Fiscal Poverty

Question 1

Key features of Fiscal Policy

Answer 1

1. Fiscal policy involves govt spending and taxation. It can be used to influence the economy as a whole or individual firms and ppl.
2. Fiscal policy can be used to stimulate AD:
   a) Reflationary fiscal poverty involves boosting AD by increasing govt spending or lowering taxes. It’s likely to involve a govt having a budget deficit.
   b) deflationary fiscal policy involves reducing AD by reducing govt spending or increasing taxes. Likely to involve the govt getting a budget surplus.
3. Reflationary fiscal policy likely ot be used during a recession when there’s a negative output gap. It’ll increase economic growth and reduce unemployment, but it’ll also increase inflation and worsen the current account of the balance of payments because as incomes increase, more is spent on imports.
4. Deflationary fiscal policy likely to be used during a boom when there’s a positive output gap. It’ll reduce economic growth and increase unemployment, but also reduce price levels and improve the current account of the balance of payments because if incomes fall, less is spent on imports.
5. A government’s fiscal stance or budget position descibes whether their policy is reflationary, deflationary, or neither. If a govt has a neutral fiscal stance then govt spending and taxation has no net effect on AD.
6. There are two important features of fiscal policy that you need to be aware of:
   - Automatic stabilisers - some of a govt fiscal policy may automatically react to changes in the economic cycle. During a recession, govt spending will increase because the govt will pay out more benefits, e.g. JSA. The govt will also receive less tax revenue, e.g. due to unemployment. These automatic stabilisers reduce the problems a recession causes, but at the expense of creating a budget deficit. During a boom, the automatic stabilisers create a budget surplus as tax revenue increases and govt spending on benefits falls.
   - Discretionary policy - this is where govts deliberately change their level of spending and tax. At any given point a govt might choose to spend on improving the country’s infrastructure or services, and increase taxes to pay for it. On other occasions the govt might take action because of the economic situation, e.g. during a recession the govt might spend more and cut taxes to stimulate AD.

Question 2

Cyclical and Structural Budget Positions are Different

Answer 2

1. A structural budget position is a government’s long-term fiscal stance. This means their budget position over a whole period of the economic cycle, including booms and/or recessions.
2. A cyclical budget position is a government’s fiscal stance in the short term. This is affected by where the economy is in the economic cycle - automatic stabilisers are likely to create a surplus during a boom and a deficit during a recession.
3. A budget deficit caused by an expansionary cyclical budget position is known as a cyclical budget deficit. This will be balanced out by a budget surplus during boom times (when cyclical budget position is contractionary).
4. A budget deficit caused by an expansionary structural budget position will add to national debt. This = structural budget deficit.

Question 3

There are Different Types of Tax System

Answer 3

1. Taxes should be cheap to collect, easy to pay and hard to avoid, and they shouldn’t create any undesirable disincentives, e.g. discouraging ppl from working or from saving.
2. On top of this, govts may want taxes to achieve horizontal and vertical equity.
   - Horizontal equity = ppl who have similar incomes an ability to pay taxes should pay the same amount of tax.
   - Vertical equity = ppl who have higher incomes and greater ability to pay taxes should pay more than those on lower incomes with less ability to pay taxes.
3. Govts mat also want taxes that promote quality in an economy. This might involve using taxes to reduce differences in ppl’s disposable income, or to raise revenue to pay for benefits and the state provision of services.
4. Govt’s raise tax revenue through direct taxation. They also use different tax systems to achieve different economic objectives - the ones you need to know are progressive taxation, regressive taxation and proportional taxation.
5. Progressive taxation = individual’s taxes rise as their income rises, and they’re used to redistribute income and reduce poverty. A government can use the tax revenue from those high incomes and redistribute it to those on low incomes in the form of benefits or state-provided merit goods - increasing equality. Progressive taxation follows the ‘ability to pay’ principle. (achieves vertical equity)
6. Regressive taxation is where an individual’s taxes fall as their income rises, and they’re used by govts to encourage supply-side growth. By reducing the taxes of the rich the govt hope that the economy will benefit from the trickle-down effect. A regressive tax system gives ppl more of an incentive to work harder and earn more income, but it may increase inequality.

