Macro 15 - fiscal policy. Flashcards
define fiscal policy?
Use of taxes and government spending to change aggregate demand.
what can the government change in terms of taxation?
- How much to tax.
- Tax brackets.
- What to tax.
- Type of tax they want to impose.
What can the government
change about it’s spending?
- Amount to spend.
- What its spends on.
what is income tax?
tax on income.
- 12,500>, personal allowance.
what is VAT?
sales tax - sales of goods.
VAT in the UK is 20%.
Reduced rate is 5%.
What is excise duty?
Tax on harmful goods such as alcohol and tobacco.
What is capital gains tax?
Tax on the sales of assets.
what is corporation tax?
Tax on profits.
25% for all limited companies.
Lowest amongst the G7 countries.
What is inheritance tax?
Tax on inheritance - 40%.
what is tax evasion?
never paying tax - illegal.
what is tax avoidance?
finding loopholes to pay lowest amount possible legally.
What are the 4 types of spending?
Capital expenditure.
Current expenditure.
Transfer payments.
Debt interest payments.
what is capital expenditure?
Covering investment in assets. Spending on capital goods.
Expenditure to increase productive capacity
what is current expenditure?
Day-to-day operational expenses incurred by the government.
what are transfer payments?
Government payments to individuals through social programmes such as welfare and student grants. No goods are exchanged.
what are debt interest payments?
Interest payment paid by the government. Payments made to holders of government bonds.
Who verifies the governments budget?
The Office for Budget Responsibility (OBR).
What is the aim of fiscal policy?
To influence the level of aggregate demand in the economy.
What is expansionary fiscal policy?
Expands aggregate demand.
Why might the government want to use expansionary fiscal policy?
To increase growth during a recession.
To reduce unemployment.
Expansionary fiscal policy on a diagram:
What is contractionary fiscal policy?
Reducing aggregate demand.
Why might the government want to use contractionary fiscal policy?
To reduce inflation during a boom
Contractionary fiscal policy on a diagram:
What are the 2 different mechanisms through which government can carry out fiscal policy.
- Discretionary fiscal policy.
- Automatic stabilisers.
What is discretionary fiscal policy?
When the government actively intervenes to influence aggregate demand. For example, cut tax when in a recession.
What is automatic stabilisers?
Changes in government spending and revenue that happen becaseu of changes inthe economic cycle. For example, in a recession, government spending will increase because you have to pay more beenfits and tax revenue is decreasing.
What is a cyclical budget deficit?
when the government budget is determined by the economic cycle.
what is a structural budget deficit?
When the government runs a budget deficit regardless of the economic cycle.
What are the 2 fiscal rules?
- The golden rule: That a government should borrow only to invest, not to fund current spending.
- The sustainable investment rule: the Government debt to GDP ratio should not exceed 40%
why has the 2 fiscal rules rendered redundant in recent years?
The government debt levels have increased during the financial crisis and covid.
what are the 3 advantages of fiscal rules?
- Policy works automatically to stabilise the economy.
- Changes in govt spending directly affects AD.
- Has the potential to increase both AD and AS simultaneously.
Explain “Policy works automatically to stabilise the economy” as an advantage of fiscal policy:
A number of forms of government spending adjust automatically to offset fluctuations in GDP - fiscal policy can therefore stabilise the economy without any real action required.
Explain “Changes in govt spending directly affects AD” as an advantage of fiscal policy:
(also enables the govt to target spending in specific areas)
Don’t rely on a complicated transmission mechanism to have a final effect on the economy. For example, increasing spending in the economy will put money into people pocket directly, whereas time lag in monetary policy.
Explain “Has the potential to increase both AD and AS simultaneously” as an advantage of fiscal policy:
subsidies.
cutting corporation tax.
cutting VAT.
What are the 6 disadvantages of fiscal policy?
- TIme lag exists.
- Difficult to estimate the size of the multiplier and MPC.
- May have an adverse effect on incentives.
- May damage other macro objectives.
- May be offset by circumstances in other countries.
- Monetarist argument.
Explain “Time lag exists” as a disadvantage of fiscal policy:
It takes time to form and implement new policy. It also might take time for households to adjust to change in their disposable income, meaning spending might not immediately increase when tax rate is cut.
Explain “Difficult to estimate the size of the multiplier and MPC” as a disadvantage of fiscal policy:
The policy might have greater or smaller impact on the economy than desired. Success is determined by the MPC. If MPC is small, investment may leak out of the circular flow.
Explain “May have an adverse effect on incentives” as a disadvantage of fiscal policy:
A rise in income tax may discourage some people form working and higher corporation tax might discourage investment.
Explain “May damage other macro objectives” as a disadvantage of fiscal policy:
A rise in taxation designed to reduce inflation, may increase unemployment.
Explain “May be offset by circumstances in other countries” as a disadvantage of fiscal policy:
If the UK is pursuing expansionary fiscal policy, but the US is experiencing a recession, AD may still fall if the economy is reliant on exports.
Explain “monetarist argument” as a disadvantage of fiscal policy:
LRAS is inelastic so any increase in AD will cause inflation, especially if it is caused by borrowing.
Explain “crowding out argument” as a disadvantage of fiscal policy:
- There is a profit incentive for private sector, not govt.
- supply of money is fixed, and equilibrium shows the rate of interest charged for borrowing money.
- IF govt uses expansionary FP by borrowing, it will increased demand for money and therefore the IR deteriorates private sector investment.
- Private sector will have to cut costs to be more efficient as they are the ones with profit incentive and not govt.
Whether or not fiscal policy is effective depends on what 5 things?
- The level of spare capacity in the economy.
- size of the multiplier.
- size of the MPC
- The phase of the cycle.
- Level of confidence in the economy.
