Fiscal Integration (I)

Question 1

Government spending types

Answer 1

• Consumption of goods and services by destination (OECD)
  o Collective consumption: (legal system, national defense) It benefits society as a whole, or large parts of society, and are often known as public goods and services. As these goods and services usually do not have a market price, the relevant products are valued at the sum of costs needed to produce these goods and services
  o Individual consumption: (health, education) This category of expenditure is equal to social transfers and includes expenditure by government on market goods and services provided to households
• Investment: Roads, Infrastructure
• Transfer payments
  o Social security (Unemployment and sickness benefits, old-age pensions)
• Financial spending: interests on the debt

Question 2

Largest component of government spending

Answer 2

Subsidies and other transfers (Social Protection)

Question 3

Arguments against government spending

Answer 3

• Pareto efficiency: Market forces produce efficient use of resources (Adam Smith’s invisible hand). The allocation of resources is efficient if a reallocation of resources is unable to make anyone better off without making someone worse off
• Taxation produces distortions and alters economic behaviour. They distort patterns of spending, labour supply, saving behaviour and other economic activities
• Prices signal the fair value of goods and services to companies and consumers

Question 4

Arguments for government spending

Answer 4

• Public Goods: Free markets might not produce certain goods that are desirable because it would be difficult to make people pay for them due to the non-excludable consumption: e.g. a coastal lighthouse

Question 5

Effect of tax in the labour market

Answer 5

1. Employment is reduced from N0 to N1
2. The wage perceived by the worker (W2) is lower
3. The wage paid by the employer is higher (W1)
4. It creates distortion (loss of efficiency) in terms of re-allocation of factors of production

Question 6

How to collect tax revenue?

Answer 6

Two options:
- 1. Low tax base and high tax rate
- 2. High tax base and low tax rate

THE BEST OPTION TO REDUCE TAX DISTORTIONS IS TAX SMOOTHING

Question 7

Explain Tax smoothing to reduce tax distortions

Answer 7

Keeping taxes stable generates fewer distortions than having taxes sometimes well above, and sometimes well below, average.

Example: SAME AVERAGE TAX RATE

• 1. A permanent tax rate of 25%
• 2. A tax rate of 30% in recessions & 20% in booms

Option 1 reduces distortions and inefficiencies

Question 8

Define Primary Deficit

Answer 8

Shortfall between tax receipts and government expenditure excluding interest on national debt

Question 9

Define Deficit

Answer 9

debt is issued in a particular fiscal year

Question 10

Define Debt

Answer 10

accumulation of past deficits and surpluses

Question 11

Define Money Illusion

Answer 11

The term to describe people who reflect their wage on nominal terms, rather than in real terms