4.5.1 Fiscal policy and Supply side policy

Question 1

Define Fiscal policy

Answer 1

Fiscal policy involves the manipulation of government spending, taxation and the budget balance. It can have both macroeconomic and microeconomic functions.

Question 2

Outline government spending and taxation as an instrument of fiscal policy

Answer 2

Governments can change the amount of spending and taxation to stimulate the economy. The government could influence the size of the circular flow by changing the government budget, and spending and taxes can be targeted in areas which need stimulating.

Fiscal policy aims to stimulate economic growth and stabilise the economy. In the UK, the government spends most of their budget on pensions and welfare benefits, followed by health and education. Income tax is the biggest source of tax revenue in the UK.

Question 3

Outline Expansionary fiscal policy and give a supporting diagram

Answer 3

This aims to increase AD. Governments increase spending or reduce taxes to do this. It leads to a worsening of the government budget deficit, and it may
mean governments have to borrow more to finance this.

Question 4

Outline the Deflationary fiscal policy and give a supporting diagram

Answer 4

This aims to decrease AD. Governments cut spending or raise taxes, which reduces consumer spending. It leads to an improvement of the government budget deficit

Question 5

How fiscal policy can be used to influence AS:

Answer 5

• The government could reduce income and corporation tax to encourage spending and investment.
• The government could subsidise training or spend more on education. This lowers costs for firms, since they will have to train fewer workers. Spending more on healthcare helps improve the quality of the labour force, and contributes towards higher productivity.
• Governments could spend more on infrastructure, such as improving roads and schools.

Question 6

Define budget deficit

Answer 6

A government has a budget deficit when expenditure exceeds tax receipts in a financial year.

Question 7

Define budget surplus

Answer 7

A government has a budget surplus when tax receipts exceed expenditure.

Question 8

Distinguish between government debt and government deficit

Answer 8

It is important to distinguish between the government debt and the government deficit. The debt is the accumulation of the government deficit over time. It is the amount the government owes. The deficit (or surplus) is the difference between expenditure and
revenue at any one point.

Question 9

Define direct taxes

Answer 9

Direct taxes are imposed on income and are paid directly to the government from the tax payer. Examples include income tax, corporation tax, NICs and inheritance
tax. Consumers and firms are responsible for paying the whole tax to the government.

Question 10

Define indirect taxes and the different types

Answer 10

Indirect taxes are imposed on expenditure on goods and services, and they increase production costs for producers. This increases market price and demand contracts.

There are two types of indirect taxes:
o Ad valorem taxes are percentages, such as VAT, which adds 20% of the unit price. This is the main indirect tax in the UK.
o Specific taxes are a set tax per unit, such as the 58p per litre fuel duty on unleaded petrol.

Question 11

Outline proportional tax as an direct tax

Answer 11

A proportional tax has a fixed rate for all tax payers, regardless of income. It is also called a flat tax. For example, all tax payers might have to pay 20% income tax rate. The incidence of taxes is equal, regardless of the ability of the taxpayer to pay. It could encourage people to earn higher incomes, because the rate of tax paid does
not increase.

Question 12

Outline progressive tax as an direct tax

Answer 12

A progressive tax has an increase in the average rate of tax as income increases. As income increases, the proportion of income taxed increases.

Question 13

Outline regressive tax as an direct tax

Answer 13

A regressive tax does not relate to income, but means those on lowest incomes have a higher average rate of tax. In other words, the proportion of income paid as tax is higher for those on lower incomes than those on higher incomes.

Question 14

Outline the Cannons of taxation

Answer 14

These ‘Canons of Taxation’ were first developed by Adam Smith. They are essentially the criteria taxes are judged by. They are:
1. The cost of collecting the tax must be low relative to the yield
2. The timing and quantity paid must be obvious to the tax payer
3. The timing and way of paying should be convenient for the tax payer
4. Taxes should be imposed depending on the ability to pay. Taxes should also be equitable.

These have been updated to include:
5) The tax should not limit efficiency, and there should only be a minimum loss of efficiency.
6) Tax should be compatible with tax systems of other countries. For the UK, taxes should be compatible with the rest of Europe.
7) Taxes should adjust with inflation.

