5.2 Fiscal Policy Flashcards
What is budget deficit?
This is when gov spending > tax revenue in a year. In other words it is the total gov borrowing in a year
structural budget deficit is a budget deficit at full employment
cyclical budget deficit is a deficit in a recession
What is a budget surplus?
This is when tax revenue > gov spending in a year
What is national debt?
This is the total stock of gov debt over time
What are the pros of a budget deficit?
Higher growth and lower unemployment due to higher AD. Desirable in a recession to close the negative output gap and return an economy to full employment
Benefits of increased gov spending ( healthcare, schools, infrastructure, public services ) - can boost growth, LRAS and living standards. Boos productive capacity of an economy. Solves market failures
Better redistribution of income as spending on benefits and education and health could help.
Incentives you get from tax cuts - work harder, higher productivity and entrepreneurship. Greater tax rev returns
Crowding in. This growth brings in new firms and businesses
What are the cons of a budget deficit?
This leads to a deterioration of gov finances (which will have to be paid back eventually ). This has to be done by increased taxation and cuts in GS and there is a huge opportunity cost of the debt interest. Bad gov finances can detract fdi if confidence in the gov is low which harms short run and long run growth
Major conflicts in the forms of CA deficit and also higher demand pull inflation which can erode competitiveness abroad
Debt fuelled GS could crowd out the private sector and harm investment. This would increase demand for loanable fund which will increase equilibrium interest rates which makes it more expensive to borrow and fund infrastructure projects.
X inefficiency that comes with gov spending which can mean costs can spiral out of control
Current state of gov finances are massive. If there are already budget deficits then its horrible
SR vs LR impacts. There are LR returns that come with increasing GS or direct tax cuts. SR debt.
Stage of economic cycle. Keynesians argue that running a budget deficit is desirable in increasing AD and returning economy to a full employment. In a boom these policies are likely to be inflationary. You should mend gov finances in a boom not worsen them
Reliant on consumer or business confidence being strong
Role of the automatic stabilisers. Support econ growth and output in a recession. rEDUCES THE NEED FOR RECESSIONARY FISCAL POLICY WHICH IS EXPANSIONARY FISCAL POLICY ON TOP OFTHE automatic stabilisers
What are the pros of a budget surplus?
Improved gov finances and promote more confidence on them which reduces debt and gives more confidence to borrowers. can attract FDI. Gov is seen as a less risky borrower which means over time they can issue lower interest rates on their bonds.
Can be greater flexibility for fiscal policy in the future. If deficits are low etc govs will be operating within their fiscal rules which allows them headroom for whenever its needed.
If the debt is low, less spending on debt interest which frees up fiscal policy for the next recession or crisis
Free market economists argue w less debt fuelled gov spending there will be less crowding out of private sector and less detraction of investment as there won’t be that much pressure on loanable funds which allows them to still borrower at lower IR.
Lower demand pull inflation and improvement in the current account deficit due to a decrease in AD
What are the cons of a budget surplus? and evaluation
You can face demand side shocks as by reducing AD. growth decreases, unemployment increases and living standard fall.
Worry about micro and macro impacts. Cuts of gov spending on healthcare means longer wait times etc and living in pain. Lower spending on education means less teachers larger class sizes or compromising education. Lower spending on infrastructure can effect those who rely on public transport etc etc. Micro impact of taxes going up you worry about living standards. Macro side it harms the long run productive potential of an economy and constrains it. Affects productivity and competitiveness.
Incentives distortion of higher taxation. Laffer concerns. Lower incentive to work and to be entrepreneurial and greater incentive to leave the country or avoid tax. Constrains LRAS and productivity. Also reduces ability to reinvest which affects long term productivity.
Evaluation
Is it necessary? What if gov finances are already stable.
Could these policies end up worsening the look of gov finances. If policies reduce GDP, even if national debt is reducing, if GDP reducing quicker then debt to GDP ratio is worsening.
Specific policy used? Don’t need to use both at same time
Stage of the economic cycle
What is fiscal policy?
This is when u use gov spending and taxation rates to influence AD.
Fiscal policy aims to stimulate economic growth and stabilise the economy.
What is expansionary fiscal policy? examples
This aims to increase AD in an economy.
Governments increase spending on healthcare education infrastructure etc
reduce income taxes - more disposable income
and corporate taxes - more profits which can be reinvested and boost AD that way
It leads to the worsening of the gov budget deficit and it may mean govs have to borrow to finance this.
Could also affect LRAS and the LR productive potential of an economy
Same policies above can boost LRAS
Reduction in income tax can incentivise workers to e active and increase quantity of labour. Also an incentive to work harder and earn more. This makes productivity and quality of labour increase
Reduction in corporate tax boosts LRAS due to an improvement of productive efficiency of an economy. Also help Q* of labour
Increase in gov spending on education n health can boost productivity and quality of labour. Increase on infrastructure can increase productive efficiency of an economy.
