LS17 + LS19 + LS21 - Taxation, Public Sector Finances, Macro Policies In A Global Context

Question 1

Types of taxation

Answer 1

Progressive taxation - as income rises, larger % of income is paid in tax- income tax
Proportional taxation - % of income paid as tax is constant so matter level of income
Regressive taxation - as income rises, smaller % of income is paid in tax -VAT

Question 2

Laffer curve

Answer 2

Relationship between tax rate and tax revenue - tax revenue is not maximised at 100% as workers are disincentivsed to work, so less tax revenue

It shows that if you raise taxes on the rich to the point where total revenue decreases as tax rate increases.

higher income tax = disincentive for workers to work for higher incomes as heavily taxed. The income effect becomes negative whereby workers work -earn less to reach satisfactory income = reducing income tax revenue. Higher taxes promotes tax evasion/ avoidance and incentivising the highly skilled workers/entrepreneurs to emigrate to countries where tax rates are lower. Not only will this reduce expected tax revenue for gov to use in redistributing income - dampen productive potential as innovation/ entrepreneurial spirit decreases. Free market

Example – France raised income tax around 2015- Brain drain

Lower tax rates – substitution effect > income effect- substitute leisure for more work- hence tax rev increases

DIAGRAM: Tax rate increases up to point A, will result in an increase of tax revenue. Further tax rate increases from A to B result in a loss of tax revenue from C to D

Question 3

Economic effects of changes in tax (incentives to work)

Answer 3

High marginal rates of tax = discourage individuals from working. free market economists argue - the supply of labour is relatively elastic and a reduction in marginal taxes on income will lead to a significant increase in work as individuals work longer hours, accept promotions and more people join the workforce.

§ High taxes on high income earners could encourage them to move abroad and taxes on the poor may lead to a poverty trap.

§ high income tax reduces incentives more than high vat. thus, a switch from direct to indirect taxes may increase incentives.

§ However-no hard evidence for the link between income tax and incentives. Nordic countries have high taxes and welfare benefits but have similar rates of growth compared to lower tax and gov spending countries like US and UK.

§ It can be argued that higher taxes mean people have to work longer hours in order to maintain their income and so even increases the incentive work

In 2022, the Adam Smith Institute calculated that average earners in the UK work from the 1st January to the 8th June (Freedom Day) to pay their taxes - all income after that point belongs to them

Question 4

Economic effects of changes in tax (real output and employment)

Answer 4

Some taxes affect AD whilst others affect AS. A rise in direct taxes will reduce the level of disposable income =fall in their spending = fall in AD. It could also cause a fall in leftover profits for businesses and therefore a fall in investment. The effect this has on output will depend on where the economy is: whether it is at full employment or not.

Higher indirect taxes and NICs increase costs for firms = decrease SRAS. Depend on where the economy is producing.

Income taxes cause a disincentive to work and therefore reduce LRAS as the most skilled workers go overseas and more people become inactive.

Question 5

Economic effects of changes in tax (price level, FDI flows, trade balance)

Answer 5

PRICE LEVEL- An increase in indirect taxes reduces disposable income & so workers may petition their employer for a salary increase
If they receive the increase the economy may face a wage-price spiral
Indirect taxes also increase costs of production for firms possibly leading to cost-push inflation

FDI FLOWS- If the rate of corporation tax increases relative to other countries, it may result in less inward foreign direct investment

TRADE BALANCE- An increase in taxes can reduce disposable income which is likely to reduce the level of imports
This may improve the trade balance (exports - imports)

Question 6

Automatic stabilisers

Answer 6

Feature of tax and transfer system that reduces economic activity during booms and stimulates activity during slumps, WITHOUT govt intervention
Recession - unemployment benefits; amount taxed falls –> leads to higher disposable income, more consumption to boost AD and recover economy; EV: depends on level of unemployment benefits, and taxes
Boom - people pay more in tax, unemployment benefits fall so income decreases, reduces rises in AD to prevent overheating

Question 7

Discretionary fiscal policy

Answer 7

Fiscal policy implemented at the discretion of policy makers

Question 8

Fiscal deficit

Answer 8

When govt spending is higher than govt revenue in a certain time period

Question 9

Debt

Answer 9

Fiscal/Budget Deficit - when govt spending is higher than govt revenue
National Debt - govt total outstanding debt - what gov towes from budget deficits over time
Debt to GDP ratio - total govt debt as a ratio of GDP - the higher the ratio, the less likely the repayment is

