4.5 Role of the state in the macroeconomy Flashcards
Capital government expenditure
Spending on long term investment goods such as new roads, schools and hospitals which will be consumed and provide benefits in over a year
Contributes to economic growth and productivity by enhancing a country’s physical and human capital
Current expenditure
Consists of day to day government spending on recurring items, such as salaries, maintenance and operational costs
Running gov agencies e.g providing public services and covering welfare programmes like JSA
Maintains existing level of public services but does not typically contribute directly to long term economic growth
Transfer payments
Government payments made to individuals or groups without any expectation of goods or services in return
e.g social welfare payments like pensions, subsidies to specific industries and grants to local governments
Redistributive in nature, aimed at providing support to individuals or entities in need
Reasons for changing size and composition of public expenditure
Global context
In response to economic crises or changing economic conditions, governments may increase spending to stimulate growth or reduce spending to control deficits
Changing demographics, such as ageing population, can lead to increased spending on healthcare and pensions
Political ideologies can influence composition of pub expenditure, with some governments favouring social welfare programs and others emphasising defence or infrastructure
Examples of pub expenditure as % of GDP
Higher
France - 58%
Italy - 56%
Japan (ageing population)
USA - 38% austerity adopted since 08’
Lower
2022 - Ireland (21.2%)
Lithuania (36.4%)
Income and % of GDP spent by gov
The lower the average income in most mixed and free economies, the lower is likely to be the percentage of GDP spent by the government
This is because poorer countries tend to have lower tax revenue due to avoidance and inefficiency at collection.
Citizens in higher income countries demand more g+s from their gov which are income inelastic
However, amongst developed countries there are significant differences in the size of gov spending. This can be due to differing attitudes e.g USA and private healthcare
Impact of spending on productivity and growth
Gov spending is wasteful and causes inefficiency according to free market economists
However, the gov can enjoy EOS when it provides goods improving productivity
They also provide infrastructure - improves efficiency of workers and geographical mobility
Education creates the human capital needed for growth whilst healthcare system reduces the num of days workers lose from serious illness
Spending on R+D may not be done by the private sector and gov can undertake this to give businesses long term competitive edge - improving quality of goods and encouraging innovation - dynamic efficiency
Spending creates multiplier effect which can be focused on areas of high unemployment creating growth
Impacts of spending on living standards
Government corrects market failure and provides public goods which can help improve social welfare
They also reduce absolute poverty by providing benefits and basic goods such as education and healthcare
However, in developing countries, governments do not have the resources to do this and this leads to malnutrition, poor water etc
Government can be inefficient at providing g+s and will have a negative disincentive effects on workers meaning overall output is reduced and so living standards fall
Principal agent problem
Government make decisions on behalf of the people and individuals may have spent that money differently. As a result, there is a loss in welfare and so 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
Crowding out
In order to spend money above their tax revenues, the government has to borrow from individuals and businesses. However, the amount of money in the economy available to borrow does not increase.
The government will therefore be competing with the private sector for finance and will cause higher I.R.
This will discourage firms from investing and individuals from buying on credit
The limited number of resources in the economy means that for every resource used in the government spending, there are less resources available for the private sector. The result is government borrowing crowds out private sector borrowing and spending and may lead to no real increase in AD
Free market economists argue that investment would be more efficient if done by private sector and that government targets investment poorly
Crowding out effect is felt most at full employment (not alway the case)
Crowding out evaluation
Transfer payments have no impact on output and so would not cause crowding out as resources are simply taken from one group and given to another.
Moreover, when levels of unemployment are high then extra government spending could lead to crowding in where it encourages investment through the multiplier
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 disincentive effect
Oil rich countries
Tend to be an exception from taxing high as revenue from oil can pay for most of government spending
Equality
Spending should increase equality as it leads to redistribution and helps to provide a minimum standard of living fro the poorest in society
Ensures everyone has access to basic goods, such as education and healthcare, which will help to give them a fair start in life
Taxation
Critical for governments to raise revenue and achieve various economic and social objectives such as correct market failure etc
Progressive tax
Those on higher incomes pay a higher marginal rate of tax - pay higher percentage of their income on tax
e.g Direct tax (income)
Regressive tax
Proportion of income paid in tax falls as the income of the taxpayer rises
Those on higher incomes pay smaller percentage of their income on tax
e.g indirect such as VAT
Proportional tax
Where the proportion of income paid in tax remains the same whilst the income of the taxpayer changes e.g 10% of income is spent on tax regardless of income
Incentive to work (tax changes)
High rates of direct tax will discourage individuals from working
High taxes on high income earners could encourage them to move abroad and taxes on poor may lead to poverty trap
High income tax reduces incentives more than high VAT
Free market 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
Increased VAT may mean that people have to work longer to maintain income so increase in incentive
Income distribution (tax changes)
Progressive tax system will increase equality of income distribution as more money is proportionally taken from from rich than the poor
Regressive tax decrease income equality
Inheritance tax - most progressive from of tax
One issue with using tax to for redistribution is that it does not give the poor anything, so the system needs to be supported with benefits
Real output and employment
A rise in direct tax will reduce the level of disposable income causes a fall in their spending and thus a fall in AD
Could also cause a fall in leftover profits for businesses and therefore a fall in investment
The effect this has on output will depend whether economy is at full employment or not
Higher indirect tax increases costs for firms and this will decrease SRAS. This impact will again depend on where the economy is producing.
