Chapter 30 - Fiscal policy

Question 1

What is fiscal policy?

Answer 1

Decisions made by the government on its expenditure, taxation and borrowing

Question 2

What may fiscal policy be used for?

Answer 2

Fiscal policy may be used to correct for market failure. For example, taxes may be used to counter the impact of externalities, and government expenditure may be used to ensure the adequate provision of public goods. At the macroeconomic level, fiscal policy can be used to influence the level of aggregate demand, and to influence the distribution of income.

Question 3

What is government budget?

Answer 3

The balance between government receipts and outlays

Question 4

What is government current expenditure?

Answer 4

Spending by the government on goods and services.

Question 5

What are transfer payments?

Answer 5

Occur when the government provides benefits (in cash or in kind) to poor households

Question 6

What is government capital expenditure?

Answer 6

Spending by government on capital projects

Question 7

What is government budget deficit?

Answer 7

A situation in which government expenditure exceeds government revenue

Question 8

What is government budget surplus?

Answer 8

A situation in which government expenditure is less than government revenue

Question 9

What is government balanced budget?

Answer 9

A situation in which government expenditure equals government revenue

Question 10

What is cyclical deficit?

Answer 10

A government budget deficit that occurs during the downturn of the business cycle, but disappears in the upturn

Question 11

What is structural deficit?

Answer 11

A government budget deficit that persists even when the economy is at full employment

Question 12

What is national debt?

Answer 12

The total amount of government debt, based on accumulated previous deficits and surpluses

Question 13

How does voting based on fiscal policy work?

Answer 13

There is a limit to how effective this process can be. The policies adopted by a government during its term of office cover a wide range of different issues, and individual voters may approve of some but not others - but they only get to vote once every 5 years or so, and then only on the whole package of measures. When the election comes round, the debates may be dominated by issues that happen to be contentious at the time, rather than the overall ideology of the parties.

Furthermore, if the election turns out to be indecisive, so that the result is a coalition across parties with differing manifestos, the resulting policies may turn out to be a mixture. Another pertinent issue is whether or not voters will be fooled by being offered (or given) tax cuts just before an election, as they may know that the reality will be different in the long term.

Question 14

What are automatic stabilisers?

Answer 14

Process by which government expenditure and revenue vary with the economic cycle, thereby helping to stabilise the economy without any conscious intervention from government

Question 15

What is discretionary fiscal policy?

Answer 15

A situation in which the government uses its discretion to intervene in the economy in an attempt to stabilise it

Question 16

What is crowding out?

Answer 16

Process by which an increase in government expenditure ‘crowds out’ private sector activity by raising the cost of borrowing

Question 17

What is crowding in?

Answer 17

Process by which a decrease in government expenditure ‘crowds in’ private sector activity by lowering the cost of borrowing

Question 18

What is direct tax?

Answer 18

A tax levied directly on income

Question 19

What is progressive tax?

Answer 19

A tax in which the marginal tax rate rises with income, i.e. a tax bearing most heavily on the relatively well-off members of society

Question 20

What is marginal tax rate?

Answer 20

Tax on additional income, defined as the change in tax payments due divided by the change in taxable income

Question 21

What is indirect tax?

Answer 21

A tax on expenditure, e.g. VAT

Question 22

What is regressive tax?

Answer 22

A tax bearing more heavily on the poorer members of society

Question 23

How does regressive tax work?

Answer 23

Take the tobacco tax. In the first place, the number of smokers is higher among lower-income groups than among the relatively rich - research has shown that only about 10% of people in professional groups now smoke compared with nearly 40% of those in unskilled manual groups. Second, expenditure on tobacco tends to take a lower proportion of income of the rich compared with that of the poor, even for those in the former group who do smoke. So, the tobacco tax falls more heavily on lower-income groups than on the better-off. It is estimated that for households in the bottom quintile

Question 24

What is proportional tax?

Answer 24

A tax that is proportional to income, being neither regressive nor progressive

Question 25

How does the Laffer curve work?

