Pack 5 Flashcards
What is public expenditure?
- spending by the government e.g healthcare
= capital expenditure + current expenditure
What are the several reasons for public expenditure in the economy?
-providing public and merit goods, such as defense: without would be under-provision of goods with positive externalities
- redistribution of income and wealth: e.g benefits will boost incomes of low income households
- regulation of economic activities: e.g OFWAT regulates water industry
- Influencing level of economic activity: can directly influence AD
What is the difference between capital and current expenditure?
Capital: on investment goods, e.g new roads
Current: on goods and services consumed in short term as well as transfer payments and debt interest
What are transfer payments?
spending for which there is no corresponding real output such as welfare payments (child benefit)
- no new demand created so does not boost AD
What are the reasons for changing size and composition of public expenditure?
- Economic development: LICs tend to have lower public expenditure than HICs due to low levels of tax revenues (people earn less) or tax system inefficient. As incomes rise = increase in demand for state provided services
- Demographics: ageing population = more demand for pensions/healthcare at same time as lower tax revenue due to smaller workforce/lower percentage paying tax
Political ideology: free-market e.g US spend much less that those where state is more involved e.g Finland
The trade cycle: countries in recession spend much more on unemployment-related benefits, also use of fiscal policy in response to changes in trade cycle
During economic crises: gov will need to support the economy
What are the effects of high public expenditure on the economy?
Increased AD: government spending is injection into circular flow
Increased LRAS: interventionist supply-side policies, e.g improved infrastructure
What are the macroeconomic effects of public expenditure on the economy?
Productivity and Growth:
- component of AD so through multiplier effect
- can also boost LRAS: spending on infrastructure, healthcare/education, innovation/R&D
- however large levels can be seen as wasteful/inefficient thus constraining productivity, LRAS and growth
Living standards and Equality:
- provision of services = boost living standards especial low incomes
- gov can also intervene through benefits
however, public services may not be efficiently run and so may not improve living standards if low quality. Also side-effects, e.g high unemployment benefits reducing incentive to work
Tax revenue and National debt:
- must be funded some way, so choice between raising tax revenue/increasing national debt
- if taxes increased, negative impacts on incentives/economic activity
- if budget deficits run and national debt increases = higher interest payments and so opportunity cost/reduced credit rating for gov
**However, extent of national debt depends on magnitude/ability of gov to continue to borrow, when interest rates low and gov has good credit rating, may be less immediate need to raise taxes
**
Crowding out:
two main types:
Resource crowding out: when economy at full employment and expansion of public expenditure = shortage of resources available for private sector (opportunity cost)
Financial crowding out: when economy below full employment and gov has to borrow to finance public expenditure, increase in demand for loans by gov = higher interest rates being charged by banks
However, when economy has significant spare capacity, e.g recession:
- crowding out less likely: below full employment, economy within its ppf and so no trade-off for resources. Also savings in economy likely higher meaning higher supply of loanable funds for banks to lend out.
- crowding in more likely: occurs when higher gov spending = increase in private sector investment
- due to positive multiplier effect due to higher gov spending and so encourage firms to invest
What is crowding out?
when extra government spending leads to lower private sector spending
What are the reasons for taxation?
- to raise tax revenue in order to pay for public expenditure
- to redistribute income and wealth: e.g income tax
- to correct market failure: e.g on cigarettes and alcohol
- to influence the level of economic activity: e.g income tax changes consumption
What is the difference between progressive, regressive and proportional taxes?
Progressive:
- where proportion of income paid in tax rises as income of taxpayer rises
e.g income tax
Regressive:
- where proportion of income paid in tax falls as income of taxpayer
e.g indirect tax on alcohol
Proportional:
- where the proportion of income paid in tax remains the same as income increases
What are examples of UK taxes?
Income tax
Corporation tax
National insurance contributions
Inheritance tax
VAT
Council tax
What are the economic effects of direct and indirect taxation?
-
Income distribution:
- progressive taxes = income equal distributions
- however, distortion to incentives -
Incentives to work:
- benefit of indirect tax as does not reduce incentive, but may provide incentives to quit smoking
- increase income tax may reduce incentive - substitution effect (replace work with leisure), however may make some people wish to work more in order to make up for their lost income in order to maintain living standards - income effect -
Tax revenues (Laffer Curve):
- if taxes rise to far, tax revenue may fall
- at low levels of tax, substitution effect very low and income effect very high so tax revenue rises
- at higher tax rates, substitution effect becomes larger than income effect so fall in tax revenue
- however hard to know optimal level -
Real output, employment and price level:
- increased AD: lower direct tax = higher AD due to increased consumption from lower income tax/higher investment from lower corporation tax
- increased LRAS: lower income tax can improve incentive to work and lower corporation tax improve incentive to invest
- however depend on level of spare capacity, if at full employment increase in direct tax will have much more significant impact on price level than real GDP
- consumers may not respond to incentives due to low consumer confidence
- time lags
- changes in indirect tax increase SRAS
- due to lower costs o production
- however only short term -
Trade balance:
- UK consumers have high marginal propensity to import
- increased income tax = reduced imports and so improve trade balance
- knock-on effects for businesses as lower consumption/AD reduces incentive to invest especially if corporation tax increase too
- in long term, impact on trade balance likely to deteriorate as lack of investment will lower firm productivity/international competitiveness of exports -
Foreign Direct Investment (FDI)
- lower rates of corporation tax attract companies to set-up in the country as pay less of their profits in tax
- benefits economy as provides jobs, investment etc
- however gov must balance gained tax revenue with lost tax revenue from domestic firms paying lower rate of tax and may need to continually fall to remain competitive with other countries
What is the difference between discretionary fiscal policy and automatic stabilisers?
Discretionary fiscal policy: gov may decide to deliberately change the level of spending in the economy
e.g gov cutting spending in order to reduce the budget deficit
Automatic stabilisers: during the trade cycle the level of government spending and taxation will vary automatically and will help to reduce fluctuations in economic activity
e.g during a recession more workers unemployed, so gov will spend more on unemployment benefits and the unemployed workers will pay less tax, so AD will not fall as much due to higher gov spending/consumption than without the stabilisers
What is the difference between the fiscal deficit (budget deficit) and national debt?
Budget deficit: when gov spends more than it receives in tax revenue in a given year
National debt: total accumulated borrowing of gov which remains to be paid to lender
- reduction in budget deficit will still increase national debt but at a decreasing rate
- can reduce national debt as a % of GDP even when running a budget deficit as long as GDP is rising faster than the budget deficit
What are the differences between a structural and cyclical deficit?
cyclical deficit: caused by gov spending and taxes changing through the trade cycle
e.g in recession cyclical deficit
structural deficit: part of fiscal deficit that is not related to the trade cycle and will not disappear as economy recovers
e.g when gov spending is greater than tax revenue not associated with the trade cycle
- if gov has structural deficit, then national debt likely to grow at whatever stage of the trade cycle the economy is in
- however calculating the exact scale of deficits is difficult as trade cycles do not follow exactly same patter over time
