Macroeconomics: Fiscal policy

Question 1

What is fiscal policy?

Answer 1

Changes in government spending, taxation and the level of government borrowing.

Question 2

What are the key roles of fiscal policy?

Answer 2

Correcting for market failures e.g. sugar drinks levy subsidies to help people afford social housing.
Changing the final distribution of income and wealth e.g. progressive direct taxes (marginal tax rates, new wealth tax).
Stabilising and stimulating AD and GDP growth e.g. changes in income tax, state welfare.
Improving the economy’s supply-side potential (LRAS) e.g. increased state spending in education and healthcare.
Responding to crises caused by external shocks e.g. fiscal activism during the pandemic including job retention scheme.

Question 3

What is government spending?

Answer 3

Money that a government allocates to fund various state-provided programmes and public services. These expenditures are typically financed through taxes and government borrowing (such as issuing bonds).

Question 4

What is the significance of government spending for the UK?

Answer 4

Helps to stabilise demand in a recession
Has a regional economic impact
Important in providing public and merit goods
Driver of long run growth
Can help achieve greater equity in society

Question 5

What is taxation?

Answer 5

When governments collect revenue from individuals, businesses, and other entities to finance public services, infrastructure, and various government functions.

Question 6

What are the main reasons for taxation?

Answer 6

Revenue generation- used to fund government programmes and services.
Redistribution of income and wealth- progressive taxation, where higher income individuals pay a higher % of their income in taxes.
Economic stabilisation- governments may implement countercyclical fiscal policies, such as reducing taxes during economic downturns to stimulate spending or increasing taxes during economic booms to cool down inflation.
Regulation and incentives- e.g. increased taxes on tobacco and alcohol can discourage consumption, while tax incentives for R+D can encourage innovation.
Public goods- taxes are essential for financing pure public goods and services that are non-excludable and non-rivalrous.

Question 7

What is the importance of equity and efficiency with taxes?

Answer 7

Equity- taxation should be fair and equitable, meaning that individuals and businesses with similar financial capacities should pay similar amounts of tax. Equity can be achieved through progressive, proportional, or regressive taxation systems.

Efficiency- taxation should minimise economic distortions and deadweight losses. An efficient tax system should not discourage productive activities or create unnecessary administrative burdens.

Economic neutrality- taxes should not distort economic decision making.

Question 8

What is horizontal equity?

Answer 8

Similar taxpayers in similar circumstances should be treated equally in terms of their tax liabilities.

Question 9

What is vertical equity?

Answer 9

Tax burdens should be distributed in a way that is fair and reflects differences in the ability to pay.

Question 10

What is the ability-to-pay principle?

Answer 10

Individuals or entities with a greater ability to pay taxes should contribute a larger share of their income/wealth to the government in the form of taxes.

Question 11

What is direct taxation?

Answer 11

Levied on income, wealth and profit.
e.g. income tax, inheritance tax, national insurance contributions, capital gains tax, and corporation tax.

Question 12

What is indirect taxation?

Answer 12

Taxes on spending e.g. excise duties on fuel, cigarettes and alcohol.

Question 13

What is income tax like in the UK?

Answer 13

Taxable income- income tax is levied on various types of income, including employment, rental income, interest, dividends and pension income.
Personal allowance- amount of income they can earn before they start paying income tax.
Progressive

Question 14

What is national insurance?

Answer 14

Paid by employees, employers and the self-employed, and are used to help fund the state pension and welfare benefits such as Jobseekers’ Allowance and sick pay.

Question 15

What is corporation tax?

Answer 15

Raised from the taxable profits of limited companies and other organisations, after considering various deductions and allowances.

Question 16

What are the different tax systems?

Answer 16

Proportional Taxes: Require all taxpayers to pay the same fraction of their income, regardless of how much money they earn.
Regressive Taxes: Require high-income taxpayers to pay a smaller fraction of their income than low-income taxpayers.
Progressive Taxes: Tax rates increase as income increases

Question 17

What is fiscal balance?

Answer 17

Total tax revenue - Total expenditure

Question 18

What is a fiscal surplus?

Answer 18

When the fiscal balance is positive (Total revenue > Total expenditure)
It allows a government to save or pay down debt, invest in infrastructure, and reduce taxes.