• Supply-side economists argue that increasing direct taxes => disincentives to work and will reduce a govt’s tax revenue. This is shown in the Laffer curve.
• The Laffer curve shows that as taxes increase, eventually this will => a decline in tax revenue because ppl will have less incentive to work.

7. Proportional taxation (a ‘flat tax’) is where everyone pays the same proportion regardless of their income level. This tax can achieve a horizontal equity, but setting a fair tax rate to apply to all members of society is difficult. E.g. a 25% tax on income might be too high for those on lower incomes to afford, and it might not raise enough revenue from those on higher incomes for the govt to be able to pay for all its public goods and services it provides.
   - Supporters of flat tax argue that it can simplfy the tax system, reduce the incentive to evade and avoid paying taxes, and increase the incentive to earn more.
   - However, flat rate tax systems may bring in less tax overall than variable rate tax systems.
   - Flat rate tax systems also don’t have vertical equity, but they can be made more progressive by having a tax free allowance.

Question 4

The UK government uses Various Different Taxes

Answer 4

1. In the UK there’s a sales tax on most products, known as VAT. VAT = a proportional tax - its a fixed percentage regardless of the selling price of a product. However, it can also be seen as a regressive tax. This is because the percentage of total income that the rich spend is less than that of the poor, so that means the percentage of total income that the rich spend on VAT will be less than it is for the poor.
2. A more progressive system of VAT might be to tax luxury goods at a higher rate.
3. Its argued that the UK has a progressive tax income system. There’s tax-free allowance and then individuals on low-to-middle income have extra income over the allowance taxed at 20%. Those on very high income are taxed at 40% on their extra income over a certain threshold, and those on a very high income are taxed at 45% on their income over a further threshold.
4. But it’s also argued that the UK tax system is regressive because if you consider direct and indirect taxes together, the lowest earners in the UK economy have to pay a higher proportion of their income as tax than the highest earners do.

Question 5

The size of government spending is affected by several things

Answer 5

1 The size + structure of a country’s popln will affect levels of govt spending. E.g. a country with a large popln may require greater levels of govt spending than a country with a small popln, and a country with an ageing popln will have greater demand for state-funded health care.
2 Government policies on inequality, poverty and the redistribution of income will alter the amount of govt spending - this might vary from govt to govt depending on their political views. E.g. a govt that wants to redistribute income may spend more on benefits.
3. The fiscal policies governments use to tackle certain problems in a country will also have an effect. During a recession a govt may increase public spending to encourage growth and reduce unemployment, but if these policies => a large national debt then the govt may introduce ‘austerity measures’ and severely reduce their spending.

