Fiscal Policy Flashcards
Fiscal Policy
The manipulation of government spending and taxation to influence AD in order to cause economic growth
Goals of Fiscal Policy
Discourage consumption of demerit goods (e.g. alcohol or cigarettes)
Fund government spending without a damaging rise in budget deficit
Redistribute income and wealth to ensure spending and taxation impact fairly both within and across generations
Macroeconomic stability
Increase aggregate supply in the long run
Government Spending and Receipts 2014-15 stats
Government Spending: £732 billion
Social protection £222 billion, Health £140 billion, Education £98 billion
Government Receipts: £648 billion
Income tax £167 billion, VAT £111 billion, National insurance £110 billion
Spending by the public sector
Transfer Payments - welfare payments aiming to provide a basic floor of income or minimum standard of living
Capital Spending - investment spending by the government, including on roads, hospitals, schools, prisons, which adds to the economy’s capital stock
Current Government Spending - spending on state-provided goods and services, including salaries for NHS workers and resources used in providing state education and defence
Why we have Government spending
Provide public goods (e.g. lighthouses) and merits goods (e.g. healthcare and education)
Public Goods
Goods not provided by the free market
They can be jointly consumed without lowering quantity or quality of the good
They are non-rivalrous so the consumption doesn’t lower availability for others
They are non-excludable so others can’t be excluded from consuming it
Merit Goods
Goods that are under consumed by society and under provided by the free market, but the government believe that they benefit society, so should be consumed in higher quantities
Taxation
Forms the revenue which flows into the government’s accounts
In the form of direct and indirect taxes
Direct Taxes
Taxes levied on income, wealth and profit
Include income tax, national insurance contributions, capital gains tax and corporation tax
Indirect Taxes
Taxes on spending
Include excise duties on fuel, cigarettes and alcohol, and VAT
Progressive Tax
The marginal rate of tax rises as income rises
As people earn more income, the rate of tax on each extra pound earned goes up
UK have a progressive tax system where base tax rate is 20%, higher income earners pay 40% with the top limit (over 150,000 per year) paying 45% tax
Proportional Tax
The marginal rate of tax is constant
Where the income tax for all earners is the same however low earners wouldn’t pay national insurance and high earners would
Regressive Tax
The rate of tax falls as income rises
The average rate of tax is lower for people of higher incomes
In the UK, this tax is on excise duties for cigarettes and alcohol so the heavy excise duty has a regressive impact on the UK’s distribution of income
Automatic Stabilisers
Mechanisms which reduce the impact of a change in the economy or national income
They adjust levels of government spending and taxation to offset the effects of a boom or a recession
Discretionary Fiscal Policy
The deliberate changes by government to influence either levels of government spending, rate of taxation, or both
This is aimed to influence AD, AS, or both
Expansionary Fiscal Policy
Loosening fiscal policy
Deliberately trying to increase AD
Increases price level and real output
Contractionary Fiscal Policy
Tightening fiscal policy
Deliberately trying to decrease AD
Decreases price level and real output, increases unemployment
Expansionary Fiscal Policy examples (4)
- cut in personal income tax → boost to disposable income → increases consumption
- cut in indirect taxes → lower prices so higher real incomes → increases consumption
- cut in corporation tax → higher post tax profits for businesses → increases investment
- cut in tax on interest from saving → boost to disposable income of people with net savings → increased consumption
Budget Deficit
Where the government spends more than it receives from tax revenues
Budget Surplus
Where the government receives more in tax revenues than it spends
National Debt
The amount of money the government owes at any one time
How Fiscal Policy Affects AS
Labour market incentives - cut in income tax improve incentives for people to seek work and boost labour productivity
Capital spending - government spending encourages investment across the whole economy
Entrepreneurship and new business creation - expansion in rate of small business start ups due to higher government spending
Research and development innovation - government spending and tax credits allow firms to invest more in R and D
Human capital of the workforce - education and retraining of workers, funded by government spending
Evaluating Fiscal Policy
Time lags - takes time for policies to be recognised and implemented and for policies to work
Imperfect Information - without knowing the value of the multiplier, it is hard to fine-tune the economy successfully so demand may be over-stimulated
Laffer curve - used as justification for lower taxes. low taxes cause FDI inflows and high disposable income causes more consumption, boosting AD
Crowding out - higher government borrowing increases demand for loanable funds and depending on elasticity of supply of loanable funds interest rates could rise
Doubts about efficiency of public sector - not all funding improves front-line services, increased costs of administration, higher wage inflation in PS
Riccardian equivalence - prospect of rising tax increases saving, decreasing consumption and AD
Automatic Stabilisers
Mechanisms that automatically reduce the impact of changes on the economy
OBR
Office for Budget Responsibility
Provides independent and authoritative analysis of the UK’s public finances
Government Spending stats 2020/21
£928bn in total
£285bn on social protection
£178bn on health
£116bn on education
Government Receipts stats 2020/21
£873bn in total
£208bn through income tax
£161bn through VAT
£150bn through national insurance
Current Spending
Public sector day to day spending on providing government services
e.g. NHS wages
Increases consumption, increasing AD
Capital Spending
Long term investment in physical infrastructure
e.g. HS2
Increases quality + quantity of FOPs, increasing LRAS
Increases AD through government multiplier
Transfer Payments
Government spending with no economic activity in return
e.g. JSA
Increases consumption, increasing AD
Demand-side Policies
Policies affecting AD to influence unemployment, real output and price level
e.g. Interest rate currently at 4.75% in UK
Debt Interest Payments
Amount of interest paid on stock of government debt
Governments net debt interest spending was £107bn, 3.9% of GDP
How a cut in Corporation Tax shifts AD
Higher profit → more investment → increase in AD → increase in real GDP
How a cut in Indirect Tax shifts AD
Lower prices → consumption increases → increase in AD → increase in real GDP
How higher Government Spending shifts AD
AD increases → causes a multiplier → transfer payments raise consumption
How a cut in Corporation Tax shifts AS
More investment in education and training → increases quality and quantity of FOPs → increases LRAS
How a cut in Indirect Tax shifts AS
Lower cost of production → increases SRAS
How higher Government Spending shifts AS
Education and training increases → increases quality and quantity of FOPs → increases LRAS
Government spending on infrastructure crowds-in private sector → increases investment → increases quantity and quality of FOPs → increases LRAS
Households during economic growth
Increased tax revenue from Income Tax, VAT, NI
Less government spending on transfer payments
Households during recession
Lower tax revenue from Income Tax, VAT, NI
More government spending on transfer payments
Firms during economic growth
Higher tax revenue from corporation tax
Firms during recession
Lower tax revenue from corporation tax
Strengths of Fiscal Policy
It is effective in the long run at dealing with a deep recession
It can be used to target specific sectors of the economy
Weaknesses of Fiscal Policy
Time lags
Political pressure
Unsustainable debt
Inability to achieve specific targets
Crowding out
