Fiscal Policy & Supply Side Policies Flashcards
Fiscal policy
The use of government spending and taxation in order to try achieve the government’s policy objectives. Can have microeconomic functions like when used to make markets more flexible and dynamic to influence consumer behaviour for example.
Balanced budget
This is when government spending equals gov revenue which is majorly tax. G=T. A deficit is when G>T and represents a net injection of demand into the circular flow of income so a deficit is expansionary. A surplus is when G<T representing a net withdrawal and is contractionary
Demand side fiscal policy
Policies used to increase or decrease the level of AD through changes in gov spending, taxation and the budget balance
Deficit financing
Deliberately running a budget deficit and then borrowing to finance the deficit. Purposefully setting public sector spending at a higher level than revenues for a period of time. The aim is to achieve full employment and to stabilise the economic cycle, without creating excessive inflationary pressures.
Keynesian views which influence the use of fiscal policy (demand-side)
Left alone, an unregulated market economy results in unnecessarily low economic growth, high unemployment and volatile business cycles.
A lack of AD caused by a tendency for private sector to save too much and invest too little can mean the economy settles into an under-full employment equilibrium from cyclical unemployment.
Can inject demand and spending power to eliminate deficient aggregate demand and achieve full employment. The gov can then use fiscal policy to fine-tune the level of AD while avoiding an unacceptable rate of inflation.
Expansionary and contractionary fiscal policy
To eliminate cyclical unemployment, the gov increases the budget deficit by raising gov spending or cutting taxes which shifts AD right. However the extent to which this reflates real output or creates excess demand and demand pull inflation depends on how close the economy was to normal capacity. The closer to capacity the greater the inflationary effect of expansionary fiscal policy. The opposite is true for contractionary (shifts left).
Supply side fiscal policy
Income tax cuts increase aggregate supply via their effects on economic incentives. Aims to increase the economy’s ability to produce goods and services by creating incentives to work, save, invest and be entrepreneurial. Interventionist supply side fiscal policies like financing of retraining schemes for unemployed workers are also designed to improve supply side performance.
Supply Side Policies
Gov policies which aim to make markets more competitive and efficient, increase production potential, and shift LRAS curve to the right. Aim to improve economic performance as a whole.
Government taxation on economic activity
Taxes and subsidies can also be used to alter the relative prices of goods and services in order to change consumption patterns and promote investment by firms in new capital goods.
Types of public expenditure
Investment into capital projects or infrastructure, such as new NHS hospitals, and expenditure to meet annual costs from such projects, such as paying NHS salaries. Transfers: redistribution of income and spending power from taxpayers to recipients of state benefits and pensions. Third type is payments on debt interest
The ‘triple lock’ for pensions
Guarantees that the state pension rises with whatever is this highest out of the wage increases, inflation, or 2.5%
Three main categories of tax
Taxes on income- personal income, corporate tax, NIC
spending or expenditure- indirect taxes like VAT or excise duties
Capital or wealth- council tax, inheritance tax,
Direct and Indirect tax
Direct is a tax that cannot be shifted to other people and are levied on income and wealth. Indirect can be shifted e.g. raising price of a good being sold to a taxpayer. Indirect taxes are levied on spending
Progressive taxation
When the proportion of income paid in tax rises as income increases. Progressive tax combined with transfers to lower-income groups reduces the spending power of the rich, while increasing that of the poor
Regressive taxation
The low paid lose a greater proportion of their incomes in tax than rich people. VAT is regressive as the tax amount is the same for everyone regardless of their incomes. Regressive taxes are usually used to disincentivise de-merit goods such as alcohol or tobacco
Proportional taxation
When the proportion of income paid in tax stays the same as income increases, which would generally reduce tax revenue significantly. Described as a flat rate such as 10% on all incomes
The principles of taxation
A criteria for judging whether a tax is good or not.
Economy: tax should be cheap to collect in relation to the revenue it yields.
Convenience and certainty: tax should be convenient to pay and taxpayers should be reasonably sure of the amount they have to pay.
Equity: tax systems should be fair, based on a taxpayers ability to pay
Efficiency: tax to achieve desired objectives with little unintended consequences
Flexibility: tax must be easy to change to meet new circumstances
Merits of income tax
For most wage and salary earners, income tax is cheap to collect, convenient and certain for the taxpayer, and if progressive is equitable in a sense that it reflects the tax payers ability to pay. In addition the basic tax threshold is set relatively high. Nevertheless, for some in society, income tax has been relatively easy to avoid and evade. People can evade by being paid strictly in cash and those very rich can avoid tax legally. Highly progressive income tax can also disincentivise hard work, and entrepreneurship
Merits of spending Tax
They can be used to encourage people to switch their spending away from demerit goods and towards merit goods. Some economists believe this is a disadvantage as gov exercise paternalism- that they claim to know better than consumers what is good for them. VAT by contrast in a neutral tax. Can also influence the distribution of income by imposing zero tax on basic necessities and high taxes on luxuries. Indirect taxes become less effective if more and more goods are taxed so it is a less useful tool for influencing consumer spending. These can also be evaded, people may say they will not include VAT if you pay in cash
Merit of taxes on capital and wealth
Some can be avoided or evaded, but with others it is less easy to do so. Wealth in the form of cash can be ‘money laundered’ when given from one person to another but wealth in the form of property is less easily hidden. If the taxman were given authority they could find out info about property values but the UK gov have not updated property values. The last time houses were valued for council tax was in 199.