It can be argued that income taxes cause a disincentive to work and therefore reduce LRAS as the most skilled workers go overseas and more people become inactive
Price level
Indirect taxes e.g VAT often cause cost push inflation. They can increase the costs of goods such as cigarettes and fuel if producers choose to past on costs to consumers
Since these are price inelastic, producers are likely to pass on costs of tax onto consumers
Trade balance
A rise in taxes will decrease income and therefore decrease consumption.
Consumers will spend less on imports which have been found to be highly income elastic in the UK.
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 will decrease
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 tend to continue to lower their taxes in order to make them the lowest to encourage investment - leading to a fall in revenues for all countries
Automatic stabilisers
Mechanisms which reduce the impact of changes in the economy on national income
Government spending on taxation are automatic stabilisers
In recession, benefits increase as more people are unemployed and so the benefits are a stabiliser as it mean the overall fall in AD is reduced
In a boom, tax increases as people have more jobs and higher incomes, and this tax reduces disposable income so decreases consumption and AD
Cannot prevent fluctuations
Benefits may act as disincentive to work and lead to higher unemployment whilst high levels of tax can decrease incentive to work hard
Discretionary fiscal policy
The deliberate manipulation of government expenditure and taxes to influence the economy - expansionary and deflationary policies
National debt
The sum of all government debts built up over many years
Fiscal deficit
When the government spends more than it receives that year
Measurement of fiscal deficit and national debt
Measured in money terms or as a percentage of GDP
GDP measure often more useful because it gives an indication of how easy it is to be for the government to finance a deficit or repay the national debt
2024-25 - expected uk deficit of 4.8% of national income
Cyclical deficit
Part of the deficit that occurs because gov spending and tax fluctuates around the trade cycle
Recession - tax revenues are low and spending is high creating a larger deficit
No cyclical deficit at peak of boom (only structural)
Structural deficit
The fiscal deficit which occurs when the cyclical deficit is zero - it is long term and not related to the state of the economy
Actual deficit
The structural deficit plus fiscal deficit
Structural surplus
Occurs when at peak of boom, there is an actual fiscal surplus
Structural balance
Occurs when at the peak of a boom, the actual fiscal balance is zero
Structural deficit and national debt
If gov has structural deficit it is likely that national debt will grow overtime as the government has to consistently borrow money to finance spending
Argued that structural deficits needs to be eliminated but is difficult to do since it is impossible to know what part of the deficit is structural and what part of it is cyclical - just as it impossible to know size of the output gap
Factors influencing size of fiscal deficits
Trade cycle
During a downturn, government tax revenues decrease whilst government spending increases and so the deficit increases
Unforeseen events
Huge increases in spending which increase deficit
Interest rates
if I.R increase, the amount the gov pays in interest repayments increase and this is likely to increase deficit. But impact depends on significance of interest repayments in the size of the deficit, market rates and credit ratings of the government
Privatisation
Provide one-off payments to the gov which will decrease the deficit in the short term - depends on value of company sold
Gov aims
Influences fiscal policy
High revenue from oil
Runs a budget surplus so gov rev is important for size of deficit
Number of dependents
Affect spending and tax revenues
Factors influencing size of national debt
Continuous deficit
National debt will increase overtime
Fiscal deficits over 3% generally will lead to growing national debt as a proportion of GDP
Its only when gov runs a budget surplus that the size of national debt decreases
Ageing population
Contribute to high national debt since the gov runs a structure deficit ignorer to fund their pensions and care and this leads to a high national debt
significance of fd and nd on interest rates
High levels of borrowing may raise interest rates since an increase in demand for money will increase the price of money.