Answer 25

An important rationale for fiscal policy is the need to raise revenue in order to finance the government's expenditure. But does an increase in tax rates necessarily lead to a rise in tax revenue? Arthur Laffer argued that the answer to this was 'no'. He pointed out that changes in tax rates have two effects on tax revenue. The arithmetic says that an increase in tax rates will increase the tax revenue. However, there is also an economic effect. As tax rates rise, incentive effects come into play, tending to work against the arithmetic effect, as people have less incentive to supply effort at the higher tax rates. The relationship can be captured in the so-called Laffer curve, an inverted U-shaped relationship between the tax rate and the amount of revenue raised,

Question 26

How can the government influence income distribution using tax?

Answer 26

The balance between regressive and progressive taxes is important if the government wishes to influence the distribution of income in order to reduce inequality. Progressive taxes such as income tax have a direct impact on the distribution of income. In addition, government expenditure on benefits constitutes a transfer of resources from the rich to the poor. Achieving a balance of taxation between direct and indirect taxes is an important aspect of the government's redistributive policy. A switch in the balance from direct to indirect taxes will tend to increase inequality.

Question 27

How economic growth does show the effectiveness of fiscal policy?

Answer 27

Both economic analysis and the UK experience support the view that fiscal policy should not be used as an active stabilisation device. If the authorities were to intervene by increasing government expenditure to shift aggregate demand during a period when economic growth was slow, this could damage the economy. Some of the increase in aggregate demand would be dissipated in higher domestic prices and higher imports. However, this does not mean that there is no role for fiscal policy in a modern economy. The balance that is achieved between the private and public sectors can have an important influence on the overall level of economic activity, and upon economic growth, so the importance of designing an appropriate fiscal policy should not be underestimated.

Question 28

How does stability in prices show the effectiveness of fiscal policy?

Answer 28

Can fiscal policy be used to tackle inflation? Where the economy suffers from demand-pull inflation, a reduction in government expenditure may help to reduce inflationary pressure. This could be effective if the economy is at full employment with a neoclassical LRAS curve, where a change in aggregate demand affects the price level but has no effect on real GDP. However, if the economy is below full employment under Keynesian assumptions, a reduction in aggregate demand may result in lower real GDP and higher unemployment. Politically, using fiscal policy to tackle inflation may be unpopular, as a decrease in government expenditure may be seen as heralding a period of austerity.

Question 29

How does full employment show the effectiveness of fiscal policy?

Answer 29

It may be tempting for the government to use fiscal policy in times of unemployment, increasing aggregate demand to encourage higher employment. Under neoclassical assumptions, this would be counter- productive, as the economy would be expected to return to full employment equilibrium without intervention.

Question 30

How does a balanced government budget show the effectiveness of fiscal policy?

Answer 30

In the aftermath of the financial crisis, fiscal policy was used to try to counteract the recession that was affecting the economy. However, this is not a policy that could be used in the long run, because of the effect on the national debt. The government was intent on reducing the size of the national debt to a sustainable level, but was also faced with pressure from many government departments to increase funding. There were funding shortages in the NHS and the education sector, among others. The need to safeguard the environment adds further pressure on government expenditure. The dilemma of how to fund much-needed expenditure without leaving high levels of debt for future generations is a continuing issue.

Question 31

How does a fair distribution of income show the effectiveness of fiscal policy?

Answer 31

Another key role for fiscal policy is in affecting the distribution of income within society. Taxes and transfers can have a large effect on income distribution. This in turn may have effects on the economy by affecting the incentives that people face in choosing their labour supply. Achieving a balance of taxation between direct and indirect taxes is an important aspect of the government's redistributive policy. A switch in the balance from direct to indirect taxes will tend to increase inequality in a society. The incentive effects must also be kept in mind. High marginal tax rates on income can have a disincentive effect; if people know that a large proportion of any additional work they undertake will be taxed away, they may be discouraged from providing more work. In other words, cutting income tax can encourage work effort by reducing marginal tax rates. This is yet another reminder of the need for a balanced policy - one that recognises that, while some income redistribution is needed to protect the vulnerable, disincentive effects may arise if the better-off are over-taxed.