and development are inherently unknowable, which makes a new project impossible to justify commercially.
How does government spending affect the level of taxation
● In most cases, where government spending is high, levels of tax must be high –> disincentive effect on work + investment
but.
● Oil-rich countries tend to be an exception, where revenue from oil can pay for most
of government spending.
What is the effect of government spending on equality
● Spending should increase equality as it leads to redistribution and helps to provide
a minimum standard of living for the poorest in society.
e.g. Northern Powerhouse, A Levels free after 18, pupil premium scheme
- But can help the rich disproportionately e.g. QE which can also harm poorest through higher asset prices
What arre the 2 main reasons for public expenditure
- Correct market failure (public goods, externalities, info failure)
- Prove more equity
What is the main justification for the government being as small as possible
Inefficiency of government (gov. failure)> market failure
Do tax and benefits always have disincentive effects?
No, depends on magnitude and context
e.g. Nordic Countries have high taxes + generous welfare benefits, activity rates are also very high while Nordic countries have similar rates of economic growth as the USA or the UK
What is a budget deficit
where the level of gov spending > tax revenue
What type of budget deficit is seen as undesireable
- Budget deficits to fund specifically current expenditure is seen as undesireable as future generations are paying for current spending
- However borrowing for ccapital expenditure or transfer payments (benefitting people directly today) is seen as fair because futurre generations will benefit from this investment - inter-generational equity
What is the Gordon Brown’s Golden Rule of borrowing and spending
Borrowing should only be used to finance expenditure on infrastructure which will benefit the UK in the longer term, and is not to be used to finance current spending/debt, as taxes should cover current spending.
What are the implications of Gordon Brrown’s golden rule of borrowing and spending
· The government needs to gain better control of the budgets.
· In the longer term, the increase in economic activity gained by the infrastructure investment should pay off the extra borrowing.
· The chancellor Gordon Brown also has a sustainable investment rule. This states national debt should always be less than 40% of GDP.
What are the causes of a budget deficit
- Recession –> rising UE
- Decrease in consumer spending
- Increase in **inactivity **
- Use of **expansionary fiscal policy **
- Increase in interest rates
- Ageing population
What are the economic justificatiions of a budget deficit
- To increase AD when economy operating below PPF
- Automatic stabilisers cushion fall in AD
- Fiscal stimulus will improve budget deficit in LR from higher growth and higher tax revenue
What are the arguments in favour of Austerity
- Reducing debt –> helps to keep UK taxes lower + reducing opp. cost
- Shrinking state encourages private sector growth
- ** increases investor confidence** in stability – attracts FDI into the UK
What are arguments against Austerity
- Austerity is self-defeating –> lower tax revenue
- Infrastructure investment will increase AD and LRAS
- Wrong to cut spending when economy is in liquidity trap
e.g. UK and USA response to GFC
Draw a diagram for crowding out
Increased government borrowing may lead to higher demand for loanable funds and a rise in market interest rates e.g. on bonds. This might increase borrowing costs for private sector businesses.
What is fiscal multiplier
fiscal multiplier measures the effect of a £1 change in spending or a £1 change in tax revenue on the level of GDP
What did the IMF find about fiscal multipliers compared to revenue multiplier
IMF research report published in 2014, “the literature finds that (government) spending multipliers tend to be larger than revenue multipliers.”
- This would be supported by Keynesian theory, which argues that tax cuts are less effective than spending increases in stimulating the economy
- The IMF also found that fiscal multipliers are generally larger in downturns than in expansions – this supports the Keynesian view of using fiscal stimulus when conventional monetary policy is found to be ineffective
When is there a low and high fiscal multiplier
What is progressive tax
This occurs when **those on higher income levels pay a
higher % of their income in tax **
e.g. the UK has a top rate of 45% on
marginal income over £150,000.
What is a regressive tax
This occurs when an increase in income leads to a smaller % of their income going on the tax
e.g. excise duties and VAT take a bigger % of low income earners.
What is proportional taxation
takes same % of income, whatever income band.
What is direct taxation
taken from people’s earnings directly e.g. income tax
and NI.
What is indirect taxation
Paid by firms selling goods
e.g. VAT is included in final price consumers pay.
What is the impact of increasing rate of income tax
- Higher revenues - but laffer curve
- Tax Evasion - might go work in another country
- Work Incentives- may reduce incentive to work or income effect means want to work more
- Redistribution
- Lower AD - cetirus paribus
- Improve X-M- lower spending on imports
- FDI - ‘race to the bottom’ e.g. Apple Ireland 0.005%
Evaluate the impacts of higher income taxes
- Disincentives? economists suggest evidence is mixed.
o income effect encourages them to work more - depends how tax revenue is used. If income tax revenue is invested in
improved infrastructure it can the benefit long run productive capacity.