Question 10

Cyclical budget deficit

Answer 10

When budget deficit occurs due to automatic stabilisers
* recovery/boom - budget deficit falls as tax rev rises, transfer payments decrease
* downturn/recession - budget deficit rises as transfer payments increase and tax revenue falls

Question 11

Structural budget deficit

Answer 11

Part of budget deficit that occurs due to discretionary fiscal policy rather than automatic stabilisers

Question 12

Factors influencing deficit

Answer 12

State of the economy - if economy in boom, higher incomes/profit, higher spending so govt is earning more tax revenue and paying out less unemployment benefits - reduce budget deficit

Age distribution - more ageing population, so higher dependency ratio –> higher pension/healthcare payments and lower tax revenue, so budget deficit rises

Discretionary Fiscal Policy - used to recover out of recession, or appease political supporters - increases budget deficit

Question 13

Impact of budget deficits and national debt

Answer 13

Interest Rates - if government services deficit through borrowing money, interest rates rise, increasing cost of borrowing for all agents

Debt Servicing - greater national debt leads to larger dept repayments, so debt servcing becomes harder, especially if interest rates are high, worsening the budget deficit and national debt

Intergenerational Equity - increasing debt through budget deficits can be seen unfair to future generations as they pay for it through higher taxes and lower government spending. But if long term this causes GDP growth, increasing govt revenue and improving ability to service its debt

Rate of inflation - if govt services debt through issuing bonds (borrowing), then the G of AD rises, with private sector components fall by an equal amount, so AD doesnt rise. If govt prints money instead, then AD rises, plus more money chasing same goods leads to demand pull inflation

Credit Ratings - credit rating is likely to fall if debt to GDP ratio rises as creditworthiness falls

FDI - high debt to GDP ratio reduces investor confidence as it is deemed a credit risk with low return on their investment, so inward FDI falls

Question 14

Factors influencing national debts

Answer 14

Size of fiscal deficits- As national debt is the accumulation of annual fiscal deficits, the size of the fiscal deficit each year will grow by the size of the deficit
If the UK were to run a budget surplus in any year, this additional revenue could be used to pay back some of the debt - or it may be used to fund government spending or investment in the following year

Government polices- These directly impact tax revenue & government spending which can change the level of the fiscal deficit leading to a change in the national debt level
E.g. Reducing corporation tax during a boom in the economy will reduce government revenue & possibly increase the deficit & national debt at a time when the deficit would naturally be decreasing due to the automatic stabilisers

Question 15

Significance of the size of deficits and national debts

Answer 15

High levels of borrowing may raise interest rates in economy since an inc in demand for money will increase the price of money, i.e. interest rates= crowding out of the economy. However, this may not always be the case as the government may borrow from overseas and during a recession, private sector investment falls which means interest rates may remain unchanged.

Countries have to spend a large amount of money on servicing their national debt through interest repayments, which has a high oppourntiy cost. impact will depend on the level of interest rates and the size of the primary deficit compared to interest repayments. In a liquidity trap ( when interest rates are extremely low), the government can often borrow at very low rates for a long time.

Some economists argue- high fiscal deficits nd national debts benefit citizens today at the expense of future generations- can cause intergenerational inequality. . Concerns over a deficit depend on whether the deficit is caused by current expenditure alone or whether it is just caused by capital expenditure. A current budget deficit is one where government revenues are less than current expenditure; the GOV has to borrow money simply to finance day to day spending. It is argued that the government should run a current budget surplus to enable it to invest for the future, except in recessions when they can run a deficit to increase AD. A current budget deficit is problematic as it means that future generations are forced to pay the bill for today’s expenditure

HOWEVER-

However, if the deficit is due to capital expenditure, the future generations benefit from increased spending and so their extra tax bill to pay for today’s borrowing can be justified. The value of debt tends to fall overtime because inflation erodes its value and because a country’s GDP grows meaning the debt is easier to pay off, so this limits the impact on future generations.

Monetarists argue that more money chasing same amount of goods= price increases. High deficits can cause inflation. Gov inc spending – AD will rise. if a government is unable to borrow money, they will print more money and this can cause hyperinflation. Printing money will not necessarily cause hyperinflation, it depends on how much is printed and where the economy is producing on the LRAS

High levels of debt tend to result in reduced credit rating for GOV. Private sector companies estimate likelihood that gov will default on its debt and give it a rating from AAA to D. Lower credit ratings mean that lending to the government is riskier and so higher interest rates are demanded from lenders. E.G. Greece.