Question 19

What is a fiscal deficit?

Answer 19

When the fiscal balance is negative (Total revenue < Total expenditure)
This indicates the government is spending more than it is in collecting revenue.

Question 20

How can a government cover its fiscal deficit?

Answer 20

Borrow money by issuing bonds

Question 21

What is national debt?

Answer 21

The government’s stock of outstanding debt.
It is the result of a country constantly running budget deficits. When this happens, the government borrows money to cover the deficit leading to an increase in the debt.

Question 22

What is a national debt used for?

Answer 22

Finance critical infrastructure projects, public services, and economic tool during recessions to stimulate economic growth.

Question 23

What is the impact of AD as a result of budget deficits?

Answer 23

Direct increase in government spending- when a government runs a budget deficit, it is spending more than collecting in revenue. This often involves increasing government expenditures.

Lower taxes- reduction in direct/indirect taxes which then causes a rise in household disposable incomes and in theory a higher level of AD.

Multiplier effect- as government spending rises, it can increase income for individuals and businesses, leading to higher consumption and investment, further boosting AD.

Question 24

What are the negative impacts on AD as a result of budget deficits?

Answer 24

Increased borrowing- To finance a budget deficit, the government often needs to borrow money by issuing bonds or other debt instruments. When the government competes with private borrowers for funds in the financial market, it can lead to higher interest rates.

Higher interest rates can lead to reduced private-sector investment and borrowing.

Expectations of higher taxes- a growing fiscal deficit might lead some households and businesses to expect higher taxes in the future causing them to cut back on spending and save more. This lowers AD.

Question 25

What is the fiscal multiplier?

Answer 25

Estimates the final change in real national income that results from an initial change in government spending and/or revenue plans.

Question 25

What is expansionary fiscal policy?

Answer 25

The government aims to increase AD by deliberately increasing real government spending and/or lowering direct and indirect taxes.

Question 26

What does the size of the fiscal multiplier depend on?

Answer 26

How the fiscal stimulus is financed such as via increased borrowing.
Extent to which a stimulus leads to higher interest rates/inflation.
Degree to which an economy is open to imports.
Impact on consumer and business expectations and confidence.
MPC and MPS of households affected.

Question 27

What is the Laffer curve?

Answer 27

The idea of free-market economists who believe in tax cutting as a means of stimulating work incentives and economic growth. They argue that lower taxes can increase growth and can therefore contribute to higher direct and indirect tax revenues for the government.

Question 28

What does the Laffer curve show?

Answer 28

The relationship between economic activity and the rate of taxation suggests there might be an optimum tax rate that maximises total tax revenue.

Question 29

Why might total tax revenues fall if the tax rate increases?

Answer 29

Increased rates of tax avoidance- there is a greater incentive to seek out tax relief and make minimum use of tax allowances.

Stronger incentive to evade taxes (illegal)- non-declaration of income and wealth by people and businesses.

Possible disincentive effects in the labour market- depending on which taxes have been increased (more economically inactive).

Possible “brain drain” effect- including the loss of highly skilled and high-income taxpayers who might leave a country.

Question 30

How can fiscal policy impact SRAS?

Answer 30

Changes in VAT affect the supply cost of businesses- a fall in VAT reduces costs and will cause SRAS to shift outwards.

Changes in environmental taxes- a rise in carbon tax will increase the costs, especially for energy-intensive firms causing SRAS to shit inwards.

Changes in import tariffs- lower tariffs as a result of trade liberalisation will lead to reduced costs so SRAS shifts outwards.

Changes in government subsidies- input subsidies paid to producers e.g. farmers lower their costs and cause an outward shift.

Question 31

How can fiscal policy impact LRAS?

Answer 31

Changes in marginal and average income tax rates can have a significant effect on work incentives in the labour market.

State funding of R+D can have important effects on process innovation and the pace of dynamic efficiency in markets.

Higher government spending on education and training can increase human capital/productivity to lift the long-term trend rate of growth.

Changes in corporation tax and import tariffs can influence the size and direction of FDI.

Government spending on new infrastructure is crucial to lift LRAS- it often makes private sector firms more efficient and profitable too.