4.5 Role of the State in the Macroeconomy Flashcards
Define current expenditure
Maintainence of public sevices and payment of public sector wages
e.g. Teachers, police, members of parliment
Define capital expenditure
Invesment in infrastructure and capital equipments, which have long term rewards
e.g. hospitals, schools etc
Define transfer payments
Payments made by the govt for which no G/S are exchanged
e.g. benefits and pensions
Define debt interest payments
Spend £ on interest payments for national debt
2 marks
Explain the relationship between a fiscal deficit and the national debt.
- There is a positive relationship (1)
- Fiscal deficit is where government spending is greater than tax revenue (1)
- National debt is the total accumulated debt of the government (1)
1 mark for explanation e.g.: - A fiscal deficit means that a country’s national debt will be increasing (1)
- A fiscal deficit will be adding to the total value of a country’s national debt (1)
- Higher debt means increased government spending on interest payments (1)
What is the public sector net cash requirement
The finance required to pay for a budget deficit- the difference between expenditure and income
Wagners law (Adolph Wagner)
How does changing incomes affect the composition of public expenditure
- Countries with low incomes–> low tax revenue–> low govt expenditure
- As incomes increase, demand for govt G/S increase, increasing public expenditure (demand was very responsive to changes in income= income elastic) E.g. library services better recycling facilities
- Lower in average incomes of a country= lower % of GDP spent by the govt
How does changing age distributions affect the composition of public expenditure
- Many developed countries have had lower birth rates for decades= large and growing age population
- Life expectancy has increased due to advances in medicine and nutrition
- Govt spending on pension payments and healthcare will increase to support this elderly population
How does changing expectations affect the composition of public expenditure
As societal norms change, expectations change and this puts pressure on governments to change the substance and delivery mechanism of many of their services. This often results in increased spending e.g. NHS patients wanted online access to their medical records and the Government had to spend significant sums on creating the platform to do that
How did the Financial crisis affect the composition of public expenditure
- 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) and in the years following the crisis, the UK government cut their expenditure and raised taxes (austerity)
How does govt expenditure impact productivity and growth
- Education creates human capital, healthcare system decreases number of days workers lose from serious illness
- Spending on R&D to give businesses a long term competitive edge + drives innovation (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)
- Through spending, govt can create multiplier effects
- Free market argues govt spending is wasteful and causes inefficiencies. However, govt is able to to enjoy E.O.S when it provides G/S, improving productivity
- It can have a negative impact on productivity and long-term growth as without a profit incentive the urgency of labour diminishes and resources are used more inefficiently
How does govt expenditure impact living standards
- Corrects market failure & provides public goods which improves social welfare
- Reduces absolute poverty by providing benefits and basic goods
- Principal agent problem–> govt make decsions on behalf of the people and individuals may have spent £ differently
How does govt expenditure impact crowding out
- Govt is competing with the private sectorfor finance which leads to higher I.R, discouraging firms from investing and individuals from buying credit
- Limited no.of resources in economy= less resources available for private sector
How does govt expenditure impact level of taxation
In most cases, where government spending is high, levels of tax must be high in order for spending to be sustainable. High levels of tax may have a disincentive effect.
How does govt expenditure impact equality
Spending should increase equality as it leads to redistribution and helps to providea minimum standard of living for the poorest in society. It ensures everyone hasaccess to basic goods, such as education and healthcare, which will help to give them a fair start in life.
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
Define and give the equation of average rate of tax (ART)
Tax paid as a proportion of income earned
ART (%)= (tax paid/ income) x 100
e.g. progressive income tax
Define progressive tax
As Y rises, average r.o.t increases
e.g.flat income tax
Define proportional tax
As incomes rise, r.o.t stays the same
e.g. indirect taxes (fuel duty, VAT)
Define regressive tax
As incomes rise, average r.o.t fall
burdens those on low incomes
Impact of tax changes on incentives to work
Higher tax rate lowers incentive to work: to strive for promotions, to work long hours, work into old age (retire early)
Free market economists argue that 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 (capital flight) and taxes on the poor–>poverty trap.