However, in reality, not the size of the debt that influences the level of risk involved with the lending the money, it is whether that country has ever defaulted on their loans before and their current economic/political climate.

EV; government borrowing can benefit growth if it used for capital spending since this will improve the supply side of the economy = reduce the deficit in l/t. On top of this, the budget deficit can be used as a tool for short term demand management: Keynesians argue a deficit is acceptable to use as a stimulus in demand during recessions.

Question 16

How can policies be used to reduce fiscal deficits and national debts

Answer 16

To decrease the national debt= UK- policy of austerity since 2010, where they attempt to decrease spending. It would also be possible to increase taxes. Both of these are unpopular, could limit growth, and reduce living standards and income equality. Free market economists say that spending can be reduced by cutting out waste, but it is highly unlikely that these efficiency savings will make a significant difference. Sweden used spending cuts and tax increases to balance their budget in the 1990

Demand stimulus = high spending = economic growth = higher tax revenues= budget surpluses and eventually a reduction of national debt.

§ Rely on automatic stabilisers to allow the economy to grow so national debt/fiscal deficit will reduce as a percentage of GDP= mainly the approach that the US took after the GFC and economy recovered fairly quickly.

§ One way to reduce national debt would be for government to default on their loans but the economic cost of this is so large that governments only default if it is the only option

Question 17

Polices to reduce poverty and inequality

Answer 17

Free market forces = unlikely to create an equal society, leading to absolute or relative poverty and inequality. Some redistribution from rich to poor is necessary

Gov can use a progressive tax system - produce a more equal distribution of income after tax. Inheritance taxes – wealth inequality will be reduced. EV- unintended consequences of raising tax, for example a reduction in incentives and the impact of the Laffer Curve.

GOV EXPENDITURE IN FORM OF BENEFITS AND TRANSFER PAYMENTS:

Universal benefits are available to everyone who meet certain criteria, respective of personal income e.g. winter fuel allowance, child benefits.

§ Means tested benefits are only available to people who have sufficiently low incomes/ wealth- provide a safety net/minimum standard of living and are better at improving inequality since they directly affect the poor.

§ Government can provide goods and services - citizens equal opportunities and access to services they may not otherwise be able to afford, such as healthcare, education and housing- helps to ensure everyone is given an equal start in life

§ The problem with these is that they also benefit those on higher incomes and incur a high opportunity cost

Question 18

How do policy measures change interest rates and supply of money

Answer 18

The central bank has the ability to change interest rates and monetary supply= control inflation, or due to global issues such as a low exchange rate or a change in world commodity prices. A fall in the bank rate is likely to increase the supply of money because it will mean there is more demand for loans- inc demand for borrowed fund

There is no simple relationship between the supply of money and inflation and it can be argued that central banks don’t have complete control over the money supply because they cannot control the ability of the financial system to create credit. The globalisation of the financial market has also made it increasingly harder to control domestic money supply.

Different views exist on the role that an increase in the money supply plays in creating inflation
Milton Friedman (a Monetarist) held the view that “Inflation is always and everywhere a monetary phenomenon in the sense that it is and can be produced only by a more rapid increase in the quantity of money than in output”
This opposes the Keynesian view that inflation is the result of a change in output

The global money supply has increased enormously since 2010 as a result of quantitative easing e.g. between March 2020 & the end of 2021 the USA had increased the money supply by $6.3 trillion
In early 2022 inflation began to spike globally confirming the fears of many monetarists

Question 19

How do policy measures increase international competitiveness

Answer 19

These typically include protectionism, currency depreciation & the use of supply side policies

The effectiveness of these policies depends on the response of trading partners

Policies to improve international competitiveness can result in creating internal domestic conflicts which are difficult to resolve e.g. by protecting the steel manufacturing industry in the UK, the cost of steel as an input for broader industry increases

Employment gained in steel manufacturing is very likely surpassed by employment lost in steel related industries as a result of the increased costs of production.

Encourage competition, forcing firms to be efficient and thus competitive within the global market-place an emphasis on quality of products and use tax incentives to encourage incentives.

Education will improve the skills of the workforce and help improve flexibility. The UK government has established the ‘Red Tape Challenge’, which aims to simplify regulation for businesses.

Question 20

Polices used in response to external shock

Answer 20

Due to globalisation world’s economies = increasingly interdependent. Macroeconomic policies can be used to combat the effects of negative shocks to the economy.

