Fiscal Policy

Question 1

Government spending trend overtime

Answer 1

Has been generally increasing (especially spikes during wars), now around 40% of GDP

Now expected to fall slightly following aftermath of Covid

Question 2

UK spending and receipts in 2023/24

Answer 2

Fiscal deficit - expenditure>tax rev (-£132bn)

Question 3

Automatic stabilisers on the government budget during a recession

What school of thought and why?

Answer 3

Budget deficit will increase naturally.

B) Keynesian as counter-cyclical i.e increase deficits while in recession (benefits&less taxes), and surplus while in boom (more tax revenue through progressive system)

Question 4

Discretionary measures also exist.

Name example
Con of discretionary measures

Answer 4

UK cutting vat from 17.5 to 15% in 2008

Inside lags - take time for government to act.

Question 5

Government borrowing 2022-2023

B) Net debt vs net borrowing. Why is debt rising while net borrowing (fiscal deficit) falling.

Answer 5

Reduced the fiscal deficit (now at -£132bn) as receipts increased. As a result borrowing fallen (but still in deficit!)

B) We are not reducing debt, we are just reducing deficits. I.e still adding to the debt as still exp>tax! Only surpluses will reduce the debt!

Question 6

So for 2023-24 fiscal deficit of £132bn.

How can a government spend more than they receive?

B) how much of total expenditure is it?

Answer 6

By borrowing i.e selling bonds (gilts)

B) So a liability on governments balance sheets since means they need to make repayments, 10% of their expenditure

Question 7

Objectives of fiscal policy (6)

Answer 7

Revenue generation for public services

Address market failure (excise)

Redistribute wealth (prog tax)

To get re-elected

Promote macroeconomic stability (increase AD)

To meet fiscal targets

Question 8

1st objective: Generate revenue

How is the best way to generate revenue, and evaluate

Answer 8

Windfall taxes - taxing profitable industries.

Eval: potentially damaging in long term

Question 9

2nd objective of fiscal policy:
Address market failure: How?

Answer 9

Excise taxes on goods with negative externalities.

Question 10

3rd objective: Redistribute wealth:

How is this done for example

Answer 10

Income tax is progressive - tax richest the most, to redistribute to poorer through benefit payments

Question 11

5th objective: To get re-elected: how may they do this?

Answer 11

Run budget deficits (spend heavy and reduce taxes) to win election

(Eval: with rational consumers under neoclassical; stimulus has no multiplier effect since they expect taxes to rise in future since gov borrowing must’ve increased)

Question 12

6th objective: Promote macroeconomic stability

E.g consider a fall in AD. What will be done to fiscal policy in a recession (Phillips curve diagram)

Answer 12

Fall in AD following recession

Respond by cutting taxes to increase consumption and increase GDP back to original point.

Question 13

Keynesian view on deficit spending (3)

Answer 13

Borrow if necessary to recover from recession (the priority)

Unemployment costly (full employment objective)

Fiscal policy should be counter-cyclical: automatic stabilisers display this perfectly!

Question 14

Neoclassical view (3)

Answer 14

Government intervention crowds out private spending by rising real interest rates.

Either raise revenue by tax or borrowing

Ricardian equivalence - Higher borrowing today implies higher taxes in future, consumers realise so don’t respond, so no multiplier effect to fiscal stimulus. (As shown in pre-2010 labour policy!)

Question 15

6th objective (final): To meet fiscal targets: Why

Example of fiscal target

Answer 15

Give credibility to government (Neoclassical!!)

(Political/ideological reasons
To take heed of economic theory)

Example:
Gordon Brown’s golden rule 1977: reduce public debt below 40%.
Darling rule 2015: balance structural deficit (CABB) by 2015

Question 16

Fiscal sustainability - deficit spending is useful but limited - government faces certain constraints on its capacity to borrow.

2 types of constraints

Answer 16

Formal/codified constraint e.g EU stability & growth pact: deficit can’t be more than 3% GDP

Informal - verdict of bond market if interest rates high, harder to borrow! Recall price-yield relationship, if price falls, interest is high, and so repayment cost for government issuing bonds will be high!

Question 17

Fiscal sustainability linking to financial crisis

Example of informal constraint

Answer 17

Downgrade of US & UK government debt by credit risk companies.

(Gov less likely to repay off their debt, more risky investors, increase rates to compensate for default risk, increasing borrowing costs for gov, so not fiscal sustainable!!)

Question 18

Governments budget constraints equation

Answer 18

Ptgt + (1+it)Bt-₁ = Bt + ΔMt + PtTt

Expenditure (includes interest debt accumulated from selling bonds they need to repay= revenue (from taxes and issuing bonds + money supply)

P- price level
g - real gov spending
i - nominal interest
B - no.of bonds issued
M - money supply
T - tax revenue
All at time t

Question 19

Condition for sustainable fiscal policy

Answer 19

Debt to GDP ratio has to be less/equal than

Σ(1/1+i-π-y) Et (St+j/yt+j)

Et (St+j/yt+j) is expected future primary surplus to GDP ratio (primary surplus is budget - interest repayments)
y is output growth rate

If holds, fiscal policy is sustainable

Question 20

Fiscal sustainability can exist with any debt-to-GDP as long as…

Answer 20

Expected future surpluses in future (pay back old debt and interest)

Question 21

So sustainable with any debt-to-gdp as long as we expect to generate future surpluses.

