fiscal policy chapter 22 Flashcards
fiscal policy
the use of taxation and government spending to influence aggregate demand in order to achieve the government’s macroeconomic aims.
budget
an annual statement in which the government outlines plans for its spending and tax revenue.
budget surplus
government revenue exceeding government expenditure.
budget deficit
government expenditure exceeding government revenue.
balanced budget
government revenue equaling government expenditure.
automatic stabilizers
changes in government spending and taxation that occur to reduce fluctuations in aggregate demand without any alteration in government policy.
cyclical budget deficit
a budget deficit caused by a decline in economic activity.
why does budget receive media attention
it is an indicator of both fiscal policy intentions and economic performance.
what is outlined in the budget statement
the finance minister outlines the government’s spending and taxation plans for the year ahead.
what do governments aim for
Most governments seek to achieve a balanced budget over time. In the short term, a government may aim for, or a budget deficit if there is a low level of economic activity. A budget deficit may occur in this situation as a result of both deliberate government action and of automatic stabilisers.
what does a government do when there is a a decline in economic growth and a rise in unemployment
increase government spending. It may also allow government spending on unemployment benefits to rise and tax revenue to fall as an automatic result of a slowdown in the economy.
why would a government not be worried about a cyclic deficit
it will move towards a balance as economic activity increases
structural deficit
a budget deficit cause by an imbalance between government spending and taxation
tax base
the coverage of what is taxed
why would a government be concerned about a structural deficit
the deficit will not disappear when GDP increases
why would a budget deficit decline in the short run
it will decline when there is a rise in tax revenue and/or a fall in government expenditure.
how does a rise in government spending and/or a cut in tax rates or the tax base reduce a budget deficit.
This is because such a change/changes could increase economic activity. If, for instance, increased government expenditure on training made workers more skilled, they may earn higher wages and so pay more taxes
national debt
the total amount of government debt. often expressed as a percentage of GDP.
government debt (public sector debt)
it is the total debt a central government has built up over time
how does budget deficit increase national debt
budget deficit is added to national debt
how does budget surplus decrease national debt
the extra revenue earned from a budget surplus can be used to pay off part of the national debt
when does the government tend to increase
tends to increase during economic downturns as this is when government expenditure tends to rise at a more rapid rate than tax revenue. There may also be a tendency for a government to spend more than its revenue even during economic booms (a structural deficit). In addition, military conflicts can result in significant increases to the national debt.
the disadvantages in having a large and increasing national debt
There is the opportunity cost of interest payments on the national debt. The government revenue used to service the debt might have been used to finance because it may cause them to have doubts about the government’s ability to pay interest on the debt and to repay the sum borrowed. Borrowing a large amount may also push up the rate of interest that has to be paid.
why are national debts not the same as external debt
some of the debt will be owed to the citizens. For example, some households may have purchased government saving certificates and some domestic banks may have bought government bonds. However, payments to foreign lenders by the government will involve an outflow of money from the country.
how can the national debt to GDP be reduced
The national debt to GDP ratio will be reduced if there is either some repayment of the debt or if GDP rises.
specific taxes
taxes that are charged as a set amount per unit
sin taxes
taxes on products considered harmful. some excise duty is referred to as sin tax. imposed to discourage people from buying products that are not good for their health
ways of taxation
indirect taxes
direct taxes
indirect taxes
taxes on the sale of goods and sercvices
why are they called indirect taxes
they are largely paid by consumers, but are collected by firms that supply the products. It is the firms that are legally responsible for paying the taxes to the government.
how do firms try to pass on taxes to consumer
Firms will try to pass on as much of the tax as possible to consumers in the form of higher prices.
what determines how much tax is passed on to the consumer
will depend on the price elasticity of demand. The more inelastic the demand, the higher the proportion of the tax that is likely to be passed on to the consumers.
most common types of indirect tax
The two most common indirect taxes are VAT (value added tax) and GST (general sales tax). Both of these taxes are ad valorem taxes. This means they are taxes based on the percentage of the price of a product.
