Fiscal Policy and Supply-Side Policies

Question 1

How can Fiscal Policy have Microeconomic functions (affect individual markets)?

Answer 1

Governments levy taxes so they can, among other things, provide merit goods (e.g. NHS), provide public goods (e.g. clean drinking water, infrastructure), reduce negative externalities (e.g. pollution), and reduce consumption of demerit goods (e.g. cigarettes).

Question 2

Fiscal Policy

Answer 2

Fiscal policy involves the use of government spending, taxation and borrowing to affect the level and growth of aggregate demand, output and jobs. Fiscal policy is also used to change the pattern of spending on goods and services in an economy.

Question 3

National Debt

Answer 3

The national debt is the total amount of money that a country owes to its creditors. It is calculated by adding up all of the government’s outstanding debt, including bonds, notes, and bills. The national debt can be a significant burden on a country’s economy.
Government debt was equivalent to 97.7% of GDP at the end of December 2023.

Question 4

Direct taxation

Answer 4

Direct taxation is levied on income, wealth and profit. Direct taxes include income tax, inheritance tax, national insurance contributions, capital gains tax, and corporation tax (a tax on company profits).

Question 5

Indirect Taxation

Answer 5

An indirect tax is a tax levied on expenditure on a good or service. The tax is imposed on producers, but they are able to pass on the liability of the tax to the consumer (in the form of higher price) if they wish. There are two types of indirect tax: specific tax and ad valorem tax.

Question 6

Progressive Tax

Answer 6

A progressive tax is where the average rate of tax (as a %) rises as income increases. Richer households pay a higher percentage of their income in tax than poorer families.

Question 7

Regressive taxation

Answer 7

A regressive tax is a tax imposed by a government which takes a higher percentage of someone’s income from those on low incomes. This means that those with lower incomes pay more in tax relative to their income.

Question 8

proportional tax

Answer 8

In a proportional tax system, all individuals pay the same tax rate, regardless of their income level. The means that the average tax rate and the marginal tax rate will remain the same. However, the amount of tax will increase with the increase in the income of tax payers.

Question 9

Adam Smith’s Canons of Taxation

Answer 9

• Economy
• Equity
• Efficiency
• Flexibility
• Convenience
• Certainty

Question 10

Laffer Curve

Answer 10

The Laffer Curve is a theoretical representation of the relationship between government revenue raised by taxation and all possible rates of taxation. Professor Arthur Laffer - Supply-Side economist 1974 - developed a theory to increase incentives and productivity.

Question 11

Crowding out

Answer 11

Crowding out refers to the negative impact that government spending can have on private investment. The theory of crowding out suggests that when the government increases its spending, it will increase the demand for goods and services, which can lead to higher interest rates and inflation. This, in turn, can make borrowing more expensive for private investors, reducing their ability to invest in new projects and businesses. As a result, private investment may decrease or “crowd out” as the government spending increases.

Question 12

Supply-Side policies

Answer 12

Supply-side policies are government attempts to increase productivity and increase efficiency in the economy. If successful, they will shift aggregate supply (AS) to the right and enable higher economic growth in the long-run.

There are two main types of supply-side policies.

Free-market supply-side policies involve policies to increase competitiveness and free-market efficiency. For example, privatisation, deregulation, lower income tax rates, and reduced power of trade unions.
Interventionist supply-side policies involve government intervention to overcome market failure. For example, higher government spending on transport, education and communication.

Question 13

Supply-side improvements

Answer 13

Supply side policies can increase economic growth by promoting productivity and efficiency. By reducing the costs of production and increasing incentives to work and invest, businesses can expand output and profits. This can lead to higher economic growth rates over the long term.

Question 14

Automatic Stabilisers

Answer 14

Automatic Fiscal effects which influence the path of economic growth due to cyclical changes in tax revenue and welfare costs.

Question 15

Transfer Payments

Answer 15

Welfare payments provided to ensure a minimum standard of living

Question 16

Current government spending

Answer 16

The ongoing running costs of government services

Question 17

Capital spending

Answer 17

Provision and maintenance of key national infrastructure items.

Question 18

Lorenz curve

Answer 18

A graph which indicates income inequality by plotting the cumulative % of total national income against the cumulative % of the corresponding population.

Question 19

Gini index

Answer 19

A statistical measure of the level of income inequality in an economy calculated by analysing the size of any inflexion in the lorenz cure.

Question 20

Government budget

Answer 20

A plan detailing the income and expenditure a government anticipates over a given period of time together with details of any borrowing requirements.

Question 21

Total budget deficit

Answer 21

Structural deficit - Deficit not related to the economic cycle
Cyclical deficit - Deficit related to the economic cycle

Question 22

Austerity

Answer 22

Fiscal austerity is a policy approach that involves reducing government spending and/or increasing taxes in order to reduce budget deficits and debt. The goal of fiscal austerity is to improve the financial health of a government by reducing its reliance on borrowing and stabilizing its debt-to-GDP ratio.

Question 23

unemployment trap

Answer 23

when the level of income available from benefits it too high relative to the income available from working so that individuals choose to remain unemployed.

Question 24

poverty trap

Answer 24

when the withdrawal of benefits and application of higher tax rates mean low paid employers choose not to earn more money as they cannot make themselves sufficiently better off.

Question 25

Multiplier effect

Answer 25

The multiplier is defined as an initial change in an injection or leakage that leads to a much greater final change in real national income. One person’s consumption is another person’s income.

Question 26

MPC

Answer 26

The marginal propensity to consume (MPC) is calculated as change in C divided by change in income.
The MPC represents the amount of each extra pound that the consumer spends when given an extra pound in income.

Question 27

Cyclical deficit

Answer 27

A cyclical budget deficit is the budget deficit that arises because of the stage of the economic cycle an economy is at, rather than underlying problems.
A key cause is the role of automatic stabilisers:
In a recession, an economy’s budget deficit rises because unemployed people pay less income tax and consume less, reducing indirect taxes such as VAT. They also receive more welfare payments through housing benefit, income support, etc.
So, government spending (G) automatically rises and government revenue through taxes (T) automatically falls.

Question 28

Discretionary Fiscal policy

Answer 28

These are intentional government policies to increase or decrease government spending or taxation. For example, Keynesian economists might favour a deliberate increase in the size of the fiscal deficit when private sector demand and confidence is low during an economic recession.

Question 29

Evaluating supply-side policies

Answer 29

1. Time lags. Depends on the type of policy and the country involved.
2. Level and growth of AD is important in making business investment and innovation viable - this is a valid Keynesian issue - demand helps to utilise extra supply.
3. Some (e.g.) may lead to greater inequalities of income and wealth. Depends on which taxes are changed and by how much.
4. State intervention to “pick winners” in different industries may be ineffective. i.e. risks of government failure.
5. Supply-side policies look to achieve relative improvements e.g. In productivity - but other countries will be making gains too.