How can we restore solvency i.e create future surpluses

Answer 21

Since agents are forward looking, we can use credible plan to adjust tax/expenditure. This increases expected future primary surplus

Question 22

What eases the condition for fiscal sustainability (3)
(Makes it easier to sustain policy)

Answer 22

Lower nominal interest rate (i, in denominator so if smaller means RHS of equation is larger, which is favourable since needs to be >= debt-to-gdp ratio!)

Increase in inflation (π in equation, intuition as above)

Increase in output growth (y in equation, same intuition)

Question 23

Cyclically adjusted budget balance (Keynesian)

Answer 23

Measures the budget balance we would get if real output took its natural level.

Question 24

Key use of the cyclically adjusted budget balance

B) Keynesian view for CABB

Answer 24

Adjusts budget according to economic cycle.

Because unadjusted figures appear too gloomy (since less income tax and increase benefit payments), and too rosy during a boom.

B) Surplus in boom to anticipate and prepare for recession

Question 25

Explain fiscal profile diagram in the cyclically adjusted budget balance model (CABB)

2) explain what contractionary or expansionary fiscal policy looks like on diagram

Answer 25

If at A+ , output>natural output (boom) so should run a budget surplus

A- output<natural output (recession) so should run a budget deficit

2) Contractionary - shift upwards, since we are either increase tax or reduce expenditure at all levels

Expansionary - downwards shift: spending too much or taxing to little at any output level

Question 26

What does a budget surplus when output gap is 0 imply

Answer 26

Taxes too high, or spending too low (Contractionary fiscal policy)

Question 27

A practical difficulty of the CABB

Answer 27

Potential/natural output - hard to observe directly, so analysts may find different estimates of the output gap

Question 28

Fiscal policy - Start with Labour pre-2010.

3 stimulus’

Answer 28

Reduced VAT from 17.5 to 15%, for 2 years in 2008, then returned.

Vehichle scrappage scheme - cash for clunkers

Help to buy scheme - housing (same scheme that ended funding for lending for households, who stuck just to firm lending!)

Question 29

Was this Keynesian or Neoclassical

Answer 29

Keynesian - since was expansionary, and done counter-cyclically, we increased the deficit after a 6% fall in GDP, creating a stimulus of 1% of GDP

(Recall CABB diagram with expansionary policy)

But it could be neoclassical.,.. pto

Question 30

Why was stimulus low (why it may not be Keynesian, and more neoclassical)

Answer 30

Stimulus only worth 1% of GDP, while economy shrank by 6.1%. In Keynesian priority is to escape recession, this didn’t do so…

Neoclassical as only did small stimulus (minimal intervention) as recognised people know gov borrowing now implies high taxes apply in future, so policymakers more limited in stimulus.

Question 31

Relationship between budget surpluses and debt

Answer 31

In surpluses, reduce debt

Question 32

That was plans till 2010.

Now 2010: Darling plan

Answer 32

Reduce STRUCTURAL deficit (CABB) over next 5 years.

(Not just reducing normal deficit, since may just be down to rosiness from boom conditions! So after accounting for the business cycle)

Question 33

Darling Plan initiative

Answer 33

Austerity (reduce spending) more than tax increases

(Aimed for 80% of deficit reduction derived from spending cuts, 20% tax increases e.g VAT now 20%)

Question 34

Austerity by government department: cuts in everything except… (2)

Answer 34

Except health and international development

Question 35

Did they achieve Darling objective?

Answer 35

Reduce structural deficit (CABB) into a balance within 5 years (as mentioned earlier)

2. Were on track until rule replaced in 2015 election

Question 36

Second aim of Darling Rule 2010

2. Did they achieve? Why/why not

Answer 36

Public sector net debt (PSND) to fall as a share of GDP

(PSND does not include borrowing, that is total debt)

2. No, there was a pause in austerity in 2012/14 - (no further cuts to spending and further increased taxes)

Question 37

2023 fiscal rules (current approach)

Hint: 2 rules, 1 cap!

Answer 37

Fiscal mandate - PSND/GDP should fall by 2028

Borrowing rule - less than 3% of GDP by 2028

Welfare cap

Question 38

Government spend during COVID PANDEMIC (2020-2021)

GDP, and stimulus

Was this Keynesian or neoclassical

Answer 38

229bn spent

GDP was 2.2 trillion in 2020. Fall of 11%

Stimulus around 10%.

Comparing to recession, stimulas strong, suggesting more Keynesian since matched it. (Compared to 2008 labour)

Question 39

In their Autumn 2024 statement, are government on track to meet 2022 objectives?

Answer 39

Yes both fiscal rules (debt rule and borrowing rule) = Both debt and borrowing to GDP ratios expected to fall by 2028

Question 40

So overall evaluation: problems (3)

Answer 40

Measuring output gap - hard so hard to identify CABB correctly and whether we are on track or not e.g in surplus while in boom, or surplus because not spending enough or taxing too high!

Many fiscal rules are modified/scrapped (6 revisions since 2011)

Unexpected events can knock fiscal policy off course e.g Darling Rule: CABB to be balanced by 2015, was on target until scrapped.

Question 41

Fiscal policy pre crisis (2002-2007)

Answer 41

Too optimistic about natural level of output so exited surplus and into deficit since thought were comfortable and could fix roof!

Was not the best time to fix the roof!

Question 42

So 2 ways to evaluate fiscal policy

Answer 42

CABB Keynes (fiscal stance)

Fiscal Targets (e.g Golden rule)

Question 43

Fiscal stance index

If FSI<1
FSI>1
FSI=1

Answer 43

<1 means debt-to-gdp ratio is on course to exceed target, so expansionary unsustainable

> 1 debt-to-gdp ratio is below target so contractionary and TOO sustainable

=1 neutral and sustainable