5.1 Fiscal Policy

Question 1

Definition & Aim of Fiscal Policy

Answer 1

Fiscal Policy is the use of government spending, taxation or borrowing to influence economic activity.

Fiscal policy aims to stimulate economic growth and stabilise the economy.

Question 2

Government Spending and Taxation

Answer 2

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

Question 3

Types of Fiscal policy

Answer 3

• Expansionary
• Contractionary

Question 4

Expansionary Fiscal Policy-What is it?

Answer 4

• Governments increase spending.
• Reduce taxes to expand the economy.
• It leads to a worsening of the government budget deficit.
• May mean governments have to borrow more to finance this.

Question 5

How does Expansionary Fiscal Policy influence AD?
Draw a diagram to represent this.

Answer 5

• It aims to INCREASE aggregate demand.

Question 6

Contractionary Fiscal Policy-What is it?

Answer 6

• Governments cut spending.
• Raise taxes, this reduces consumer spending.
• It leads to an improvement of the government budget deficit.

Question 7

How does Contractionary Fiscal Policy influence AD?
Draw a diagram to show this.

Answer 7

• It aims to DECREASE aggregate demand.

Question 8

How can fiscal policy be used to influence AS?

These factors can also boost LRAS

Answer 8

• 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, also boosts productivity).
• Spending more on healthcare-(helps improve the quality of the labour force, contributing towards higher productivity).
• Governments could spend more on infrastructure (such as improving roads and schools which can boost AS).

Question 9

The government has a Budget Surplus when…?

Answer 9

• tax receipts exceed expenditure

Question 10

The government has a Budget Deficit when…?

Answer 10

• expenditure exceeds tax receipts in a financial year.

Question 11

Difference between Government Debt and Government Deficit?

Answer 11

• The debt-accumulation of the government deficit over time, it is the amount the government owes.
• The deficit (or surplus)- the difference between expenditure and revenue at any one point.

Question 12

What are automatic stabalisers?

Answer 12

• automatic fiscal changes as the economy moves through different stages of the business cycle
• may include a fall in tax revenues from the circular flow during a recession or an increase in state welfare benefits when the unemployment rate is rising.

Question 13

Explain the role of automatic stabilisers during economic growth/a boom phase

Answer 13

-During periods of rapid economic growth (a boom phase):
* Tax revenues will rise as household real incomes and corporate profits grow – unemployment is declining
* Government welfare spending then falls as more people are in work and require less state financial support
* As a result, government finances improve including a falling budget deficit / possible fiscal surplus
* Consequently, fiscal policy is taking income out of the circular flow – automatic stabilisers help moderate a boom

Question 14

Explain the role of automatic stabilisers during a recession

Answer 14

• During an economic recession, real output and employment contracts
• As real incomes fall, people pay less in direct and indirect taxes and company tax payments also drop
• Government spending on welfare support such as Universal Credit increases
• Combined, this will increase the budget deficit
• A fiscal deficit is a net injection into the circular flow – thus helping to limit the depth / severity of a recession

Question 15

Evaluation: How effective are automatic stabilisers in the UK economy?

Answer 15

• Impact depends on whether a government allows the automatic stabilisers to operate fully – and does not introduce fiscal austerity measures such as real spending cuts during a slowdown / recession
• Impact depends on the relative generosity of the welfare system such as base levels of payment for universal credit and unemployment support-some governments have capped total welfare payments.
• Impact depends on the marginal propensity to spend and save of those households whose income is boosted by welfare during a recession

Question 16

When to use automatic stabilisers in an essay

Answer 16

• Good to use this when discussing expansionary fiscal policy
• e.g. if the role of automatic stabalisers in a recession are very large, it reduces the need for discretionary fiscal policy (expansionary fiscal policies on top of automatic stabilisers)

Question 17

Direct Taxes and Impact

Answer 17

• imposed on incomes
• paid directly to the government from
  the tax payer.
• Consumers and firms are responsible for paying the whole tax to the government.

Question 18

Examples of Direct Taxes?

Answer 18

• income tax
• corporation tax,
• NICs
• inheritance tax.

Question 19

Indirect Taxes and Impact

Answer 19

• imposed on expenditure on goods and services.
• increase costs of production for firms, so they supply less
• This increases market price and demand contracts.

Question 20

Examples of Indirect Taxes?

