Role of the state in the macroeconomy

Question 1

What is the distinction between capital expenditure, current expenditure and transfer payments?

Answer 1

1. Capital expenditure – This refers to long-term investment expenditure on capital goods such as HS2, new schools and new motorways.
2. Current expenditure – This relates to the government’s day-to-day expenditure on goods and services, for example wages and salaries of civil servants; drugs used by the NHS.
3. Transfer payments – These are payments made by the state to individuals without there being any exchange of goods and services. They are used to redistribute income. UK examples include universal credit and state pensions.

Question 2

What factors affect the size of public expenditure? (7)

What are automatic stabilisers?

Answer 2

1. The level of GDP.
2. Demand for public services – demand for many public services such as health and education is income elastic.
3. Size and age distribution of the population.
4. The state of the economy – when the economy is in recession, then public expenditure is likely to rise because of automatic stabilisers.
   Automatic stabilisers are changes in government spending or in tax revenue that occur automatically without deliberate action being taken by the government.
5. Interest on the national debt.
6. The rate of inflation – in nominal terms, public expenditure will inevitably increase during periods of inflation not least because many benefits are index linked, i.e. linked to the rate of inflation.
7. Political priorities – e.g. government might with to improve public services.

Question 3

What does social protection include?

Why in recent years has this increased as a share of public expenditure?

Answer 3

Social protection which includes the ranges of benefits, health and education represented the largest proportion of the UK government’s public expenditure. This has increased as a share of public expenditure in recent years because of:
1. Increased payments for housing benefits as a result of rising rents.
2. Increased expenditure on tax credits
3. The ageing population
4. Increased number of children of school age.
However, austerity measures have been designed to reduce or limit benefits in the future.

Question 4

How does public expenditure as a proportion of GDP affect productivity and growth?

Answer 4

If a country’s public expenditure is a relatively high proportion of GDP, then its productivity and economic growth rates may be relatively low because of the absence of the profit motive and competition in the public sector.

Question 5

How does public expenditure as a proportion of GDP affect living standards?

Answer 5

The impact will depend critically on the composition of public expenditure, for example the proportion of public expenditure spent on transfer payments and on health relative to the amount spent on defence

Question 6

How does public expenditure as a proportion of GDP affect crowding out?

What is resource crowding out?
What is financial crowding out?

Answer 6

Structural deficits could imply that the size of the public sector is increasing, which could cause resource or financial crowding out.
Resource crowding out occurs when the economy is operating at full employment and the expansion of the public sector means that there is a shortage of resources in the private sector.
Financial crowding out occurs when the expansion of the state sector is financed by increased government borrowing. This causes an increase in demand for loanable funds, which drives up interest rates and crowds out private sector investment.

Question 7

How does public expenditure as a proportion of GDP affect the level of taxation?

Answer 7

If public expenditure is a high proportion of GDP then it is likely that taxation will also be a high proportion of GDP in order to fund the high levels of public expenditure.

Question 8

How does public expenditure as a proportion of GDP affect equality?

Answer 8

Much research suggests that higher public spending is associated with greater equality, for example in Sweden and Denmark. However, this is not always true because some countries have both high public spending and a significant degree of inequality.

Question 9

What is the distinction between progressive, proportional and regressive taxes?

Answer 9

Progressive taxes – taxes in which the proportion of income paid in tax rises as income increases.
Proportional taxes – taxes in which the proportion of income paid in tax remains constant as income increases.
Regressive taxes – taxes in which the proportion of income paid in tax falls as income increases.

Question 10

What are direct taxes?

Give three examples.

Answer 10

Direct taxes are those levied on incomes and wealth and include:

1. Income tax – a progressive tax levied at three different rates for varying levels of income: 20%, 40% and 45%.
2. Corporation tax – a proportional tax on company profits, currently levied at 20% in the UK but is to be reduced to 17.5% by 2020.
3. Capital gains tax – a tax on the increase in value of assets between the time they were bought and the time they were sold, e.g. on shares and investment property.

Question 11

What are indirect taxes?

Give three examples.

Answer 11

Indirect taxes are taxes on expenditure and include:

1. Value Added Tax (VAT) – an ad valorem tax, i.e. a percentage of the price of the product.
2. Excise duties – usually specific taxes, i.e. set amount per unit.
3. Tarrifs

Question 12

What are the effects of changes in direct tax rates on incentives to work?

Answer 12

An increase in income tax rates might cause a disincentive to work because:

1. The unemployed and those currently ‘inactive’ would be less willing to take up employment.
2. Workers currently employed may be less willing to do overtime, more likely to reduce their working hours, more likely to retire early and less willing to apply for promotion.

