Lec 8 - Fiscal Policy (continued)

Question 1

Government budget definition

Answer 1

An annual statement of projected outlays and receipts during the next year together with the laws and regulations that support those outlays and revenues.

Question 2

Fiscal policy definition

Answer 2

the use of the government’s budget to achieve macroeconomic objectives, such as full employment, sustained economic growth and price level stability.

Question 3

Outcomes of government budget

Answer 3

If receipts exceed outlays, the government has a budget surplus.
If outlays exceed receipts, the government has a budget deficit.
If receipts equal outlays, the government has a balanced budget.

Question 4

Types of government receipts

What are the main five?

Answer 4

Taxes on income and wealth
Taxes on business
Taxes on expenditure
National Insurance contributions
Other receipts and royalties

Question 5

Types of government outlays

What are the main three types?

Answer 5

Debt interest
Transfer payments
Expenditure on goods and services

Question 6

Government debt definition

Answer 6

The total amount borrowed by the government.
The sum of past deficits minus the sum of past surpluses plus payments to buy assets minus receipts from the sale of assets.

Question 7

Fiscal stimulus effect on recessionary gap

what effect does an increase in govt expenditure have on aggregate expenditure?

Answer 7

An increase in government expenditure or a tax cut increases aggregate expenditure (curve shifts outward).

The multiplier process increases aggregate demand (curve shifts outward again).

Question 8

Supply side effects of fiscal policy - labour market

Answer 8

Potential GDP depends on the full-employment quantity of labour, which in turn is influenced by taxes.

The income tax decreases the supply of labour because it decreases the after-tax wage rate.
The before-tax wage rate rises, the after-tax wage rate falls and employment decreases.

The gap is the tax wedge.

Question 9

Supply side effects of fiscal policy - Taxes on expenditure and the tax wedge

Answer 9

Taxes on consumption expenditure add to the tax wedge.
The reason is that a tax on consumption raises the prices paid for consumption goods and services: it is equivalent to a cut in the real wage rate.

Question 10

Supply side effects of fiscal policy - Tax on capital income

Answer 10

A tax decreases the supply of loanable funds.
The interest rate rises, but the after-tax interest rate falls.
Investment and saving decrease.

Question 11

Supply side effects of fiscal policy - Tax cut

Answer 11

Taxes drive a wedge between the cost of labour and the take-home pay and between the cost of borrowing and the return on lending.

Taxes decrease employment, saving and investment and decrease real GDP and its growth rate.

A tax cut decreases these negative effects and increases real GDP and its growth rate.

The supply-side effects of a tax cut probably dominate the demand-side effects and make the multiplier larger than the government expenditure multiplier.

Question 12

The Laffer Curve definition & purpose

Answer 12

The relationship between the tax rate and the amount of tax revenue collected is called the Laffer curve.

Purpose of Laffer curve is to show what the optimal tax rate is for maximising tax revenue.

Question 13

Generational accounting definition

Answer 13

An accounting system that measures the lifetime tax burden and benefits of each generation.

Question 14

Generation accounting - present value

Answer 14

Taxes are paid by people with jobs.
State pensions are paid to people after they retire.
Healthcare benefits are also provided on a larger scale to older people.

The concept of present value is used to compare the value of an amount of money at one date (working years) with that at a later date (retirement/older years).

Question 15

Fiscal imbalance definition & purpose

Answer 15

The present value of the government’s commitments to pay benefits minus the present value of its tax revenues.

Purpose of fiscal imbalance is to assess the government’s obligations.

Question 16

Methods of coping with fiscal imbalances

Answer 16

1 Raise income taxes
2 Raise National Insurance contributions
3 Cut government discretionary spending
4 Cut unemployment and other welfare state benefits
5 Raise the state pension age

None of these measures is painless or free from political controversy.
By combining the five measures, the pain from each could be lessened, but it would still be severe.

Question 17

Generational imbalance definition

Answer 17

The division of the fiscal imbalance between the current and future generations, assuming that the current generation will enjoy the existing levels of taxes and benefits.

Question 18

Economic old age dependency ratio

Answer 18

Economic old age dependency ratio: the number of inactive population aged 65+ divided by the number of employed persons aged 20-64.

Question 19

Fiscal stimulus definition

Answer 19

The use of fiscal policy to increase production and employment.

Question 20

Types of fiscal stimulus

Answer 20

Automatic

Discretionary

Question 21

Automatic fiscal stimulus definition

Answer 21

A fiscal policy action triggered by the state of the economy with no government action.

Question 22

Discretionary fiscal stimulus definition

Answer 22

A policy action that is initiated by the government.

Question 23

Automatic fiscal stimulus in practice - tax revenues

Answer 23

Tax revenues change automatically with the state of the economy.

Parliament sets the tax rates, but the tax revenue collected depends on tax rates and people’s incomes:
when the real GDP increases in an expansion, incomes increase and tax revenues increase;
when real GDP decreases in a recession, incomes decrease and tax revenues decrease.

Question 24

Automatic fiscal policy - means-tested spending

Answer 24

The government creates programmes that pay benefits to qualified people and businesses which depend on the economic state of the economy: when the economy is in an expansion, unemployment falls, so needs-tested spending decreases; when the economy is in a recession, unemployment rises, so needs-tested spending increases.

Question 25

Automatic fiscal stimulus - recessionary gap & inflationary gap

Answer 25

In a recession, receipts decrease and outlays increase.
So the budget provides an automatic stimulus that helps shrink the recessionary gap.

In a boom, receipts increase and outlays decrease.
So the budget provides automatic restraint that helps shrink the inflationary gap.