4.5 - The Role of the State in the Macroeconomy Flashcards
What was a budget deficit?
When public expenditure is greater than tax revenue
Case study - What happened to the USA business cycle between 1918-1929?
- USA was initially in a boom -> continuous growth & 50% increase in output
- 1929 - stock market crashed -> bust -> fall in animal spirits -> 40% fall in average income & 25% rise in unemployment
Case study - What happened to Chile’s business cycle in the 1940s?
- Went through a boom in the 1940s due to effect industrialisations
- Went into a bust in 1982 -> GDP fell by 14.3% + unemployment
Case study - What happened to Japan’s business cycle post-war?
- Increased intelligence investment -> became a technology leader
- Went through a recession in 1991 -> decreased spending -> deflationary spiral
What is a cyclical deficit?
- When public expenditure increases and tax revenue decreases during a recession
- Recession -> fall in real GDP -> decreased production -> decreased workers needed -> derived demand for labour falls -> increased unemployment -> increased benefits & training -> decreased income tax revenue -> deficit
What causes a cyclical deficit?
- Recession -> fall in real GDP -> decreased production -> decreased workers needed -> derived demand for labour falls -> increased unemployment -> increased benefits & training -> decreased income tax revenue -> deficit
What is a structural deficit?
- A budget deficit that remains at any point of the business cycle
- It occurs when public expenditure is greater than tax revenue
- E.g. gov reduction in corporation tax to attract FDI
- Occurs as a result of active decisions by the government
What is national debt?
Give a case study example.
- Total debt built up by government borrowing over time
- Uk’s budget deficit has been falling since 2010, but national debt keeps rising (£1800bn in 2017)
What is the significance of budget deficits & national debt?
- All major developed countries have it - China has a national debt of $5tn & the US = $20tn, UK = more than $2tn
- Don’t matter too much - important to invest in the future now to keep encouraging growth & development e.g. Malawi subsidising fertilisers for farmers ($3tn debt)
What is financial crowding out?
- Increased gov borrowing ->increased interest rates -> decreased private sector investment (crowds firms out of business)
What is crowding out?
When gov borrows large sums of money -> increased demand for money -> increased price of money -> rise in interest rates
What is the impact of national debt on future generations?
- Budget deficit -> increased IR (borrowing to finance public expenditure) -> increased national debt -> increased interest that needs to be paid back -> national debt rises -> rise in taxes & public expenditure for future gens if repayment continues to be delayed -> fall in income & SoL
Why might national debt not be a problem? (eval)
- If money borrowed was used for capital expenditure
- National debt is a small percentage of GDP
- If they’re still able to continue to borrow at a low interest rate
What are the 3 types of public expenditure?
- Capital expenditure
- Current expenditure
- Transfer payments
What is capital expenditure? Give an example.
- What the government spends on long-term assets which have long-term rewards
- Examples: solar panels, building new hospitals
What is current expenditure? Give an example.
What the government spends on recurring costs, e.g. wages, teacher salaries, raw materials
What are transfer payments? Give an example.
- When the government spends money without getting anything in return e.g. benefits & foreign aid
What factors influence public expenditure?
- Age distribution
- Income
- Political values
How does age distribution influence public expenditure? Use 2 case study examples.
- Japan & Botswana
- High living standards -> high life expectancy - Japan is the oldest country in the world
- Japanese are very career focused -> have less children - 27% of the population are over 65 (highest worldwide)
- High spending on pensions & healthcare - pensions are 10% of Japan’s GDP
- 1 in 3 in Botswana are under 15 -> increased spending on education - 7.8% of their GDP is on education
How does income influence public expenditure? What is Wagner’s Law?
- Wagner said that as incomes rise -> increased demand for governemnt g&s -> increased public expenditure - demand for public sector goods = income elastic
- People in developing countries where incomes are low, demand basic necessities not costly public goods e.g. parks etc
- Inferior goods e.g. public transport system, education system
How do political values influence public expenditure? Use your case study example (compared to the USA)
- 50% of citizens say trust in Denmark gov each yr -> they are prepared to pay high taxes for high quality public services
- Denmark has the world’s highest taxes
- Denmark’s gov public expenditure is is 58% of GDP
- 18% trust in USA gov - citizens vote for low taxes & low public expenditure
How do changes in public expenditure affect productivity & growth?
- Increased capital & current expenditure (part of G component) -> AD rises -> growth
- More NHS funding -> improvements in healthcare -> increased productivity -> rise in LRAS -> growth
Evaluate the effects of changes in public expenditure on productivity & growth?
Spending may be eaten up by bureaucracy or spent inefficiently
How do changes in public expenditure affect living standards & equality?
- Increased transfer payments -> rise in income for society’s poorest -> close income gaps
Evaluate the effects of changes in public expenditure on living standards & equality? Use case study example.
Public expenditure can be spent on services that don’t directly help the poor e.g. military is 20% of USA’s public expenditure
What is resource crowding out?
- When all resources in the economy are being used efficiently - show as efficient resource allocation on PPF by movement along PPF -> fewer resources for private sector
- A rise in public expenditure on social housing -> opportunity cost to private sector - less land available for building
What is the difference between direct & indirect taxes? Give examples of each.