direct taxes
taxes on income and wealth
two examples of direct taxes
Two examples of direct taxes are income tax (also sometimes called personal income tax) and corporate tax (also known as corporation tax and corporate income tax)
income tax
Income tax is a tax on the income of individuals and corporate tax is a tax on the profits of firms.
tax avoidance
the legal bending of rules of the tax system to pay less tax
tax evasion
the illegal non payment or underpayment of a tax
advantages of indirect tax
They can be changed, if needed, relatively quickly and easily. They are cheaper to collect than direct taxes as firms do part of the administrative work. They can also be used to discourage the purchase of particular products. The main advantage claimed for indirect taxes is that they do not discourage effort, innovation and saving.
how does tax acts as a disincentive
Direct taxes may act as a disincentive to save as they mean that income can be taxed twice - once when it is earned and again when interest is received on any part that is saved. High direct taxes may stop firms introducing new methods and products if they think their post-tax income will be too low.
how is a rise in direct tax benificial
Some workers may decide to work more hours to maintain their level of disposable income. High direct taxes may encourage tax avoidance and tax evasion.
how can greater reliance on indirect taxes be negative
how can greater reliance on indirect taxes be negative
Greater reliance on indirect taxes may make income less evenly distributed. This is because indirect taxes are regressive taxes. Paying a tax of, for example, $2 on a product will take up a larger percentage of the income of a person on a low income than that of a rich person.
how does an increase in indirect taxes contribute to cost push inflation
Indirect taxes place an extra cost on suppliers. They are likely to result in higher prices and this may lead people to expect prices to continue to rise. High rates of indirect taxes may also encourage people to try to avoid paying them. For instance, people may smuggle products into the country to avoid paying import tariffs.
regressive tax
a tax which takes a larger percentage of the income or wealth of those on low incomes. indirect tax is regressive. a smaller percentage is taken as income rises. this means that such a tax takes a higher percentage of the income of people on low incomes
proportional tax
a tax which makes the same percentage of the income or wealth of those on low incomes. it is simple to understand and administer but is regressive
marginal rate of taxation (mrt)
the proportion of extra income taken in tax. in the case of progressive tax, the marginal tax rate is higher than the average tax rate thus the proportion of tax people would pay on extra income would be greater than the proportion they pay on the total amount they earn.
For example, if a person earns an extra £100 and £30 is taken in tax, the marginal tax rate is £30/£100 = 0.3. This can also be expressed as 30%.
average rate of taxation (art)
the proportion of income that is taxed. If a person earns £50000 and pays £10000 in tax, the average tax rate is 0.2 or 20%.
progressive tax
tax that takes a higher percentage of a person or firm’s income as the income rises. direct taxes are progressive. as income rises, a higher percentage is paid in tax
marginal tax rate and progressive tax
in the case of progressive tax, the marginal tax rate is higher than the average tax rate thus the proportion of tax people would pay on extra income would be greater than the proportion they pay on the total amount they earn.
marginal tax rate and regressive tax
in the case of a regressive tax, the marginal tax rate is lower than the average tax rate.
marginal rate and proportional tax
The relationship is also different in the case of a proportional tax. In this case, the marginal tax rate equals the average tax rate.
why does government need taxes to finance government spending
revenue needs to be raised to finance government spending on merit goods. in theory, finance its spending just by printing money. However, such an approach would be very inflationary.
how does tax influence AD
If the government wants to reduce aggregate demand it will raise tax rates and/or increase the tax base. If it wants to reduce aggregate demand, it will do the reverse. The need to influence aggregate demand is probably the main reason for imposing taxes.
how can progressive income tax be used to distribute income more evenly
Such a tax narrows the gap between the disposable income of rich people and people on low incomes. The gap could be further narrowed by the government using some of the tax taken from rich people to provide cash benefits to those on low incomes.
why is taxes imposed on certain products
These may be imports. A government may be concerned that the country is spending more on imports than it is earning from selling exports. Taxes may also be imposed on demerit goods in order to improve people’s health and the environment.