However, higher taxes mean people have to work longer hours in order to maintain their income and so even increases the incentive work.
Laffer curve
Impact of tax changes on tax revenues
Relationship between ↑ tax rates and the level of tax revenues received
As tax rate ↑, govt tax revenue ↑ until a certain point where revenue is maximised and then will fall.
This is due to disincentivised workers work less, leading to less income and less tax revenue + the rich have increased incentive to use tax avoidance + tax evasion
Impact of tax changes on income distribution
A progressive tax system redistributes from those with higher income to those with lower income and reduces income inequality
Regressive (indirect) taxes may increase income inequality
Inheritance taxes are the most progressive form of taxation
Impact of tax changes on real output and employment
If tax rate increases, increase in leakages of circular flow of incomes. AD falls as consumers have less yD and firms have less profits so C+I fall
SRAS may fall as CoP increase
Income taxes cause a disincentive to work and therefore reduce LRAS as the most skilled workers go overseas and more people become inactive
Impact of tax changes on trade balance
● A rise in taxes will decrease income and therefore decrease consumption, so consumers spend less on imports . Imports in the UK have been found to be highly income elastic. As a result, the trade balance will
improve in the short run.
● However, in the long run, lower AD will reduce businesses’ need to invest and this could reduce competitiveness meaning that exports decrease.
Impact of tax changes on FDI flows
● Low taxes on profit and investment tend to encourage businesses to invest in a country since it will help them to see a higher level of return.
● The problem with this 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; the eventual result is a fall in revenues for all countries.
Define fiscal deficit
Govt spending > taxation
Define fiscal surplus
Tax revenue > govt spending
Define National Debt
Unpaid fiscal deficits i.e. accumulation of fiscal deficits yet to be repaid
Define automatic stabilisers
Countercyclical response to the business cycle. e.g. during a positive output gap, income and spending is high, increase tax revenure and reduction in the need for transfer payments, during a boom G falls and T rises, which decreases the size of a positive output gap –> ‘stabilise’ economic performance
Define discretionary fiscal policies
Used when automatic stabilisers are not sufficient to improve macro performance.
Deliberate govt spending–> additional govt interventions to further smoot out positive/ negative output gaps
However these policies have a time lag: need to be passed by parliament and then implemented
Examples of discretionary fiscal policies
During the Financial Crisis 2008
* ‘Help to Buy’ Scheme: to improve the housing market
* Car scrappage Scheme 2009: Encourage individuals to buy new cars
* Temporary reduction in VAT
Define cyclical deficits
Occur during negative output gaps. Therefore should be corrected by running surpluses during positive output gaps.
Sustainable: Debt is repaid during postive output gaps
Define structural deficits
An economy may be operating at the full employment level of output caused by tax avoidance or poor governance
Govt spending > taxation during a positive output gap
Unsustainable: National debt increases
How does the state of the economy influence the size of fiscal deficits
Fiscal deficits are bigger in negative output gaps, which increases the need for automtic stabilisers, so more transfer payments to be paid out to individuals + reduction in tax revenue as more people being unemployed
May also use fiscal discretionary policy
How does demographic factors influence the size of fiscal deficits
Aged populations means lots of people in retirement–> running fiscal deficits, claim tranfer payments (old age pensions) + no longer conributing to tax
Young population means more individuals go to school so requires more current expenditure, decreasing tax revenue
How does political priorites influence the size of fiscal deficits
The austerity aim has helped to decrease the size of the deficit but attempting to increase AD would increase spending. The austerity policy managed to reduce the fiscal deficit by 75% since 2010.
How does the performance of the housing market influence the size of fiscal deficits
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
How does interest payments on debt influence the size of fiscal deficits
If yield (I.R) are low, this encourages the govt to increase fiscal deficits as the opp. cost of borrowing money is low
If yield is high, this incentivises the govt to decrease fiscal so cost of borrwing is high
How does unforeseen events influence the size of fiscal deficits
Many unforeseen events occur each year which require government support 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)
Explain how interest rates is an implication of national debt
An increase on national debt increases I.R, which can crowd-out private investment.