Question 15

Outline the Limitations of fiscal policy

Answer 15

• Governments might have imperfect information about the economy. It could lead to inefficient spending.
• There is a significant time lag involved with employing fiscal policy. It could take months or years to have an effect.
• If the government borrows from the private sector, there are fewer funds available for the private sector, which could lead to crowding out.
• The bigger the size of the multiplier, the bigger the effect on AD and the more effective the policy.
• If interest rates are high, fiscal policy might not be effective for increasing demand.
• If the government spends too much, there could be difficulties paying back the debt, which could make it difficult to borrow in the future

Question 16

Define Current government expenditure

Answer 16

Current government expenditure is spending which recurs. This is on goods and services which are consumed and last for a short period of time. For example, it could be on drugs for the health service

Question 17

Define Capital government expenditure

Answer 17

Capital government expenditure is spent on assets, which can be used multiple times. For example, it could be government expenditure on roads or building a
school.

Question 18

Define and give examples of Transfer payments

Answer 18

Transfer payments are welfare payments from the government. They aim to provide a minimum standard of living for those on low incomes. No goods or services are
exchanged for transfer payments.

Examples of transfer payments in the UK include:
o Job Seeker’s Allowance
o Income Support
o Child benefit
o The state pension

Question 19

Reasons for the changing size and composition of public expenditure in a global context

Answer 19

• In the UK, the government spends most of their budget on pensions and welfare benefits, followed by health and education. Income tax is the biggest source of tax revenue in the UK.
• Education spending in the UK has remained relatively constant. This is because it is protected so it does not fall, but it also does not increase much either.
• Social security payments are payments from the government to assist those who have low incomes. After the war, people saw this as necessary, so there has been a general increase in spending.
• Defence spending in the UK is falling. This is the area the government spends least on.

Question 20

The significance of differing levels of public expenditure as a proportion of GDP on Productivity and growth

Answer 20

• Governments can spend money on supply-side policies to improve human capital and boost long run growth. Human capital is important for competitiveness. The government could invest in youth apprentice schemes, for example, to make people more employable and productive from a young age.
• Education and training can mean higher value products can be made and productivity can be improved. Fiscal policy aims to stimulate economic growth and stabilise the economy.
• The government could influence the size of the circular flow by changing the government budget, and spending and taxes can be targeted in areas which need stimulating.

Question 21

The significance of differing levels of public expenditure as a proportion of GDP on Crowding out

Answer 21

• Governments might have to fund its spending using taxes or running a budget deficit. This leaves fewer funds in the private sector for firms to use, since the government is borrowing money, which crowds them out of the market.
• When the government borrows a lot of money, interest rates might increase.
• This discourages spending and investment among the private sector.
• This reduction in private sector investment is the ‘crowding out’ of investment.
• Sometimes, crowding out refers to the government provision of a good or service, which would otherwise be provided by the private sector

Question 22

The significance of differing levels of public expenditure as a proportion of GDP on Level of taxation

Answer 22

The tax rate might increase if government debts get too high. If confidence is lost in the government’s ability to repay the debt, governments might have to raise interest rates to encourage investors to buy bonds, so that they can finance the debt. It could lead to higher taxes and austerity measures, especially if the debt becomes uncontrollable.

In the UK, the size of government spending is about 40% of GDP. This means that citizens in the UK have a lower tax burden than in a country such as Switzerland, where government spending is 60% of GDP.

Question 23

The significance of differing levels of public expenditure as a proportion of GDP on Equality and living standards

Answer 23

Progressive taxes could be used to reduce inequality, since the poorest in society pay the smallest proportion of their income as tax. Redistributive policies and welfare payments, such as Income Support, could be used to
help those on the lowest incomes. Also, government spending on housing and the provision of public services,
such as education and healthcare, helps provide equal opportunities for people from all income backgrounds. This ensures that even those on low incomes can afford a good standard of healthcare and education. By providing these services, the government ensures that all members of society can achieve a minimum standard of living

Question 24

Define cyclical deficit

Answer 24

This is a temporary deficit, which is related to the business cycle. A deficit might occur during recessions, when governments increase spending to stimulate the
economy.

Question 25

Define structural deficit

Answer 25

This is a deficit which is due to an imbalance in the revenue and expenditure of the
government, so it exists at every point in the business cycle

Question 26

The consequences of budget deficits and surpluses for macroeconomic performance.