Supply side view on taxation
Income tax rates and benefit rates should both be reduced. They believe that tax and benefit cuts would alter the work/leisure choice in favour of supplying labour, for the benefit claimants who lack the skills necessary for high-paid jobs. To make everyone better off it is necessary to increase the gap between the amount people earn when they work and what they receive when they are out of work. Increased inequality is needed to create incentives to facilitate economic growth which will be long term benefits. Through the ‘trickle down effect’ the poor end up better
National debt
The stock of all past government borrowing which has not been paid back. Operating in a budget deficit means that the government is borrowing and therefore adds to this debt. Conversely a surplus can allow the government to slightly reduce some of the national debt
Automatic stabilisers
Fiscal policy instruments, like progressive taxes, that automatically stimulate AD in an economic downswing and depress AD in an upswing, ‘smoothing’ the economic cycle. For example, a collapse of confidence or export orders causes AD to fall, national income falls, unemployment rises and demand-led public spending on unemployment pay rises, if income tax is progressive gov revenues fall faster than national income, increased public spending and decreased tax revenue injects demand back into the economy, stabilising AD.
Costs of budget deficit
To finance a budget deficit, the gov often need to borrow money through the issue of bonds or other debt instruments. When the gov competes with private borrowers for funds in the financial markets, it can lead to higher interest rates. These can lead to reduced private sector investment and borrowing. This is ‘crowding out’, increased gov borrowing reduces availability of funds for private sector investment which can offset impact of deficit. A growing deficit may lead to expectations of higher tax causing people to cut spending and save more in anticipation which reduces AD
Incidence of taxes
Who ultimately bears the economic burden of a tax. For example, if a business is taxed, it may pass on some of the tax burden to consumers through higher prices
Pros of budgets deficit
Direct increase in gov spending which is a determinant of AD and contributes to a rise in AD. A deficit may also be due to a reduction in either direct or indirect taxes which raises household disposable incomes and in theory higher AD. As gov spending rises it can raise income for individuals and businesses causing higher consumption and investment causing a multiplier effect and boosting AD.
Pros and Cons of budget surplus
Budget surpluses may reduce inflationary pressures by taking demand out of the economy and enable national debt to fall.
Persistent surpluses may induce harmful deflation caused by excessive depression of AD, can also mean taxes are higher than necessary, reducing potential growth by damaging the supply-side performance of the economy.
Significance of the size of national debt
Large national debt is a burden to future generations of taxpayers, paying interest on the debt. However borrowing can be reproductive and not be a burden, for example the gov borrowing to finance infrastructure projects and the resulting liability is matched by a wealth-producing asset like the motorway. This contributes to future national output. But long term borrowing for current spending like wars or teacher salaries will not reap future benefits and can be bad.
Supply side improvements
Reforms undertaken by the private sector to increase productivity so as to reduce costs and to become more efficient and competitive. Often without prompting of the government.
Free market and interventionist supply side policies
Interventionist- such as regional policy, competition policy, generally increases the role of the state and limits the role of the market. The main ones accepted by free marketists are gov provision of external economies that benefit firms such as education and training and investment in infrastructure like high speed trains.
Pro free market- cut gov involvement, includes tax cuts to create incentives to work, save, invest, cuts in welfare benefits to reduce unemployment incentive, privatisation and deregulation. With supply side it is believed that by creating incentives for businesses and workers, potential output will increase and rate of economic growth improve. Successful policies will reduce unemployment and inflation long term, but increases in labour productivity are key.
The Laffer Curve
It is believed they high rates of income tax and the overall tax burden creates disincentives which reduces governments total tax revenue as taxation increases past an optimal point. This creates the Laffer curve from 0-100% taxation and represents a negative x^2 graph with the turning point being at 50% tax
Supply side policies in reducing natural rate of unemployment
Suppose the government cuts employers’ national insurance contributions, employment costs fall and it becomes more attractive for firms to employ labour. As a result the AD for labour shifts rightward, likewise if income tax is cut, this will increase workers disposable incomes and thus incentive to work, shifting AS for labour right wards as well. Both these changes increase the economics natural level of employment.
Monetary policy with supply side policy
Monetary policies should be supportive of supply side policies, monetary should make sure there is just enough demand to absorb the extra output produced by the economy and to maintain the general public’s confidence. The success of the monetary policy depends on the fiscal policy
Supply side policies with the rate of inflation
By reducing businesses costs of production and by reducing monopoly profits through making markets more price competitive, supply side policies reduce cost push inflationary pressures. By enabling productive capacity to grow in line with AD, successful policies also help reduce demand-pull inflation
Supply side policies with balance of payments
By creating high efficient firms, it is likely to improve the country’s quality competitiveness which raises the quality of goods to consumers, increased price and quality competitiveness give the country a competitive edge, both in domestic and overseas markets. Overseas residents buy more of the country’s goods (exports) and the domestic customers switch to high quality domestic goods to imports fall which improved the country’s balance of trade
Examples of industrial supply side policies
Privatisation- change of ownership from gov to private sector
Deregulation- removal of previously imposed regulations
Subsidising spending on research and development- cut in corporation tax to increase business profits, providing firms with greater financial resources to boost investment and raise spending on R&D.
Examples of labour market supply side policies
Lower income tax- tax can be reduced to create labour market incentives
Reduce welfare benefits- lower levels create incentive to choose low-paid employment over benefits
Improving training of labour- improve MRPL and ability to work higher paying jobs
Flexible pensions- arrange private pensions to reduce burden on tax payers and allow transfer of private pensions across employers when changing jobs
Examples of financial/capital market supply side policies
Deregulating financial markets- creates greater competition among banks and financial institutions, increases supply of funds and reduces cost of borrowing for UK firms.
Encouraging saving- give individual share holders first preference in the market for shares issued during privatisation, create special tax privileges for saving
Promoting entrepreneurship- company taxation has been reduced and markers have been deregulated to encourage risk taking
Crowding out
A process where an increase in government spending leads to a fall in private sector spending with little or no increase in AD. This occurs as a result of the increase in interest rates associated with the growth of the public sector