Govt wants to borrow lots of £ to create lots of additional govt bonds. Supplying more govt bonds to entice people to buy all of them, offer people with high returns on those investments, increasing yield on govt bond so lending to govt is more attractive
Govt have all currency available in economy, which increases I.R. and stops growth of private sector
Explain how debt servicing is an implication of national debt
High debt means a significant proportion of tax revenue is merely paying off interest on previous borrwing
This is an opp. cost. Tax revenue is not going on current capital and transfer but paying off interest on debt instead
5% of government spending goes on interest payments which amounts to over £800m a week.
Explain how inter-generational equity is an implication of national debt
Borrowing today means that those living today recieve benefits at the expense of future generations. This decreases the spending power of future generations reducing economic welfare
The greater the debt, the greater the burden on the next generation of tax payers
BUT the % of GDP of debt falls overtime due to inflation
Explain how credit ratings is an implication of national debt
Economies with high national debts will see its credit rating fall, leading to an increase in borrowing costs (I.R.)
Explain the relationship between national debt and fiscal deficit
National debt is the sum of all fiscal deficits. A fiscal deficit occurs when government spending is higher than tax revenue. When fiscal deficits rise, national debt growth increases. This also factors in the rising amount of interest payments on increased borrowing as the Public Sector Cash Requirement ( cash needed to fund spending) is higher. When fiscal deficit fall, national debt is still rising, but at a slower rate. The only way national debt can fall is through policies which allow fiscal surplus via more tax revenue compared to government spending over time.
Explain the impact on the circular flow of income of an increasing budget deficit
A budget deficit will arise if government spending is greater than tax revenue. As this spending is an injection, and the tax revenue a leakage, net injections and national income should increase. With multiplier effects and the increased growth of national income, this could increase investment via the accelerator effect, and this should increase national income further.
Evaluation: higher NI increases import spending for an economy like the UK which has a high marginal propensity to import, and higher tax revenue should increase leakages. Both these leakages will reduce net injections and national income depending on what the government does with this tax revenue.
Is high level of national debt a concern?
- Depends in part of the root causes (both cyclical and structural)
- Depends in part on the cost of annual debt interest payments which is in turn affected by the yield on new bond issues
- Depends on the ability of the govt to attract investors to buy new debt
- Depends on the forecast impact of inflation on real value of unpaid debt
- Depends on value judgements about how best to fund public services and welfare and which generation should bear the cost of doing this
Why does a rise in national debt depend on the ability of the govt to attract investors to buy new debt
When investors are attracted to UK government bonds, it often results in lower I.R. (or yields) on new debt issued by the government. If the demand for gilts is strong, the UK government can issue debt at lower interest rates because investors are willing to accept a smaller return on their investment in exchange for the security of holding government bonds. This reduces the overall debt servicing costs (the interest the government must pay to bondholders) relative to the size of the debt.
Investor confidence in UK govt bonds is high
Keynsian economic theory on debt and welfare funding
Keynesian economists often argue that increased government spending (even if it leads to higher debt) can be beneficial, especially during times of economic downturn or recession. They believe that public investment in welfare and services can stimulate economic growth, create jobs, and increase tax revenues in the future, thereby making the debt more manageable.