Question 6

Large Budget Deficits can cause Big Problems

Answer 6

1. A budget deficit must be paid for by public sector borrowing, so that govt can spend more money than it recieves in revenue.
2. In the UK, the govt can borrow the money it needs from UK banks, which will create deposits that the govt can spend. It also can borrow money from the private sector by selling Treasury Bills, which the govt will pay off over a period of time, or it can borrow money from foreign financial markets.
3. This kind of borrowing is fine in the short run, especially if the borrowed money is used to stimulate demand in a country. But there will be problems if there’s excessive borrowing:
   - Excessive borrowing could => demand-pull inflation partly due to the fact that govt borrowing increases the
   money supply, so there’s more money in the economy than can be matched by output.
   - As borrowing may => inflation, it can also => rise in interest rates to curb that inflation. Higher interest rates will discourage investment by firms and make a country’s currency rise in value, meaning that its exports are less price competitive.
4. Continued govt borrowing will increase a country’s national debt. A large and long-term national debt can cause several problems too:
   - If a country’s debt becomes very large then it may cause firms and foreign countries to stop lending money to that country’s govt. This will constrain the country’s ability to grow in the future.
   - Future taxpayers will be left with large interest payments on debt to pay off. Debt repayments have an opportunity cost as future govts may have to cut spending to pay off a debt, which may harm economic growth.
   - A large national debt suggests that there’s been excessive borrowing, which => inflation and interest rates to rise. It also suggests that public sector spending is v large, which may ‘crowd out’ private sector spending. Although, if govt spending boosts the economy there may be a ‘crowding in’ instead - firms will invest more if the economy is growing quickly.
   - A country with a large debt is less attractive to foreign direct investment (FDI) as foreign countries willl be uncertain how the debtor nation’s economy will do in the future and whether it will be a good bet for investment.
5. Methods to correct a budget deficit will depend on what kind of budget deficit it is.
   - A cyclical budget deficit is caused by recessions and comes about due to a govt’s automatic stabilisers. This kind of deficit will be corrected when the economy recovers again - the deficit will be replaced by a surplus.
   - However, a structural budget deficit, caused by excessive borrowing, is much harder to solve. To cure this problem, govt’s will have to raise taxes and reduce public spending so that they can pay off their debt. However, these actions could harm economic growth and cause other problems.

Question 7

Budget Surpluses are Not Ideal either

Answer 7

1. A budget surplus is generally more desirable than a budget deficit - however, its not always a good thing either.
2. A budget surplus might suggest that taxes are too high or that govts aren’t spending enough on the economy. Both of these things could harm or constrain economic growth.
3. Lowering taxes or increasing govt spending would correct a budget surplus.

Question 8

Governments follow Fiscal rules to Avoid Overspending

Answer 8

1. The UK government first brought in fiscal rules in 1997. One of these was the golden rule - over the economic cycle the government can borrow to invest in things like infrastructure (which should generate future growth), but cannot borrow to fund current expenditure (e.g. wages).
2. Following fiscal rules like these should help to prevent a government from continuously borrowing and overspending to promote growth, which increases national debt and inflation. It’ll also help governments to achieve economic stability as they’ll avoid uncertainty and fluctuating inflation.
3. Fiscal rules can also influence the behaviour of businesses and consumers, by increasing consumer confidence in future economic stability. E.g. consumers may be more willing to spend and firms may increase investment if they’re confident in the country’s economic stability.
4. However, this will only work if there is a belief that governments will keep to the rules they’ve set.
5. In 2010 the UK government created the Office for Budget Responsibility (OBR) - an independent body that:
   - Publishes reports analysing UK public spending, taxation, and government predictions of future spending.
   - Assesses the performance of the govt against the fiscal targets it’s set itself.
   - Uses long-term projections to analyse how sustainable govt spending and revenue is.
6. By doing this, the OBR helps the govt to keep its fiscal policy under control.

Question 9

Governments use fiscal policy to Tackle Poverty

Answer 9

• Fiscal policy can be used to reduce poverty in a country. Three key ways a govt can do this is through benefits, provision of certain goods and services, and progressive taxation.
• Govt spending on benefits, e.g. JSA, pensions and disability benefits, is a way of helping those who are unemployed or unable to work, and reducing absolute poverty.
• A govt can also spend its tax revenue to provide goods and services, such as free health care or education, to enable those who are suffering from poverty to have access to these things.
• Furthermore, by providing some goods and services to poorer members of society, a govt will be investing in the improvement of its country’s human capital - i.e. this spending may make labour much more productive.
• Progressive taxation may reduce relative poverty by narrowing the gaps between people’s disposable income, and the revenue raised can pay for benefits and the state provision of goods and services. On top of this, governments could provide tax cuts and discounts for the poor.
• Finally, if fiscal policy creates growth, then this may reduce both relative and absolute poverty. Greater economic growth will mean more jobs, higher incomes and a better standard of living.