One example could be a commodity price shock- oil prices greatly increase. Gov could use expansionary policy to reduce impact of a fall in GDP or deflationary policy to reduce the impact on inflation.

Another example may be a financial crisis, where government can use expansionary policy to increase AD. Following Brexit, I/R were lowered = improve confidence but then raised to deal with inflation caused by the falling value of the pound.

Changes in exchange rates can cause inflation within the country or could cause a fall in growth and a poor balance of payments, both of which the government can attempt to solve through various methods. Political instability in the UK or in other countries is likely to impact the economy, and will mean the government needs to take action

Question 21

Transfer pricing

Answer 21

Transfer pricing is one way for firms to engage in tax avoidance. This can occur if a firm produces a good in one country and then transfers it to another to make it into another good which it then sells.

If taxes are higher in the first country than the second country, they can set a low price on the product made in the first country. The overall aim is to increase their profit made in the low tax country and decrease it in the high tax country and so overall reduce their tax bill.

In the UK, companies which don’t allocate sufficient profits here are challenged by HMRC and this has led to billions of pounds earnt in taxes.

Transfer Pricing Guidelines were introduced by the OECD in 1995, providing guidelines on cross-border services, intangibles, cost contribution arrangements and advance pricing guidelines; these were modified in 2010. They aim for the price to be the same as if the two parties were independent of each other; the ‘arm’s length’ principle.

Question 22

What limits government in its ability to control global companies

Answer 22

It is difficult for individual governments to control TNCs . Small countries may earn less in revenue than a TNC earns in profits. Highly educated, successful executives are able to use a vast number of resources to find a solution which will benefit them

EU suffers from legal tax avoidance schemes, such as the ‘Dutch sandwich’ and the ‘double Irish’, where costs, revenues and profits are routed through Ireland, the Netherlands or Luxemburg and then sent to a tax haven like the Bahamas or the Cayman Islands.

Solutions to taxation are extremely difficult as they require worldwide agreement. However, any solution which would benefit a country like UK would lead to great losses for countries like the Bahamas, Ireland and Luxembourg

Also division within countries , for example in the USA between the Democrats and Republicans. This division allows TNCs are able to prevent any agreement they do not like through immense lobbying. Any solutions are also time consuming and costly

Question 23

Problems facing policymakers when applying policies

Answer 23

Inaccurate information:

Data often lags reality as underlying economic conditions can change quickly .S/T information, such as GDP figures- often inaccurate - mean gov is unable to see if there are problems within the economy. Trying to cut down on tax evasion and avoidance is difficult - gov doesn’t have the full picture on level of avoidance, who it is that is avoiding the tax and best way to reduce it. The BOE makes its decisions based on past data but it is possible trends in the economy may be changing so past data gives an inaccurate picture of where the economy is currently heading. With I/R so low for such a long period, past data is unlikely to give an accurate representation of the current economic climate which makes it difficult for the Bank to know which action to take. Full cost-benefit analyses can be time consuming and costly and it is impractical for the govt to gain every single bit of information they need.

Risks and uncertainties: GOV can’t accurately predict the future - difficult for them to know whether extra spending is necessary etc. Can’t know the full impact of their decisions as consumers often react unexpectedly and this could undermine gov policy. Managing risk = essential part of good decision making.

External shocks: Gov is unable to control and prepare for these external shocks; the best they can hope to do is lessen their impact. Since every situation is different, it may be difficult to know the best method to solve the problem. Policies employed by policy makers may not have their intended impacts and it may undermine current policies in place, for example Brexit has delayed government plans to balance the budget.

IN CONCLUSION:

Monetary policy- Effectiveness is limited due to external shocks due to globalised markets and how interdependent we are

Question 24

Austerity

Answer 24

Policy aimed to reduce a govt budget deficit through increases in govt revenues - tax rises, reducing govt spending

Question 25

Macro effects of austerity measures

Answer 25

Raising taxes -> lowered consumer spending -> lower investment -> so fall in AD and fall in econ growth
Also increases level of spare capacity

Question 26

Firms improving international competitiveness

Answer 26

Investing in new capital - raising productivity. Improve design and quality of their products through R&D to improve demand

Question 27

Govt improving international competitiveness

Answer 27

improving geographical mobility

macroeconomic stability - low and stable inflation, sound public finance, stable exc rate, econ growth

public sector reform to reduce red tape

privatisation

Improving infrastructure

Encourage immigration

Promote competition policy

Incentives for investment such as tax breaks if companies use profits for investment