Will cause crowding out of the economy
However, this may not always be the case as the government ay borrow from overseas and during a recession, private sector investment falls which means interest rates may remain unchanged
Opportunity cost
Countries have to spend a large amount of money on servicing their national debt through interest repayments, which has high opportunity cost
A primary budget deficit is the actual budget deficit but does not include interest repayments on the national debt
The impact will depend on the level of interest rates and the size of the primary deficit compared to interest rates and size of primary deficit compared to interest repayments
In liquidity trap, government has to borrow money to simply to finance day to day spending
Argued that government should run a current budget surplus to enable it to invest for the future expect in recession where they can run a deficit to increase AD
Current budget deficit
Problematic as it means future generations are forced to pay for todays expenditure
If deficit is due to capital expenditure, the future generations benefit from increased spending and so their extra tax bull to pay for todays borrowing can be justified
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
Inflation (significance of fd and nd)
High fiscal deficit can cause inflation
If gov increases spending and their is no similar fall in private sector spending, AD will rise and this can be inflationary
If a gov 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.
Credit rating
High levels of debt tend to result in a reduced credit rating for the government
Private sector companies estimate the likelihood that a government 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
However, in reality, it is not the size of the debt that influences the level of risk involved with the lending of money, it is whether the country has ever defaulted on their loads before and their current economic/ political climate
Foreign currency
If government has borrowed from abroad, it may be difficult getting enough foreign currency to make repayments on its debt
This could also cause problems for consumers as if there is not enough foreign currency, they will be unable to import goods
Benefit growth
Gov borrowing can benefit growth if used for capital spending since this will improve the supply side of the economy and this reduce the deficit in the long term
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 a recessions
Austerity
Type of government fiscal policy
Fiscal austerity is a policy approach that involves reducing government spending and or increasing taxes in order to reduce budget deficits and debt
To improve financial health of gov by reducing its reliance on borrowing and stabilising its debt to GDP ratio
Adopted by UK in 2010 in following expansionary fiscal policy used in 2008
Issuing bonds
Gov can issue bonds to raise finance
This is considered long term effective solution to eliminate gov debt
However it can help avoid raising taxes in the short run
The government has to pay interest to the investors who buys the debt which has to be repaid at some point
Reliance on automatic stabilisers
Allows economy to grow so national debt/fiscal debt will reduce as a % of GDP
Mainly approach that US took after the GFC and their economy recovered daily quickly
Default on loans
One way to reduce national debt but the economic cost of this is so large that the governments only default it if it is their only option
Russia and Argentina have defaulted on their debts in the past
Policy to reduce poverty and inequality
Progressive tax system which will produce a more equal distribution of income after tax
Inheritance tax means that wealth inequality will be reduced as less money can be passed on to the next generation
Tax means that money can be taken from the rich and given to the poor
However, this tax is difficult to enforce as they are avoidable by careful tax planning
Benefits
Policy to reduce inequality
Universal benefits are available to everyone who meet a certain criteria, respective of personal income
Means tested benefits are only available to people who have sufficiently low levels of income/wealth. They are targeted at people who need the most help and provide a safety net/minimum standard of living and are better at improving inequality as they directly affect the poor
However benefits may reduce incentive to work, especially if they can earn a similar amount on benefits to what they could in work
The extent to which governments should use spending to redistribute income is highly controversial, particularly with high levels of national debt and austerity as seen in the UK
Transfer payments as a mean of reducing inequality
Gov can provide goods and services which give citizens equal opportunities and access to services they may not otherwise be able to afford, such as healthcare and eduction
This helps ensure that everyone is given an equal start in life e.g poor children will not lose out if their parents cannot afford them eduction
Problem with these is that they also benefit those on higher incomes and incur an opportunity cost
UK - free healthcare however in USA and other countries not the case
Reduce wage differentials
A national minimum wage will improve the incomes of the poor whilst maximum wages or pay ratios will reduce the incomes of the rich and could even mean companies increase the pay of their lowest income
However minimum wage may cause unemployment (firms cut back on costs) and maximum wages may lead to loss of most skilled workers (brain drain)
Equal pay legislation will prevent inequality between men and women or between different ethnic groups
Trade union friendly legislation will allow the wages of their workers to rise and those in unions are more likely to be paid low so this will improve equality
Employers can be forced to provide benefits to their workers such as sickness benefits, pensions and medical care which will increase wages
Access to education and training
Improvements to access will prevent children from poorer backgrounds achieving less than others which would reduce their earning potential
Government attempted this through additional funding and easier access to universities (contextual grades)
Price controls
On essential goods, such as housing, bus fares, bread, electricity etc
Will increase spending power of the poor
However this could cause excess supply and may lead to the development of black markets
Trickle down
Concept argues that increasing the incomes of the rich will lead to an increase in the income of the poor
The rich create jobs by spending their money and employing others and reducing their income would reduce employment and lead to lower loving standards