Question 13

What are the effects of changes in direct tax rates on tax revenues?

Answer 13

Increases in tax rates might cause tax revenues to fall. This can be explained using the Laffer curve.
When the tax rate is increased up to a certain point, tax revenue increases. However, a further increase in the tax rate may cause a fall in tax revenue, this can happen for several reasons:
1. Increased disincentives to work
2. An increase in tax avoidance which is legal
3. An increase in tax evasion which is illegal
4. A rise in the number of tax exiles.

Question 14

What are the effects of changes in direct tax rates on income distribution?

Answer 14

An increase in income tax rates will make the tax system more progressive, so making the distribution more equitable.

Question 15

What are the effects of changes in direct tax rates on real output and employment?

Answer 15

Higher rates of income tax would cause a fall in disposable income, a fall in consumption and a fall in aggregate demand. The disincentive effects of higher rates of income tax might also cause a fall in aggregate supply. Consequently, there would be a fall in real output and in turn a fall in employment.

Question 16

What are the effects of changes in direct tax rates on the price level?

Answer 16

The fall in aggregate demand following higher income tax rates would cause a fall in the price level. This may be partially offset by any fall in aggregate supply but the impact of the leftward shift in the aggregate demand curve is likely to be more significant.

Question 17

What are the effects of changes in direct tax rates on the trade balance?

Answer 17

An increase in income tax rates would reduce disposable income. In turn, this would cause a fall in consumption, resulting in a decrease in imports. Consequently, there should be an improvement in the trade balance.

Question 18

What are the effects of changes in direct tax rates on FDI flows?

Answer 18

An increase in direct taxes is likely to deter inward FDI. Further, an increase in income tax rates is also likely to deter inward FDI because disposable income would fall, causing a decrease in consumption.

Question 19

What are the effects of changes in indirect tax rates on incentives to work?

Answer 19

An increase in the rate of VAT might cause an incentive to work more because workers will try to maintain their current living standards by working harder so that they can afford the same amount as before the rise in the rate of VAT.

Question 20

What are the effects of changes in indirect tax rates on tax revenues?

Answer 20

If the VAT rate is increased, then tax revenues will almost certainly increase because VAT is applied to most goods and services, at least some of which will have price inelastic demand.

Question 21

What are the effects of changes in indirect tax rates on income distribution?

Answer 21

Research by the ONS in 2011 suggests that the impact of VAT is broadly regressive. Therefore, an increase in VAT would cause income distribution to become less even.

Question 22

What are the effects of changes in indirect tax rates on real output and employment?

Answer 22

A higher rate of VAT would cause a fall in real income, which would cause a fall in consumption and a fall in aggregated demand, leading to a reduction in real output and employment. For businesses the higher VAT rate would raise costs, so causing a fall in aggregate supply, which would lead to a reduction in real output and employment.

Question 23

What are the effects of changes in indirect tax rates on the price level?

Answer 23

The short-run effect of an increase in indirect taxes will be to increase the price level. However, it should be remembered that taxes are a leakage from the circular flow, so higher indirect taxes will cause a decrease in aggregate demand and, therefore a fall in the price level in the longer term.

Question 24

What are the effects of changes in indirect tax rates on the trade balance?

Answer 24

Businesses can zero-rate goods exported outside the European Union (EU) or sent to someone who is registered for VAT in another EU country. Consequently, a change in VAT would only affect goods exported to someone in the EU who is not registered for VAT. Therefore, VAT changes by a country in the EU are likely to have very little impact.

Question 25

What are the effects of changes in indirect tax rates on FDI flows?

Answer 25

If a government of a country raises its indirect taxes significantly, then global companies may be deterred from investing in that country because the tax rate might lead to a reduction in the domestic demand for the company’s goods.

Question 26

What are automatic stabilisers?

Answer 26

These are changes in government expenditure and tax revenue which occur as GDP rises or falls without any change in government policy.
In a recession, unemployment increases, so the government spends more on unemployment benefits and other means-tested benefits.
Such an increase in government expenditure is automatic.
Further, tax revenues will fall because fewer people are working and therefore revenue from income tax will be lower.
Meanwhile, VAT receipts will be lower because consumer spending is lower.
In addition, there will be a fall in corporation tax receipts because company profits will be lower.

Question 27

What is discretionary fiscal policy?

Answer 27

Discretionary fiscal policy involves deliberate changes in public expenditure by the government in an attempt to influence the level of economic activity.