What is fiscal austerity
Increase in taxation and/ or a decrease in govt spending
Disadvantages of fiscal austerity
- Fall in household yD
- Cutting welfare payments impacts on poverty + inequality e.g. 800 libraries have closed in the UK since austerity was implemented in 2010
- Taking away incomes of poorest in economy, which can lead to absolute or relative poverty
- Lorenz curve shifts right
Reducing fiscal deficits and national debt
What are the negative short run impacts of fiscal austerity
- Govt spending= injection, taxation- withdrawal
- AD moves inwards
- Unemployment rises and firms layoff workers
- Increase in govt spedning on welfare benefits
- Fall in tax revenue
Reducing fiscal deficits and national debt
What are the negative long run impacts of fiscal austerity
Declining services and infrastructure affects both physical and human capital, which leads to immobility of labour, reducing international competitivness, decreasing domestic investment as firms can get better human capital oversease
Reducing poverty and inequality
How can fiscal policy tackle poverty and inequality
- Fiscal policy: more use of porgressive taxes and inceased redistribution via more public spending on merit goods, welfare support and policies aimed at improving mobility of labour
- E.g. better healthcare, better education, better access to housing will increase social mobility, better human capital to apply for high paid jobs + fitter/ healther, better skills
- Increase NMW, imposing maximum wage rates on high income earners reduces gap between highest paid and lowest paid workers
What are disadvanatges on implementing fiscal policy to tackle poverty and inequality
- Laffer curve: lower tax revenue
- Reduces incentive to work if transfer payments increase
- Crowding argument (reduces incentives to invest)
Changes in I.R. and supply of money
Fisher equation of exchange
MV=PY
M= money stock- quantity of notes+ coins in circulation
V= velocity of circulation
P= price level
Y= level of real income (volume of transactions)
V tends to remain constant/ stable
Changes in I.R. and supply of money
What do classical economists say will happen if M.S. increases
Classical economists will assume that expansion of M.S. will increase P.L. without increasing real income because economy will move towards full employment anyways
Increase in M.S.–> households and firms have excess cash balances, which will boost C+I but also savings, decreasing I.R, which increases AD, creating inflation
Changes in I.R. and supply of money
What do monetarists say will happen if M.S. increases
Monetarists: Expanding M.S. might not create SR inflation due to spare capacity in the SR, Expansionary monetary policy can therefore be used in the SR.
Changes in I.R. and supply of money
What do Keynsian economists say will happen if M.S. increases
Keynesian economists believe when M.S. increases, liquidity of banks increases. This decreased I.R. and encourages a growth in AD, which tackles spare capacity.
Why do Keynsian economists believe an increase in M.S. may not increase AD
Keynesian economists believe this may not happen due to poor animal spirits. Lower I.R. may not attract borrowing because of pessimism over the future of the economy and therefore the ability to repay. Bankes may also be reluctant to lend for the same reasons i.e. high risk of default on lent money
Measures to increase international competitiveness
- SSP’s e.g. improving both physical and human capital
- Trade liberalization (increases competition and steers towards industries where we have comparative advantage): Resouces of allocation is more efficient
- Lower taxes to encourage more investment and employment (corporation tax- increase FDI, income tax- boost productivity of workers, incentivize firms to enter labour force)
- Policies aimed at currency depreciation
What is transfer pricing
MNCs own lots of smaller businesses. Here they can move profits into economies where corporate tax rates are lower. This means govts may receive very limited tax revenue from MNCs
4 problems faced by policy makers when making policies in global context
- Inadequate info
- Inability to control external shocks
- Uncertainty
- Risk
Why is inaccurate infomationa problem facing policymakers when applying policies
- Data often lags reality as underlying economic conditions can change quickly
- Data on unemployment, inflation, GDP growth etc. is useful for identifying trends, but the reason for the trend may not always be clear and policy decisions may be based on incorrect assumptions
- Some policies might be decided without perfect information. This might require a full costbenefit analysis, and it could be time-consuming and expensive.
Why is the inability to control external shocks a problem facing policymakers when applying policies
External shocks have a ripple effect on economies around the world and globalisation makes it very difficult to protect against them
Why is risks and uncertainities a problem facing policymakers when applying policies
- Identifying risks and establishing the uncertainties contained within any policy decision can be a very difficult task indeed
- The risks may be greater than expected
- The uncertainties may not even be identifiable when the policy is instituted e.g. the impact of the Brexit vote contained many foreseen outcomes (e.g. loss of free movement), but there were also many uncertainties which were not recognised e.g. the need for many small UK firms to relocate operations to Europe in order to avoid excessive export costs