Also believed that inequality is necessary to encourage people to work hard and therefore increase their income
Law of diminishing marginal utility
Suggests that redistribution increases total utility and therefore is better allocation of resources
The higher the spending of an individual, the less satisfaction gained from spending an extra pound
£10 a week given to a poor family increases the satisfaction more than £10 given to rich family would
High growth rates of nordic countries where redistribution is high suggests that it is not negative for economic growth
Changes in interest rates and the supply of money
Monetary policy to stimulate economy and raise government revenue
e.g low interest rates
This encourages spending and investment, in order to try and boost economic growth
Quantitative easing
Used typically when interest rates are very low and cannot be lowered much further
The bank buys assets in the form of government bonds using the money they have printed electronically
This is then used to buy bonds from investors which increases cash flow in the financial system
This encourages lending to firms and individuals since it makes the cost of borrowing lower
The theory is that this encourages more investment, more spending and higher growth
Could cause inflationary pressures
Measures to increase international competitiveness
The cheaper the relative unit labour costs, the more competitive the country in manufacturing
China, India and more have lower labour costs to a lot of production requiring manufacturing has moved abroad
Unit labour costs rise when wages increase at faster rate than productivity. Chinas large population means low wage costs but rise of consumer spending has driven wages up
Countries such as Germany are famous for producing high quality engineered goods, such as cars so consumers might be willing to pay more for them
Currency manipulation
Used by china to increase international compteiviness
Devalued the renminbi in order to make their relative export price lower
however this is not policy relevant for countries with floating exchange rates
Lowering corporation tax
Used by UK 2021 - 19% - 17% to increase international competitiveness
Should help increase inward investment
Supply side policies
Furthermore, simplifying business regulation for businesses so it is cheaper and easier to meet environmental targets and create new jobs
Should help encourage investment and innovation so domestic firms can become more internationally competitive
Join WTO
Sign trade agreements to increase international competitiveness
Responding to commodity price shock
Oil prices increase greatly
Gov can use expansionary policy to reduce the impact of a fall in GDP of deflationary policy to reduce impact on inflation
Responding to financial crisis
expansionary policy to increase AD
Brexit
Interest rates lowered to improve confidence but then raised to deal with inflation caused by the falling value of the pound
TNC
Transnational companies
Can bring huge gains to an economy through their creation of jobs, the tax revenues they raise, the knowledge they bring and the investment they undertake
Can have negative social and economic impact by destroying local culture, affecting environment and withdrawing more in profits than injection through investment
Also have history of influencing politicians to take decisions that will favour their interests and are involved in tax avoidance
Joint company with local partner
Some developing countries don’t allow TNC’s to set up in their country without first setting up a joint company with local partner, meaning that some profits are retained within the country and knowledge/tech is transferred
Many governments use import contracts with TNCs meaning that at least some part of the value of the order must be manufactured in the country
Transfer pricing
Transfer pricing is a way for firms to engage in tax avoidance
Occurs if firm produces a good in one country and then transfers it to another (low tax) to make it into a good which it then sells for a low price
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 bills
Regulating transfer pricing
UK - companies which don’t allocate sufficient profits are challenged by HMRC and this has led to billions of pounds earn in taxes
OECD - Transfer pricing guidelines on cross border services, intangibles, cost contribution arrangements and advance pricing guidelines (modified in 2010)
Arms length principle - aim for the price to be the same as if the two parties were independent of each other
Ability to control global companies
Difficult for individual governments to control TNC’s
Small countries earn less in revenue than a TNC earns in profits
May need TNCs to sustain the country - bring in the most investment of the country
EU suffers from legal tax avoidance schemes where costs revenues and profits are routed through Ireland and then sent to tax haven like Bahamas
Solutions to taxation
Difficult as they require worldwide agreement
However, any solution which would benefit country like UK would lead to possess for countries like the Bahamas and Ireland
There is also division within countries e.g Democrats vs Republicans
Division allows TNCs to be able to prevent any agreement they do not like through immense lobbying
Solutions are also time consuming and costly
Inaccurate information
Problem facing policy maker
Short term info such as GDP figures for previous month are often inaccurate and so government may be unable to see if there are problems within the economy
Cutting down on avoidance/evasion is difficult as the government does not have full picture of level of avoidance, who is avoiding and best way to reduce it
BoE makes decisions based on past data but trends in economy change so data may be outdated and an inaccurate picture of where economy is heading especially with interest rates so low
Full cost benefit analysis can be time consuming and costly and impractical for gov to gain every single bit of info they need
Risks and uncertainties
Gov cannot accurately predict future and so it is difficult for them to know whether extra spending is necessary
Can’t know full impact of decision as consumers often react unexpectedly and could undermine gov policy
Managing risk is essential for good decision making
External shocks
Gov is unable to control and prepare for these external shocks - the best they can do is lessen impact
Very unique so difficult to know best method to solve problem
Policies employed by policy makes may not have their intended impacts and it may undermine current policies in place e.g Brexit delayed gov plans to budget