Answer 20

• Ad valorem taxes
• Specific taxes

Question 21

What are Ad Valorem Taxes?

Answer 21

• main type of indirect tax in the UK
• are percentages, such as VAT, which adds 20% of the unit price.

Question 22

What are Specific Taxes?

Answer 22

• a set tax per unit-such as the 58p per litre fuel duty on unleaded petrol.

Question 23

What are Proportional Taxes and what is the impact?

Answer 23

• has a fixed rate for all tax payers, regardless of income.
• also called a flat tax.
• 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 24

What are Progressive Taxes and what is the impact?

Answer 24

• has an increase in the average rate of tax as income increases.
• As income ^ the proportion of income taxed ^.
• helps reduce inequality- (because those on lower incomes pay less tax).
• Higher income households are more able to pay higher rates of tax than lower income households.
• direct taxes are more progressive .

Question 25

What are Regressive Taxes and what is the impact?

Answer 25

• does not relate to income
• 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.
• leads to a less equitable distribution of income (those on lower incomes bear a larger burden of the tax)
• indirect taxes are more regressive

Question 26

Who developed the ‘Principles of Taxation’?

Answer 26

• Adam Smith
• The ‘canons of taxation’

Question 27

What are the Principles of Taxation?

Answer 27

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.

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 28

What are the limitations of Fiscal Policies?

Answer 28

• Governments might have imperfect information about the economy-(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).
• Higher demand pull inflationary pressure
• Worsening of the CAD-higher growth->higher incomes->more spending on imports
• Crowding out effect-If the government borrows from the private sector, there are fewer funds available for the private sector for investment (lead to crowding out) interest rates increase which makes it more expensive for private firms to borrow
• 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).
• Worsening of the government finances-if the government spends too much, there could be difficulties paying back the debt-(which could make it difficult to borrow in the future).
• X-Inefficiency-gov spending could be wasteful and costs may spiral out of control

Question 29

Capital Government Expenditure

Answer 29

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

Question 30

Current Government Expenditure

Answer 30

• is spending which recurs- 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 31

Transfer Payments

Answer 31

• 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.

Question 32

Examples of Transfer Payments

Answer 32

• Job Seeker’s Allowance
• Income Support
• Child benefit
• The state pension

Question 33

Why are Transfer Payments around?

Answer 33

• to ensure people have a basic standard of living.
• help reduces the level of inequality in society.
• Transfer payments are a means for the government to redistribute income from the rich to the poor.

Question 34

What are the reasons for the changing size and composition of public expenditure in a global context?

Answer 34

• In the UK, the government spends most of their budget on pensions and welfare benefits, followed by health and education.
• Income tax-biggest source of tax revenue in the UK.
• Education spending in the UK has remained relatively constant.
• Social security payments are payments from the government to assist those who
  have low incomes-there has been a general increase in spending.
• Defence spending in the UK is falling-government spends least on this.

Question 35

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

-Productivity and Growth

Answer 35

• 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-(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.
• 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 36

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

-Crowding Out

Answer 36

• Governments might have to fund its spending using taxes or running a budget deficit-(leaves fewer funds in the private sector for firms to use as the government is borrowing money)
  -which crowds them out of the market.
• 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.
• crowding out refers to the government provision of a good or service, which would otherwise be provided by the private sector.

Question 37

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

-Level of taxation

Answer 37

• 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.
• (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 38

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

Equity and Living Standards

Answer 38

• Progressive taxes could be used to reduce inequality-(since those on lower incomes pay lower rates of tax).
• Redistributive policies and welfare payments, such as Income Support, could be used to help those on the lowest incomes.
• 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- government ensures that all members of society can achieve a minimum standard of living.

Question 39

What is a Balanced Budget?

Answer 39

• when expenditure is equal to revenue.

Question 40

What is the National Debt?

Answer 40

• The national debt is the accumulation of the government deficit over time.
• It is the amount the government owes.

Question 41

What happens if the government is continuously running a deficit?

Answer 41

• the size of the debt increases.

Question 42

What happens when a government reduces the size of their deficit?

Answer 42

• the rate of increase of the total debt is slower, but the debt is still increasing.

Question 43

When does the size of the national debt decrease?

Answer 43

• when the government runs a budget surplus.

Question 44

What is a Cyclical Deficit and when might it occur?