Answer 26

A fiscal deficit could be inflationary if it increases AD.
More government spending could lead to crowding out of the private sector. This leaves fewer funds in the private sector for firms to use, since the government is
borrowing money, which crowds them out of the market.
It could lead to increased interest rates. This is because the government has to offer investors an attractive rate in order to encourage them to buy the debt.

Question 27

The significance of the size of the national debt

Answer 27

The cost of borrowing could increase, since by borrowing money, the government is increasing demand for credit in the economy. If confidence is lost in the government’s ability to repay the debt, governments might have to raise interest rates to encourage investors to buy bonds, so that they can finance the debt. It could lead to higher taxes and austerity measures, especially if the debt becomes uncontrollable.

Question 28

The role of the Office for Budget Responsibility

Answer 28

• The OBR provides analysis of the UK’s finances.
• They produce 5-year forecasts for the economy, including the impact of tax and spending changes announced in the Budget.
• They judge the government’s performance against its fiscal targets. These are to balance the budget 5 years ahead and have net public sector debt falling in 2015-16.
• They assess the likelihood of the government meeting the targets.
• They scrutinise tax and welfare spending measures.
• They also assess how sustainable public sector finances are in the long run

Question 29

Briefly outline what is meant by Supply side policies

Answer 29

Supply-side policies aim to improve the long run productive potential of the economy. The economy can experience supply-side improvements in the private sector, without government intervention. For example, there could be improvements in productivity,
innovation and investment.

Question 30

Two main types of supply side policies

Answer 30

• Free-market supply-side policies involve policies to increase competitiveness and free-market efficiency. For example, privatisation, deregulation, lower income tax rates, and reduced power of trade unions.
• Interventionist supply-side policies involve government intervention to overcome market failure. For example, higher government spending on transport, education and communication.

Question 31

Benefits of Supply-Side Policies

Answer 31

1. Lower Inflation- Shifting AS to the right will cause a lower price level. By making the economy more efficient, supply-side policies will help reduce cost-push inflation. For example, if privatisation leads to more efficiency it can lead to lower prices.
2. Lower Unemployment- Supply-side policies can contribute to reducing structural, frictional and real wage unemployment and therefore help reduce the natural rate of unemployment.
3. Improved economic growth- Supply-side policies will increase the sustainable rate of economic growth by increasing LRAS; this enables a higher rate of economic growth without causing inflation.
4. Improved trade and Balance of Payments.- By making firms more productive and competitive, they will be able to export more. This is important in light of the increased competition from an increasingly globalised marketplace

Question 32

Free market supply-side policies

Answer 32

• To increase incentives- Reducing income and corporation tax to encourage spending and investment. This could increase the long run productive potential of the economy, especially if labour and capital becomes more productive. This improves the underlying trend of economic growth.
• To promote competition- By deregulating or privatising the public sector, firms can compete in a competitive market, which should also help improve economic efficiency.
• To reform the labour market - Reducing the NMW (or abolishing it altogether) will allow free market forces to allocate wages and the labour market should clears. Reducing trade union power makes employing workers less restrictive and it increases the mobility of labour. This makes the labour market more efficient

Question 33

Interventionist supply-side policies

Answer 33

• To promote competition - A stricter government competition policy could help reduce the monopoly power of some firms and ensure smaller firms can compete, too.
• To reform the labour market - Governments could try and improve the geographical mobility of labour by subsidising the relocation of workers and improving the availability of job vacancy information.
• To improve skills and quality of the labour force - The government could subsidise training or spend more on education. This also lowers costs for firms, since they will have to train fewer workers. Spending more on healthcare helps improve the quality of the labour force, and contributes towards higher productivity.
• To improve infrastructure - Governments could spend more on infrastructure, such as improving roads and schools.

Question 34

Weakness of supply side policies

Answer 34

• Productivity growth depends largely on private enterprise and trends in technological innovation. There is a limit to which the government can accelerate the growth of technological change and improvements in working practices.
• Supply-side policies can be counter-productive. For example, flexible labour markets may reduce costs for business – but if they cause job-insecurity, workers may become demotivated and labour productivity stagnates. Since 2009, the UK has seen a fall in structural unemployment due to more flexible labour markets – but productivity growth is almost stagnant.
• In a recession, supply-side policies cannot tackle the fundamental problem which is lack of aggregate demand.
• Time. All supply-side policies take a long time to have an effect. Some policies, such as education spending may not influence the economy for 20-30 years.