Fiscal Policy

Question 1

fiscal policy definition:

Answer 1

involves the use of government spending, direct and indirect taxation and government borrowing to affect the level and growth of aggregate demand, output and jobs

Question 2

roles of fiscal policy?

Answer 2

• keep inflation on target (2%)
• stimulate economic growth and employment during times of recession
• maintain a stable economic cycle that minimises “boom and bust”
• change the pattern of spending on goods and services
• a means by which a redistribution of income and wealth can be achieved
• an instrument of micro-economic government intervention to correct for market failures

Question 3

what does it mean for fiscal policy to be expansionary?

Answer 3

if the government is trying to positively stimulate economic activity. boosting aggregate demand by increasing government spending or lowering taxes. likely to involve budget deficit

Question 4

methods of expansionary fiscal policy:

Answer 4

-cutting taxes
-cut in income tax may give consumers more
disposable income, thus raising consumption
-cut in corporation tax may increase available
profits for firms which may stimulate investment
-raising government spending
-gov may increase its spending on core
infrastructure projects or increase the pay of
public sector workers
-increasing the budget deficit
-to increase spending if gov doesn’t want to raise
taxation is to increase borrowing
-adds to national debt, and must be repaid with
interest

Question 5

impact on expansionary fiscal policy on aggregate demand? diagram

Answer 5

Price level and real national output. LRAS curve and AD shifts up the curve to the right to AD1. Y moves to Y1 creating added benefit of employment Price level rises from PL to PL1, may hamper the inflation target

Question 6

impact on expansionary fiscal policy on aggregate supply? diagram

Answer 6

Price level and real national output. LRAS curve shifts to the right to LRAS1, AD does not change. Price level moves down from PL to PL1

Question 7

what does it mean for fiscal policy to be contractionary?

Answer 7

if the government is trying to constrain aggregate demand, reduce debt or control inflation. involves reducing aggregate demand by reducing government spending or increasing taxes. likely to involve budget surplus

Question 8

methods of contractionary fiscal policy:

Answer 8

-increasing taxes
-may discourage spending and reduce
consumption
-will reduce aggregate demand and may help to
bring inflation under control
-cutting government spending
-reduce expenditure on public projects or cut key
government budgets if it considers spending to
be unaffordable or inflationary
-cutting the budget deficit
-cutting long term borrowing commitments may
help to stabilise economic growth as reduced
debt repayments in future can be reinvested
back into the economy

Question 9

impact of contractionary fiscal policy on aggregate demand? diagram

Answer 9

Price level and real national output: LRAS curve and AD shifts inwards to the left from AD to AD1, reduction in real national output from Y to Y1 this damages economic growth. Price level drops from PL to PL1 (reducing inflationary pressure)

Question 10

what is government spending?

Answer 10

spending by the public sector on goods and services such as education, health care and defence

Question 11

what is current expenditure?

Answer 11

short-term spending on day to day running of the country e.g. wages, consumables

Question 12

what is capital expenditure?

Answer 12

long-term spending on assets e.g. hospitals, schools, roads, infrastructure etc.

Question 13

what are transfer payments?

Answer 13

a redistribution of income for which no good or service is provided in return e.g. benefit payments

Question 14

sources of finance of government spending?

Answer 14

• taxation includes income, corporation and value added
• public sector net cash requirement is finance required to pay for a budget deficit
• gov provide a variety of goods and services that have to be paid for by the consumer
• government sell off state assets and privatise businesses

Question 15

importance of government spending: education and health care

Answer 15

education:
-increase skills and productivity of workers
-improvement in human capital will lower structural unemployment
-more innovation/ competitiveness
health care:
-improved health outcomes will boost active labour supply
-increase productivity
-lessens risk of relative poverty

Question 16

how does government spending affects incomes: welfare state transfers and state-provided services

Answer 16

welfare state transfers: 
-child/unemployment benefits
-state pensions
-targeted welfare payments
state-provided services:
-education
-health care 
-social housing
-employment training

Question 17

describe direct taxation:

Answer 17

levied on income, wealth and profit. include income tax, inheritance tax, national insurance contributions, capital gains tax, and corporation tax.
burden of a direct tax cannot be passed on

Question 18

describe indirect taxation:

Answer 18

indirect taxes are taxes on spending
examples include: excise duties on fuel, cigarettes
producers may be able to pass on an indirect tax-depending on price elasticity of demand and supply

Question 19

what is progressive tax?

Answer 19

the marginal rate of tax rises as income rises, causes a rise in the average rate of tax

Question 20

what is proportional tax?

Answer 20

the marginal rate of tax is constant leading to a constant average rate of tax

Question 21

what is regressive tax?

Answer 21

the rate of tax falls as incomes rise

i.e. the average rate of tax is lower for people of higher incomes

Question 22

changes in tax rates and tax allowances can have direct and indirect effects on the level of what?

Answer 22

aggregate demand

Question 23

examples of changes in tax rates and allowances having direct and indirect effects on the level of aggregate demand

Answer 23

-income tax and disposable income: (expansionary- cut tax rates, boost disposable income- adds to consumer demand)
(expansionary- cut indirect taxes- lower prices, higher real incomes- adds to consumer demand)
-corporation taxes and business investment (expansionary- higher “post tax” profits for businesses- adds to business capital spending)
(expansionary- cut in tax on interest from saving- boost to disposable income of people with net savings- adds to consumer demand)
-taxation of imports affects trade
-national insurance and labour demand
-VAT and levels of consumer spending
-taxation and business R&D spending

Question 24

changes in tax rates and tax allowances can have a direct and indirect effect on both short-run and long-run what?

Answer 24

aggregate supply

Question 25

examples of changes in tax rates and tax allowances having a direct and indirect effect on both short-run and long-run aggregate supply

Answer 25

• work incentives/active labour supply
• inward migration of key workers
• capital investment
• enterprise/entrepreneurship
• taxation and incentives to study
• tariffs affect import costs

Question 26

impact of rise in indirect tax on businesses:

Answer 26

• inflation: rise price in short run as business pass on tax
• economic growth: lower EG- bc lower output, slower as real incomes and demand falls
• unemployment: rise- bc lower output (higher if AD weakens)
• balance of payment: falling incomes may cause demand for imports to contract, exports fall due to lower international competitiveness
• spare capacity: rise- bc higher output, lower employment, rising spare capacity from weaker demand
• business investment: lower- COP, decline if businesses are hit by lower profits and weaker consumer spending
• government fiscal balance: higher- short run improvement from higher taxes but risk of falling revenues in long term

Question 27

how could tax cuts stimulate economic recovery?

Answer 27

• consumer spending: boost demand for goods and services but low confidence- tax cuts likely to be saved rather than spent
• business investment: lower corporation tax to increase investment but businesses may choose to invest overseas
• lower employment taxes: reduce national insurance so that businesses create more jobs but skills shortages might limit new job creation
• lower fuel/ carbon taxes: lower costs for businesses, less inflation and higher profits but possible conflicts with environmental policies

Question 28

evaluate a low tax economy: arguments for low tax

Answer 28

-stimulate work incentives and productivity
-helps to create more jobs bc businesses less tax to pay
encourages an inflow of FDI from businesses looking for low tax country
-incentivises enterprise and start-ups
-lower tax rates might end up increasing total tax revenues

Question 29

evaluate a low tax economy: arguments against low tax

Answer 29

• taxation is key for changing final distribution of income and wealth
• tax cuts don’t necessarily lead to an increase in total tax revenues for the government
• taxes are needed to fund high quality public services