If income tax revenue is needed for welfare payments, there will be no
increase in productive capacity.
What is the impact of increasing indirect tax
-
Cost-push inflation
However, this price rise will be a one-off increase and, after 12
months, the price rise will no longer count toward inflation. - Fall in Output - depends on other factors affecting AD and AS, unlikely to cause a fall in GDP on its own
- Social Efficiency
- Changed easily and less likely to distort work incentives
What is tax competition
- Countries may seek to encourage foreign direct investment (FDI) through
offering lower tax rates.
e.g. Ireland 12.5% has attracted many big multinationals to invest, through
low tax rates.
- The problem with tax competition is that it can encourage countries to
keep trying to offer lower tax rates to attract big companies. This leads to
countries having to increase tax on consumers and workers.
which taxes affect AS and which affect AD
Direct Taxes affect AD directly due to lower consumption
Indirect taxes affect SRAS
What is VAT standard rate and the discounted rates
- The standard rate of VAT has been 20% since 2011
Reduced rate of 5% is applied to these items
○ Domestic fuel and power, women’s sanitary products, children’s car seats, contraceptives, certain residential conversions and renovations
Zero-rated VAT on these items:
○ Food, Construction of new dwellings, Domestic passenger transport, Books, newspapers and magazines, Children’s clothing, Water and sewerage services, Drugs and supplies on prescription, Supplies to charities, Cycle helmets
How could tax cuts stimulate economic recovery
-
Consumer spending
Cuts in VAT or income tax to boost demand for goods and services -
Business investment
Lower corporation tax to increase investment and tax incentives for R&D -
Lower employment taxes
Reduced national insurance so that businesses create more jobs -
Lower fuel / carbon taxes
Lower costs for businesses, less inflation and higher profits
Evaluate the view that tax cuts will stimulate economic recovery
- Low confidence – tax cuts likely to be saved rather than spent
- Businesses might choose to invest overseas instead
- Skills shortages might limit new job creation
- Possible conflicts with environmental policies e.g. 91p on pound for investment in oil extraction
- Lower Revenue multiplier
What is the Laffer Curve
tax rate cut could lead to an increase in tax revenue, or a decrease in tax revenue, depending whether you have already passed the ‘optimal tax rate’ (whatever % that may be)
Evaluate the Laffer Curve
- Many people are on fixed hours / zero hours contracts – so tax rates have little bearing on work incentives
- Tax rates not the only factor affecting work incentives – we must also consider the impact of the benefits system
- Where is the optimal point? Could work in either way
What is the case for windfall taxation on Energy Companies
- Levy estimated to raise £8 Billion to provide funding for the Energy Price Guarantee and Energy Bill Support Scheme
- BP earned record £7.1 billion in just 3 months during summer last year
- Shell CEO said that they are not planning to stop any future projects
What are the possible uses of the £8 billion revenues
£700 million investment in Sizewell C alone will be enough electricity to power 6 million houses for over 50 years
e.g. budget invested £20 billion in carbon capture
What is Public Sector Net Borrowing (PSNB)
This is the annual difference between net spending and net taxation. It is the amount the government needs to borrow in a particular year. It is referred to as the budget deficit.
What were the reasons for surge in inflation during 2022
- Rising oil and gas prices
- Ukraine war disrupting gas/energy and food supplies.
* Lingering supply side issues from Covid lockdowns and impact on the
price of shipping. - Strong demand in US, with economy close to overheating.
- Central Banks leaving interest rates at a low level.
Why does increasing the money supply not always cause inflation
- The growth of real output is the same as the growth of the money supply
- Increase in bank reserve ratios (banks didnt want to lend)
- Hard to Measure Money Supply
- Changes in velocity of Circulation
- Liquidity Trap
What are shock absorbers of external shocks
*Floating exchange rates (scope for a depreciation)
* Freedom to set / adjust monetary policy when conditions change
* Geographically and occupationally mobile / flexible labour force
* Strong non price competitiveness of domestic businesses
* A diversified economy (not over reliant on a few sectors)
* Strong fiscal position (stabilisation funds)
What is a liquidity trap characterised by
1) Very low interest rates
2) Low inflation
3) Slow/**negative economic growth **
4) Preference for saving rather than spending and investment
5) Monetary policy becomes ineffective in boosting demand
What happened in liquidity trap of 2009-15
there was a large increase of 7% in M0 but it could not stop the decline in M4
e.g. at start of the credit crunch, there waas a sharp rise in the UK saving ratio from 4.2% in 2008 q1 to 2010 q2
Inelastic demand for investment (MEC) so firms are not tempted by lower interest rates
