Chapter 14 > Fiscal Policy & Role of the Government

Question 1

How is government spending measured?

Answer 1

Public spending over GDP

Question 2

How big should the public sector be?

Answer 2

Controversial issue:
It has been increasing sharply in many industrialised countries in recent decades due to increasing social welfare spending (8% in the 1870s, 15% in the 1920s, 30% in the 1960s, 40% today).

Question 3

What is the relationship between public spending and GDP growth?

Answer 3

Evidence on the overall impact of public spending on GDP and growth is hard to find.
Efficiency on spending (good public management) is more important than budget size.

Question 4

What are the arguments in favour and against government involvement in the economy?

Answer 4

From an Economic Theory point of view:

There are arguments for government intervention → Market inefficiencies.

There are objective limits to government spending:

• Distortions from taxes.
• Government Solvency.
• Crowding out of private activity.

Question 5

What is the “invisible hand “ of the free market?

Answer 5

This is an “idea” against government involvement as it states that the ‘invisible hand’ of the free market would lead to economic efficiency under ideal conditions. Governments play a role when ideal conditions don’t exist.

Question 6

What is pareto efficiency?

Answer 6

A given allocation of resources is Pareto efficient if reallocation to make someone better off is not possible without making someone worst off.

Question 7

What does the efficient allocation by the market require?

Answer 7

• Rational behaviour by agents.
• Perfect competition (no monopolies).
• Complete information (transparency).
• Complete markets (all commodities with value are offered).

Question 8

How can you define public goods?

Answer 8

Public goods can be defined by their two main features:

• They are non-excludable → All citizens enjoy their benefits independently of their payments.
• The amount consumed does not affect the cost of provision (marginal cost is very small or zero).

Question 9

What is Nasty Nash equilibrium and how is it related to public goods?

Answer 9

Nash equilibrium → Is a situation in which, given everyone else’s behaviour, each person is acting in a way that is individual rational.

Nasty equilibrium → Cheating, breaking conventions and stepping outside the law are individually advantageous, though collectively costly.

Laws and social conventions can prevent societies from being trapped in bad equilibria in which standards of living are low. Therefore, one of the governments primary roles if to try, in art through legal and police systems, to reduce corruption, theft and disrespect of the law.

Question 10

What roles do governments have?

Answer 10

Public goods

Paternalistic role

Distribution of income

Question 11

Why do governments have an increasing paternalistic role?

Answer 11

Reflecting the belief that, left to themselves, many citizens will not act in their own longer-term economic interests.

E.g. People may not perceive how education can benefit their future incomes and, left to themselves, they would “under-consume” education, therefore, governments subsidise education by forcing school until a certain age.

Question 12

Another reason for government involvement is that of distribution of income, why?

Answer 12

The distribution of income that might arise from free market outcomes may undesirable for many reasons:

• Citizens find it ethically unacceptable that other people live in poverty.
• Citizens may fear that they become poor themselves.
• Crime, delinquency and disease are likely to be worse if a large economic underclass has poor economic prospects, bad schooling and inadequate healthcare.

Question 13

How is public spending financed?

Answer 13

Revenue -> Taxes + others

Deficit (borrowing)

Question 14

Why do taxes cause distortions?

Answer 14

According to Smith’s invisible hand, when markets are complete and competitive, the allocation of resources is efficient. Taxes drive a wedge—or create a gap—between what sellers receive for supplying goods and services and the prices that buyers pay. This means that both supply and demand are less than without tax.

The real cost of raising revenue through taxation is that it can distort patterns of spending and labour supply, savings behaviours or other aspects of economic activity. Virtually, any form of tax alters economic behaviour.

Question 15

What is the relationship between tax revenue and distortion?

Answer 15

There is a limit to how much revenue government can raise.

The marginal cost of taxation, in terms of distortions, increases with revenue. The cost approaches infinity close to R*, the maximum revenue.

Question 16

What does the laffer curve show?

Answer 16

Curve describes the relation between tax revenue and tax rate.

Beyond some point, the rise in tax rates makes the overall tax revenue generated fall.

Question 17

What are the implications of the laffer curve?

Answer 17

Two different tax rates generate the same overall revenue → The lower rate can stimulate the economy increasing the base (i.e., the number of contributors), compensating the loss of revenue due to a lower rate.

Cutting taxes might increase tax revenue (e.g. Trump tax cut in 2018).

Question 18

What does it mean when a government runs a deficit?

Answer 18

It is borrowing to finance the gap between expenditure and taxation. As a result, the stock of outstanding debt increases.

Question 19

What is public budget deficit?

Answer 19

Debt issued in a particular fiscal year. The deficit refers to a period of time, normally a year.

Question 20

What is public debt?

Answer 20

Standing liabilities of the government resulting from the accumulation of past deficits and surpluses. The debt is a stock measures at a given date

Question 21

Public deficits are a problem but may sometimes be necessary. What are justifications for governments to run deficits?

Answer 21

Governments may be running deficits to finance investment.

Or when the economy suffers a temporary shock → E.g. During a war. But, two arguments:

1. Arguments in favour of running a sustained deficit.
2. Tax-smoothing argument (efficiency argument) about distortions.

Question 22

What is the rationale for tax smoothing?

Answer 22

Taxes distort individual behaviour: they force people to do things differently (e.g. work less hard, spend less, etc…).

This implies that governments should keep taxes at a smooth average level, rather than change them every period, in order to balance a budget (especially when faced with unexpected expensive events, such as wars).

Tax smoothing is more efficient than tax changes, as keeping taxes stable, generates fewer distortions than having taxes sometimes well above, and sometimes well below, average.

Question 23

What is fiscal policy?

Answer 23

All decisions made by the government regarding public spending and public revenue constitute the government ́s Fiscal Policy.

Fiscal Policy is:

1. A way for the government to intervene in economic life
2. A tool for stimulating economic growth

Question 24

What are the types of fiscal stabilisation?

Answer 24

Fiscal Policy can be:

• Expansionary to stimulate the economy (increasing government spending or lowering taxes).
• Contractionary to cool down the economy (lowering public spending or increasing tax revenues).
• Neutral if policy decisions on the spending side are compensated with decisions on the revenue side from the point of view of the final contribution to real GDP growth.