Answer 44

• its a temporary deficit, related to the business cycle.
• might occur during recessions, when governments increase spending to stimulate the economy.

Question 45

What is Structural Deficit and when might it occur?

Answer 45

• its a deficit due to an imbalance in the revenue and expenditure of the government.
• it exists at every point in the business cycle.

Question 46

What are the benefits of a rising budget deficit and national debt?

Answer 46

• Higher growth and reduced unemployment: very desirable in a recession to close a negative output gap
• Higher government spending: on education, healthcare, infrastructure which increases the productive capacity of the economy, boosts LRAS, more growth and productivity
• Redistribution of income: more spending on benefits to lower regressive taxation-lower tax rates on lower income earners helps reduce inequalities
• Incentives of tax cuts: motivate people to work harder and become more productive, boost LRAS
• Crowding in (keynesian): more ES can crowd in the private sector and promote investment which boosts
  AD and stimulates economic growth

Question 47

What are the costs of a rising budget deficit and national debt?

Answer 47

• Deterioration of gov finances: lower confidence in the governments abilityt to finance the debt which may mean they have to increase interest rates to encourage investors to buy bonds to finance the debt
• Inflation/CAD conflits: higher demand pull inflation which can erode international competitiveness and worsen the CAD
• Crowding out effect: gov borrowing leaves fewer funds available for private sector investment which crowds them out of the market, if interest rates increase its more expensive to borrow which discourages private sector consumption and investment
• X-Inefficiency: wastefulness of gov finances and costs may spiral out of control

Question 48

What are the benefits of a budget surplus/lowering national debt?

Answer 48

• Increased confidence in gov finances: by lowering the budget deficit theres more confidence in the economy, improved credit ratings as government bonds are deemed less risky to borrow
• Flexibility with fiscal policy
• Less crowding out
• Lower inflation

Question 49

What are the costs of a budget surplus/lowering the national debt?

Answer 49

• Demand side shocks: lower growth and higher unemployment (macroeconomic objectives conflicts)
• A rise in income inequality due to higher tax rates
• The LR returns of increased growth and lower taxes ignored
• Higher taxes disincentivise workers from entering the higher paying jobs as they may not be able to keep most of their income

Question 50

What is the significance of the size of the national debt?

Answer 50

• 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.

Question 51

Define austerity

Answer 51

• government policies to reduce government spending or increase taxation, in order to reduce budget deficits and attempt to control growing public debt

Question 52

List and Explain 4 costs/negative of austerity

Answer 52

• Can be self-defeating:
  -if in a recession, governments who cut spending hard will see a large fall in nominal GDP, this will lead to a shrinking of tax revenues thus, austerity can reduce economic growth so much that the budget deficit fails to improve
• Can cause some sectors to lose funding:
  -such as a drop in spending on education and training could reduce LRAS, lower the productive capacity of the economy
• Can reduce AD:
  -increased taxes (a withdrawal) and decreased government spending (an injection) could reduce AD-this could lead to increased unemployment, decreased national income, the negative multiplier, etc
• May lead to brain drain

Question 53

What is a key benefit of austerity?

Answer 53

• reduces national debt

Question 54

List and Explain 3 benefits of austerity

Answer 54

• Improves confidence:
  -cutting budget deficits will give investors greater confidence about the long-term performance of the economy
• Reduces crowding-out–lower debt levels will encourage more private sector investment
• Reduces burden on future generations:
  -if the national debt continues to grow, this will be passed onto the future generation in the forms of higher taxes-thus austerity can help prevent this from happening

Question 55

List 2 points of evaluation for whether austerity is desirable or not

Answer 55

• the current level of business confidence
• the current state of the economy

Question 56

Explain why the benefits/costs of austerity depend on the current level of business confidence

Answer 56

• if there is high business confidence, austerity would be more desirable as lower government spending would be met with greater private sector spending

Question 57

Explain why the benefits/costs of austerity depend on the current state of the economy

Answer 57

• if in a recession, austerity is likely to just decrease AD, which is not beneficial
• however, it would be beneficial for when the economy is overheating

Question 58

What is the role of the Office for Budget Responsibility?

Answer 58

• 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.
• They assess the likelihood of the government meeting the targets.
• They scrutinise tax and welfare spending measures.
• They assess how sustainable public sector finances are in the long run.