Question 28

What is the distinction between the fiscal deficit and the national debt?

Answer 28

A fiscal deficit implies that public expenditure is greater than tax revenues.
The national debt is the cumulative total of past government borrowing.
The national debt is the total sum owed by a government to holders of government bonds (gilt-edged securities). In other words, it represents the total of a government’s outstanding debt that it has accumulated over time.

Question 29

What is the distinction between structural and cyclical deficits?

Answer 29

The government’s finances change in line with the trade cycle, in other words they would usually be expected to deteriorate when the economy is in recession. These are referred to as cyclical deficits. A cyclical deficit is not regarded as a serious problem because it should disappear when the economy returns to trend growth rate.

The structural deficit is the fiscal deficit that remains when the economy is normal, or when the output gap is zero.

Question 30

What factors affect the size of fiscal deficits? (9)

Answer 30

1. The state of the economy
2. Discretionary fiscal policy
3. Political priorities
4. Demographic factors
5. Sales of state-owned assets
6. The efficiency of tax collection
7. The degree of tax avoidance and tax evasion
8. Interest payment on the national debt
9. The amount of government subsidies and financial support

Question 31

What factors influence the size of national debts? (4)

Answer 31

1. Fiscal deficits/surpluses
2. Wars
3. Economic crises such as the 2008 financial crisis.
4. Measures adopted by the government which create immediate and long-term obligations.

Question 32

Why is the fiscal deficit as a proportion of GDP more significant than the absolute size?

Answer 32

The fiscal deficit as a proportion of GDP is more significant than the absolute size of the fiscal deficit because it gives a better indication of the ability of the country to finance the debt and eventually repay it.

Question 33

What are the possible consequences of a persistent structural deficit and an increasing national debt? (5)

Answer 33

1. Loss of the country’s AAA credit rating – which could mean higher interest rates when it borrows money.
2. Crowding out
3. Inflation because net injections will be increasing
4. A fall in confidence, leading to a fall in FDI
5. Rising interest payments on the national debt

Question 34

Why may a fiscal deficit and rising national debt not be considered a serious problem?

Answer 34

A fiscal deficit and rising national debt caused by significant investment on infrastructure and/or education or health may not be regarded as a serious problem because such expenditure would increase long-run aggregate supply.

Question 35

What measures could be used to reduce fiscal deficits and national debts? (3)

Answer 35

1. Reduce public expenditure
2. Increase taxes
3. Implement policies to increase economic growth, some economists argue that these policies would have the effect of reducing the fiscal deficit and national debt as a proportion of GDP.

Question 36

What measures could be used to reduce poverty and inequality? (6)

Answer 36

1. Improved quality of education and training for the poor.
2. Making the tax system more progressive.
3. Higher inheritance taxes.
4. Increasing the number and range of ‘means-tested benefits’
5. Measures to reduce unemployment.
6. Introduction of or increase in the national minimum wage/national living wage.

Question 37

What measures could be used to increase international competitiveness?

Answer 37

Policies used to eliminate a balance of payments deficit on the current account would also be relevant as a means of increasing international competitiveness.

Question 38

Give examples of external shocks to the economy? (7)

Answer 38

1. A sudden increase (or decrease) in global oil or commodity prices in general.
2. A financial crisis causing a decrease in confidence in the banking system.
3. A bursting of asset price bubbles.
4. Extreme weather events causing major damage to infrastructure.
5. Contagious diseases
6. Terrorist attacks or global conflicts.
7. Cyber-attacks which could impact on communications, energy supplies, banking transactions and/or retailing.

Question 39

What limits are there to government ability to control global companies? (3)

Answer 39

Global companies may:

1. Be footloose, i.e. they can move easily from one country to another in the search of the lowest wage and other costs.
2. Have a monopoly on technological and intellectual property
3. Threaten to withdraw investment.

Question 40

What problems face policy makers when applying policies? (2)

Answer 40

1) Inaccurate information -
Forecasts are notoriously inaccurate, e.g. of the future rate of inflation. This also applies to costs of major projects, e.g. HS2
Estimates of past data for a variety of indicators are frequently revised significantly in subsequent years, e.g. GDP and balance of payments on current account.
2) Risk is present when future events occur with measurable probability, whereas uncertainly is present when the likelihood of future events is indefinite or incalculable. Uncertainties cannot be eliminated or insured against.
3) Inability to control external shocks
Most of the external shocks described above are difficult to predict and, consequently, to allow for when applying policies. Therefore, policies being followed may no longer be appropriate.