What is deflationary fiscal policy?
This aims to decrease AD. Govs cut spending or increase taxes, which reduces gov spending. It leads to an improvement of the gov budget deficit
What does expansionary fiscal policy do?
Boosts economic growth. If growth is slow or in a recession, a boost may be necessary.
Reduces cyclical employment. If AD shifts to the right there are more GandS being produced and firms need more labour to match the demand
Increases demand pull inflation. If below target, a slight inflation increase may be desirable
reduces income inequality through more benefits or reduction of tax rates
What does contractionary fiscal policy do?
Reduces inflation by cooling the economy down. Central banks job to maintain inflation
Reduces budget deficit / national debt. Reduce the borrowing the gov doing.
Redistributes income - more tax on the rich and then redistribute through income top ups for the poor
Reduces current account deficit as there will be less imports due to lower incomes.
What are the cons of expansionary fiscal policy? and evaluation points
Macro objective trade offs that come with this policy are An increase in demand-pull inflation and CA deficit. If inflation shoots the target then there will be a conflict of objectives. Higher incomes for households mean more spending on imports which means a wider CA deficit.
An increase in economic growth means higher incomes for households which will increase imports which means a larger current account deficit
Worsening of gov finances. National debt will also increase as they need to fund this spending Will have to cut in other sectors of the economy. Welfare education etc. Taxes will have to rise in the future which has lots of negative effects. Incentives etc. Big opp cost that comes with paying debt interest. Households could save now to prepare for the tax rises in the future if they know the gov is not capable of lowering taxes sustainably. This is called ricardian equivalence. Reducing income tax might not have suc a great effect then
Crowding out effect. Debt feuled gov spending could heavily crowd out the public sector. This increases demands for loanable funds which pushes up equilibrium interest rates which means more expensive for private sector to borrow and invest.
Spending could be X inefficient. This means it could be wasteful for projects and costs could get very high due to x inefficiency as there is no profit motive
Time lags - takes time for effects to kick in. Won’t see big boosts of AD for time
Evaluation:
Size of the output gap and effectiveness are directly related. If there is a small output gap then expansionary policy is less likely to have a huge impact on higher growth and lower employment, it will just lead to more demand pull inflation. And vice versa
Depends on the size of multiplier. If it is large then the impact of the policy is likely to be greater. Less need for large tax cuts or increased gov spending
Consumer and business confidence. An income tax cut will be saved and not spent
Current state of gov finances before the policy is enacted. If its dodgy with high levels of debt or deficits, then the policy can’t be afforded
SR vs LR effects of gov finances if this policy. Could lead to lots of LR benefits to economy through higher tax revenues. So LR returns outweigh the short term debt
Income tax cut may lead to higher tax revenue for the gov. Those who are in work have an incentive to work harder as they can keep more income as disposable income. Entrepreneurs have more incentive to take risk. Also reduces the incentive to tax evade and avoid
If automatic stabilisers are strong it reduces the need for expansionary fiscal policy. They help to support output in a recession.
Crowding out effect vs crowding in effect. Keynesian don’t agree with crowding out effect. This is as there is a huge amount of savings taking place so the chance of equilibrium interest rates being pushed up is very low. They say in a recession gov spending could crowd in the private sector. This is when gov spending creates demand generates output and economic activity which incentivises private sector businesses and invests and grows their business. This leads to more private sector activity and crowd in
Classical view that this policy isn’t needed as the economy will self heal as eventually wages will fall and economy will return to full employment on its own. No intervention
What are the types of gov spending and what are the reasons behind gov spending?
Current spending is the day to day spending on the maintenance of public services and public sector wages
Capital spending is spending on infrastructure projects
Welfare spending is the spending on benefits and pensions in the economy
Debt interest spending
First 3 will increase AD
Govs spend money to influence the macroeconomy
Reduce income inequality
Correct market failure through subsidies and state provisions etc
What are the types of taxation and what are the reasons behind taxation?
Indirect tax is expenditure tax levied on firms which increases their costs of production
Can be specific which is a tax per unit sold. Alcohol, fuel and cigarette duty
Can be ad valorem tax. These are a percent of the final price. VAT
Direct taxes are taxes on income. Income and corporation taxes
Raises gov revenue in order to fund anything the gov wants. Can also help influence the macro economy by boosting AD in a recession fight against unemployment and deflation etc
Higher tax can help cool an economy down by reducing AD. Also bring down budget deficits etc
Helps redistribute incomes. In a progressive system, taxes the rich more
Can help fight market failure in terms of overproduction and consumption issues
Also for protectionism reasons which protects against foreign businesses