what can government spending be divided into
transfer payment
current government spending
capital government spending
exhaustive government spending
non exhaustive government spending
transfer payments
they are welfare payments to certain groups of people. it includes spending on unemployment benefits, state pension and interest payments on the national debt
current government spending
government spending on providing goods and services used to provide state financed services. it covers the operating costs like wages or medicine used
capital government spending
government spending on investment. spending on capital goods used in public sector like building state schools or hospitals
exhaustive government spending
government spending which makes use of resources. it covers current and capital spending. it is spending which uses resources and is counted in AD and GDP.
non exhaustive government spending
government spending which allows others to decide how resources are used. the people who receive payments make the decision about how to use resources. it includes spending on transfer payments.
how does government spend to influence AD and so the level of economic activity
if private sector spending is thought to be too low, a government may decide to inject more spending into the economy. it will aim for a budget deficit, spending more than it raises in taxation
how does government spend to influence AD
Government spending on education, healthcare and infrastructure can raise an economy’s productive potential.
why do governments spend on transfer benefits
to ensure that people have a basic level of income, and so avoid poverty, and to reduce income inequality.
why do governments spend on merit goods
Governments spend on merit and public goods in order to overcome market failure. As GDP rises, there is likely to be pressure on the government to spend more on merit and public goods. This is because people will have higher expectations
why do governments spend to win political popularity
governments may also spend to win political popularity so that they can stay in power. Government spending in a number of countries regularly rises just before an election.
why can governments spending be influenced by pressure goods
pressure groups encourage them to spend more on, for instance, the environment.
expansionary fiscal policy
increases in government spending and cuts in taxes designed to increase aggregate demand.
how can expansionary fiscal policy be achieved
This can be achieved by a government increasing its spending and/or cutting tax rates or the tax base.
how does expansionary fiscal policy affect government budget
A government may decide to increase an existing budget deficit so as to make a larger net injection into the circular flow of income.
contractionary fiscal policy
decreases in government spending and increases in taxes designed to reduce the growth of aggregate demand.
how can contractionary fiscal policy be achieved
the government will reduce its spending and/or increase taxes
how does contractionary fiscal policy affect government budget
government may aim for a budget surplus.
discretionary fiscal policy
deliberate changes in government spending and taxation.
what causes changes in government spending
may be the result of changes in government policy or the result of changes in economic activity.
automatic stabilizers
Automatic stabilizers are forms of government spending and taxation that change, without any deliberate government action, to offset fluctuations (changes) in GDP.
how can automatic stabilizers influence AD
They offset fluctuations in demand by reducing taxes and increasing government spending during a recession, and they do the opposite in expansion
how can governments use contractionary fiscal policy tools to reduce demand-pull inflation.
Income tax rates may be increased, the threshold at which people start paying the tax may be reduced and the tax base may be widened. Governments may cut their own spending. this may be favorable in countries that have a relatively small population that pays taxes
why can raising income tax to reduce demand pull inflation may not go as planned
This is because workers may seek higher wages to maintain their disposable income. If their wage claims are granted, firms’ costs of production may increase.
disadvantages of using contractionary fiscal policy tools
Higher costs can generate cost-push inflation. Higher income tax rates may also, as noted earlier, create disincentive effects. Some workers may respond to a reduction in disposable income by leaving the labour force. Other workers may emigrate to countries with lower tax rates. This will reduce the economy’s productive capacity and so reduce aggregate supply.
how can expansionary fiscal policy be used to increase the country’s output and to raise employment
If a country has high cyclical unemployment, the government is likely to try to increase aggregate demand. It might seek to achieve this by cutting direct and indirect tax rates to stimulate higher consumer expenditure and investment. It could also add to aggregate demand directly by increasing its own spending.
what affects the success of expansionary fiscal policy tools in stimulating economic growth and reducing unemployment
For instance, expansionary fiscal policy may not be very effective if households and firms are worried about the future. In this case, they may save most of any extra disposable income they receive as a result of lower taxes and higher government spending. There is also the risk that the government may inject too much spending into the economy, causing demand-pull inflation.
