Fiscal policy

Question 1

Supply side fiscal policy

Answer 1

Tax and spending policies that influence the output/LRAS side of the economy through either incentives or productivity.

Question 2

Supply side fiscal policy examples

Answer 2

• Reducing labour market rigidities
• Raising incentives
• Government spending/subsidising

Question 3

Supply side fiscal policy - Reducing labour market rigidities

Answer 3

• Unemployment benefits, reduce benefits raises opp. cost of being unemployed. Reduces frictional U. This lowers NRU and raises the potential output of the economy.
• Reduce min. wage, lower NRU/real wage unemployment. Excess supply and higher unemployment.
• Immigration law, loosen. Increased the labour supply/size of workforce.

Question 4

Supply side fiscal policy - Raising incentives

Answer 4

• Reduce income tax, if subsitution effects dominates the income effect than this raises the amount of work people seek.
• Reducing corporation tax leads to higher investment, in the short run this raises AD, but in the long run investment in capital will raise long run growth and increase the productive potential of the economy.
  EVAL - Less government revenue, funded by borrowing, redcuction in foreign investment, interest rates could rise.
• If you tax less of firms profits, it doesnt mean they will reinvest their money but instead they could just pay their shareholders more.

Question 5

Supply side fiscal policy - Government spending/subsidising

Answer 5

• Spending on eduction
• Spending on infastructure
• Spending on health
• Certain benefits like, housing benefits offering affordable housing can reduce geographical immobility/structural unemployment. Workers in high unemployment regions can move to areas with low unemployment and high cost of living. This is a component of structural unemployment.

Question 6

Government Budget

Answer 6

A government budget is comprised of tax revenues and government expenditures, a budget is in surplus when tax receipts are exceeding expenditure and is balanced when expenditure is equal to revenue.

Question 7

Current expenditure

Answer 7

Spending that recurs, this is on goods and services which are consumed and last for short periods of times.

Question 8

Capital expenditure

Answer 8

Spent on assets which can be used multiple times, for example it could be government expenditure on roads or building a school.

Question 9

Two types of indirect tax

Answer 9

Ad Valorem, taxes are percentages, such as VAT.
Specific taxes, these are set tax per unit, such as the 58p per litre fuel duty on unleaded petrol.

Question 10

Pros of direct taxes

Answer 10

• Direct taxes tend to be progressive, people in higher income groups pay a greater percentage than poorer people.
• Important to the governments economic policy. If the government is fighting inflation it can impose, for example, high levels of income tax to restrict consumer demand. If the government is concerned about unemployment it can reduce the levels of income tax to increase consumer demand and increase production.

Question 11

Cons of direct taxes

Answer 11

• Direct taxation may be a disincentive to hard work. High rates of income tax, for example, may discourage people from working over­time or trying to gain promotion at work. Some economists blame the ‘brain drain’ (i.e., the emigration of highly qualified persons, such as scientists and doctors) on India’s high levels of taxation.
• Encourages tax evasion

Question 12

Pros of indirect tax

Answer 12

• Indirect taxation is a good way of raising revenue when levied on goods with an inelastic demand, such as necessities.
• Indirect taxes do not have a discentive effect on work.
• Important for economic policy such as discoraging consumption on demerit goods.

Question 13

Cons of indirect tax

Answer 13

• Indirect taxes are regressive. A regressive tax is one which causes a poor person to pay a higher percentage of his or her income as tax than a rich person. For instance, the tax ingredient of the price of a new television set would be the same for the poor and the rich person, but as a percentage of the poor person’s income, it is far greater.
• Indirect taxes may contribute to inflation. The imposition of an indirect tax on an item like petrol will increase its price. Since petrol is an essential input in a large number of industries, this may set off an inflationary spiral.

Question 14

Expansionary fiscal policy

Answer 14

This aims to increase AD via increases in spending or reducing taxes to do this, it leads to worsening of the government budget defici and it may mean governments have to borrow in order to finance this.

Question 15

Critisicms of fiscal policy

Answer 15

• Time lags, increasing government spending will take time, it could talke several months fot a government decision to filter through into the economy and actually affect AD.
• Crowding out. Some economists argue that expansionary fiscal policy (higher government spending) will not increase AD because the higher government spending will crowd out the private sector. This is because the government have to borrow from the private sector who will then have lower funds for private investment.
• Higher borrowing costs. Under certain conditions, expansionary fiscal policy can lead to higher bond yields, increasing the cost of debt repayments.
• Governments may have to run a fiscal deficit in order to fund expansionary fiscal policy.

Question 16

EVAL of fiscal policy

Answer 16

• It depends on the size of the multiplier. If the multiplier effect is large, then changes in government spending will have a bigger effect on overall demand.
• It depends on the state of the economy. Fiscal policy is most effective in a deep recession where monetary policy is insufficient to boost demand. In a deep recession (liquidity trap). Higher government spending will not cause crowding out because the private sector saving has increased substantially.
• It depends on other factors in the economy, for example if the government pursue expansioanry fiscal policy, but interest rates rise, and the global economy is in a recession it may be insufficient to boost demand.
• If there is concern over the governments finances the government may not be able to borrow to finance fiscal policy.

Question 17

Automatic fiscal stabilisers

Answer 17

If the economy is growing, people will automatically pay more taxes ( VAT and Income tax) and the Government will spend less on unemployment benefits. The increased T and lower G will act as a check on AD. But, in a recession, the opposite will occur with tax revenue falling but increased government spending on benefits, this will help increase AD

Question 18

Importance of the Laffer Curve?

Answer 18

The Laffer curve states that if tax rates are increased above a certain level then tax revenues can actually fall because higher tax rates discoruage work.

• Theoretically cutting taxes could increase tax revenue.
• If Tax rates are 100% or 0% the government would recieve no revenue.
• If tax rates are very high, and then they are cut, it can create an incentive for business to expand and people to work longer. This boost to economic growth will lead to higher tax revenues – higher income tax, corporation tax and VAT.

Question 19

Subsitution effect

Answer 19

If higher tax leads to lower wages then work becomes relatively less attractive than leisure, the subsitution effect of higher tax is taht workers will want to work less

Question 20

Income effect

Answer 20

If higher tax leads to lower wages then a worker may feel the need to work longer hours to maintain his target level of income, therfore the income effect means that higher tax may mean some workers feel the need to work longer.

Question 21

Discretionary fiscal policy

Answer 21

These are intentional government policies to increase or decrease government spending or taxation.