- Direct: taxes paid directly to the government e.g. income, corporation tax
- Indirect: paid by the producer when the consumer purchases the product e.g. VAT
What is the difference between specific & ad-valorem tax?
- Specific: a fixed amount on each unit sold
- Ad-valorem: percentage of the price of the good
What are the 3 ways of implementing tax?
- Progressive tax
- Regressive tax
- Proportional tax
What is progressive tax? Give a real-world example.
- The proportion of income, profit, or price you pay in tax increases as your income, profit or price increases
Example: UK
- Income > £12, 570 = 20% of every £ above this
- Income > £50, 270 = 40% of every £ above this
- Income > £150,000 = 45% of every £ above this
What is regressive tax? Give a real-world example.
- The proportion of income, profit, or price you pay in tax decreases as your income, profit or price decreases
- Example: National Insurance - 12% -> 2% once you start earning above £50,000
What is a proportional tax?
- The proportion of income, profit, or price you pay in tax stays the same as your income, profit or price rises
Examples:
- UK corporation tax - 25%
- Cigarettes - 16.5% (ad-valorem)
How do changes in tax affect incentive to work?
- Rise in direct taxes -> decreased incentive to work -> able to keep less of your income -> may work fewer hours -> laziness + early retirement
- Rise in indirect taxes -> increased incentive to work -> products will become more expensive -> people want to work more hours to earn more so they can buy the same amount of products
Examples:
- Top income tax rate - 20% -> 24% (2024) & basic rate rose to 18%
- VAT - 17.5% -> 20% (budget)
How do changes in tax affect tax revenue? How does this relate to Laffer curve?
- Shows the relationship between the tax rate and tax revenue
- As income tax rises -> incentive to work falls -> income tax revenue falls
What does the Laffer curve show?
- As the tax rate increases, tax revenue will increase to begin with
- But, as income tax rates get higher, incentive to work will fall because people will get to keep less of their money -> they work less -> earn less income -> government receives less income tax revenue
What are the reasons why income tax revenue starts to fall off as tax rate increases?
- Decreased incentive to work - people work fewer hours & earn less income -> pay less income tax.
- Increase in tax evasion & avoidance - people are more likely to try & find ways to avoid paying income tax if the rate increases
- Brain drain - highly skilled & productive high earners may choose to move to a different country where they are able to keep more of their income -> government receives none of their income tax
How do changes in tax affect income distribution?
- Increased direct tax (e.g. income tax) often means the rich will up paying more tax -> closes the gap between the rich & poor - more equality
- Indirect taxes, e.g. VAT, are often regressive - the poor spend a much higher % of their income (higher MPC) -> pay a higher percentage of their income in VAT -> widens the gap between rich & poor - more inequality
How do changes in tax affect price level?
- Increased direct tax -> workers keep less of their income & businesses keep less of their profit -> reduce consumption & investment -> AD falls -> price level falls
- Indirect taxes, e.g. VAT, are often regressive - rise in VAT -> G&S more expensive -> consumption falls -> AD falls -> price level falls
How do changes in tax affect output & employment?
- Increase in direct taxes → Workers keep less of their income + companies keep less of their profits → consumption & investment fall → AD falls → derived demand for labour falls → employment falls → output falls → Real GDP falls
- Rise in VAT → G&S more expensive → decrease consumption → decrease AD (same chains)
How do changes in tax affect trade balance?
- An increase in some indirect taxes, e.g. tariffs, can reduce the demand for imports (more expensive) -> improves the trade balance
- However, an increase in other indirect taxes, like VAT, has no impact on import demand - just make all goods more expensive
How do changes in tax affect FDI flows?
- Increase in direct taxes → managers & CEOs keep less of their incomes → FDI decreases
- Increase in indirect taxes → G&S more expensive → Consumers buy less → Companies make less profit → Less FDI
What are the 2 main problems facing policymakers?
- Inaccurate information
- Risk & Uncertainty
How does inaccurate information affect policymakers? Give real world examples.
-In 2014, inaccurate information about school enrolment -> massive misallocation of resources in Kenya
- Thank you payments were given to schools with increased enrollment rates (corrupt officials lied) -> areas in need went underfunded
How does risk & uncerainty affect policymakers?
Give real world example
- In 1947, the UK invested £36.5 million on an investment in machinery in Tanzania - wanted to develop Tanzania’s export sector
- However, there was a huge risk -> policy went wrong, which led to tens of thousands of acres of land being destroyed - machines ended up being unsuitable for humidity
What is transfer pricing?
Allows parent companies to move profits between their daughter companies, in order to minimise the corporation tax they have to pay
What is a daughter company?
A smaller company which is owned or controlled by the larger company
What is the arm’s length principle?
- A method of regulating transfer pricing
- It states that, in any transaction between daughter companies, the price should be set the same as it would be if the company was selling its good to an unrelated, third party.
What type of policy is the arms length principle?
- A type of direct control - it directly controls the minimum prices that daughter companies can charge for their goods
What does TNC’s being footloose mean, and what is the impact of this?
- TNCs are footloose: they can relatively easily locate in different countries
- Governments are more scared to regulate transfer pricing as the TNC can just move to a different country where it is able to use transfer pricing -> the country which has regulated will lose investment, jobs & tax revenue
