Fiscal Policy - Advanced Evaluation

Question 1

Fiscal Drag - Evaluation for increasing income taxes or changing tax brackets.

Answer 1

I would rather not use this its just something to be aware of. For example, the UK government annouced the plan to freeze income tax brackets until 2028 –> this is a sneaky way to increase taxes due to fiscal drag.

Question 2

Laffer Curve Disincentives - Evaluation for increasing income taxes

Answer 2

• However, if the UK government do increase the rate of income tax then this can provide Laffer Curve disincentives. For example, in Scotland, the Scottish government introduced a new income tax bracket from £75,000 to £125,140 who pay 45% income tax as opposed to 40% before.
• Problems in increasing the rate of income tax can be seen in the laffer curve above. If the government increase the rate of income tax to reduce the bugdet deficit then, they would have to increases taxes from T1 to T2, causing an increase in revenue from R1-R2, therefore maximising revenue.
• However, it may be the case that taxes are already at the maximum revenue. As a result, an increase in income taxes from T2 to T3 would mean that there is a fall in tax revenue for the government R2-R3 and therefore increasing the tax rate may not necessarily be benefical to reduce the budget deficit.
• Furthermore, an increase in the rate of income tax increases the incentive for tax avoidance and tax evasion. This is particularly likely for higher income earners who can afford services to reduce the amount of tax they pay (acccountants). For poorer individuals this may mean increases in “cash in hand” jobs leading to lower levels of income tax for the government. Therefore, the government may not want to increase the rate of income tax in order to solve the budget deficit/contractionary fiscal policy. However, there is very little empircal evidence for the laffer curve.

Question 3

Crowding Out Effect - Evaluation for Expansionary Fiscal Policy

Answer 3

• However, the government may not want to enact (insert expansionary fiscal policy) due to the opportunity cost.
• In the UK, there is already a large budget deficit, projected to be $87.2bn in 2024 therfore, If the government wants to enact x, then they may need to borrow money to do so, by allocating government bonds.
• If government spending becomes debt-fuelled this can then crowd out the private sector.
• In the market for loanable funds, there is a rightwards shift in demand due to the government needing to borrow money for x.
• At the current market interest rates i1, there is excess demand, this drives up the current market interest rates from i1 to i2.
• At the higher market interest rate, i2, there is less of an incentive for private sector investment due to it being less profitable (ceteris paribis).
• This can then have impacts on both the supply-side and demand-side of the economy. For instance, if firms invest less this can reduce potential growth and short-run economic growth therefore expansionary fiscal policy may not be benefical….

Question 4

Ricardian Equivalence - Evaluation for expansionary fiscal policy

Answer 4

• However, the government may not want to enact expansionary fiscal policy due to the theoretical implications of Ricardian equivalence.
• If government spending is debt-feulled through the allocation of government bonds, the public knows that in the long-run the government must pay that off and other existing debts.
• As a result, people will anticipate higher taxes in the future, and consumers, assumed to be forward-thinking, will save so that they can maintain a constant standard of living when taxes do invevitably rise.
• This can have negative impacts on both the demand-side and supply-side of the economy. For instance, decreased consumption decreasing AD…… therefore expansionary fiscal policy may not be desirable.