The Role Of The State

Question 1

What is fiscal (or budget) deficit?

Answer 1

Fiscal/Budget Deficit - the difference between government income (tax receipts) and government spending, in a fiscal year. A positive (tax income > spending) is called a surplus, a negative (tax income < spending) is a deficit and implies the government must borrow this amount to cover its spending. In 2012/13 the deficit was 115 billion pounds.

Question 2

What is the difference between debt and deficit

Answer 2

The National Debt is the cumulative total amount borrowed by the UK governments, whereas the deficit is a yearly figure. The UK debt was 1,185bn pounds in 2012/13.

Question 3

What does …as % of GDP implies?

Answer 3

As the figures don’t really tell us if these figures are ‘significant’. To get an idea of how big the debt/deficit is we need to compare it to a country’s ability to repay, for which we use GDP (total ‘taxable base’ of an economy). In 2012/13 the deficit was 7.3% of GDP, while debt was 74.2%.

Question 4

What are automatic stabilisers?

Answer 4

When GDP falls this impacts the fiscal balance. Falling GDP would mean the government collects less in tax revenue (less spending = less VAT collected, more unemployment = less income tax and National Insurance paid, lower profits = less Corporation tax collected…) and at the same time the government spends more (unemployment and other income related benefits). Thus a fall in GDP leads to a more expansionary fiscal policy, which helps boost AD and partly offsets the fall in GDP (‘stabilises the economy’).

Question 5

What is a discretionary fiscal policy?

Answer 5

Discretionary fiscal policy is where the government chooses to adjust fiscal policy, changing tax rates or changing the level of government spending.

Question 6

What is a cyclical deficit?

Answer 6

Cyclical deficit is a deficit caused by the automatic stabilisers which result from lower GDP growth. As such it is often considered less significant, since it will ‘solve itself’ if GDP grows again.

Question 7

What is a structural deficit?

Answer 7

Structural deficit is a deficit associated with discretionary fiscal policy. Even if there is no cyclical deficit and GDP is growing at trend rates then tax income may be less than spending. This is a more serious problem as it implies the government must take some action to remove the deficit.

Question 8

What is the current spending(deficit)?

Answer 8

Current spending(deficit) - these are the areas of government spending associated with the ‘day-to-day’ running of the economy. It includes welfare payments, pension payments, wages to government employees etc. A deficit which finances current spending is generally considered a problem - the government is committed to spending more than it receives.

Question 9

What is capital spending(deficit)?

Answer 9

Capital spending(deficit) - these are investments by the government, like HS2 or new hospitals. Borrowing to fund investment is considered less of a problem, as these investments are ‘one-off’ and should boost AS and so GDP in the LR.

Question 10

What are the causes of the fiscal deficit?(4)

Answer 10

1. Structural/Government Spending:
   - Ageing population - this means more spending on health care and pensions. By 2061 it is expected that 26% of the population will be over 65 and this will mean extra costs of approximately 5% of GDP.
   - Improving quality/quantity of public services - could be linked to improved AS (education) and are often politically motivated or aimed at redistribution of income. The Labour government expanded spending (mainly on tax credits, education and the NHS) from 2000, until 2005 when it raised taxes and cut back spending increases to keep wilting its target of a debt of below 40% GDP. In 2006 the government had a deficit of just under 3% of GDP, but since they believed that GDP was below capacity (trend) there was only a structural deficit of 2%. Current estimates suggest GDP was actually above trend, so the structural deficit was just over 3%.
2. Structural/Tax Revenues
   - Ageing population - again an ageing population/retirees implies fewer people working as a % of population, which will reduce tax revenues as well
3. Cyclical/Government Spending
   - Bank bailouts - the near collapse of Northern Rock convinced the government it needed to ‘bail out’ (ie prevent the collapse) of other banks. This meant giving some banks a large cash injection, to ensure they had the funds to meet their liabilities. This was done by the government buying shares/a large stake in banks, notable RBS and Lloyds, where it spends 76bn pounds (nearly 5% of GDP) for 83% ownership of RBS and 41% of Lloyds.
   - Fiscal stimulus - in response to falling GDP the government launched a stimulus package, including increased government spending, for example 3bn pounds on capital projects. This amounted to around 1.3% of GDP (including tax cuts)
   - Automatic stabilisers - as a result of the fall in GDP the automatic stabilisers kicked in
4. Cyclical/Tax Revenues
   - Fiscal stimulus - much of the stimulus was from tax cuts. VAT was temporarily cut by 2.5%, as well as raising the personal allowance for income tax
   - Automatic stabilisers

Question 11

Is a fiscal deficit bad?(6)

Answer 11

In theory a fiscal deficit causes a number of problems, which can be summarised as problems of having a large debt, the causes of the deficit are the problem and ‘other’:

1. In order to pay back existing debt the gov needs to be able to borrow ‘new debt’. If the level of total debt rises significantly the bond market may fear the gov will be unable to repay and default. This means that, if the perceived risk of lending to the gov has risen, the bond markets will charge the gov higher rates of interest (“bond prices fall”). A rate of 7% is usually considered unsustainable (the Greeks were being charged 18% in 2011)
2. Opportunity Cost of “servicing the debt” (paying interest on debt). The UK currently spends around 43bn pounds (around 3% of GDP) on this. In LEDCs this can lead to a debt cycle.
3. If a fiscal deficit is caused by ‘high’ gov spending then this creates problems for an economy. In particular it will cause “financial crowding out” and push up interest rates for private sector firms.
4. If a fiscal deficit is caused by low tax receipts this may suggest either gov failure (corruption, inefficiency in tax collection, encouraging evasion/avoidance) or other problems of low tax.
5. Failure to meet self imposed rules may impact on confidence.
6. Appreciation of the currency. In order to buy UK gov bonds foreigners need pounds, this increases demand for ponds and appreciates the currency. Around 30% of UK gov bonds are owned by foreigners. Appreciation causes a fall in competitiveness of UK products (less X more M…).

Question 12

Why can a fiscal deficit be not a major problem?(5)

What is the evaluation for this?

Answer 12

Some economists argue that while not necessarily ‘good’ a deficit (especially a cyclical deficit) is not really a major problem:

1. Is there a direct link between the level of deficit/debt and bond prices? Bond prices reflect relative risk, not absolute risk, so the higher risk of default in Southern Europe increased demand for safer UK bonds (pushing up bond prices/reducing bond yields). Also markets appear to be able to distinguish between cyclical and structural deficits and aren’t overly concerned about cyclical deficit.
2. Deficit could increase GDP. Deficit means an expansionary fiscal policy (= boosts AD). This may mean that an increased deficit in money terms could lead to a falling deficit as a % of GDP. If GDP rises faster than the deficit it may be easier to pay back the deficit, so an increase in G/cut in tax, led to a greater than 1.5% growth in GDP then the deficit would reduce as a % of GDP. Also over an ‘economic cycle’ we might expect inflation to average at the BoE target of 2%, so borrowing at anything less than that over 10 years means a negative interest rate, so even if real GDP stays the same the deficit as a % of GDP should fall!
3. Evaluation of issues concerning high G/low T. For example is crowding our an issue in times when there is spare capacity in the economy?
4. Does breaking self imposed rules matter? Other factors probably;y influence confidence far more than the gov’s ability to stick to its financial mandate (house prices, unemployment levels…).
5. A deficit, and the boost to AD this implies, may prevent deflation in times of recession (especially if supply side factors, like oil prices are putting downward pressure on prices). Deflation is bad as it increases the real interest rate, so encouraging saving/discouraging consumption and investment. These further reduce AD and we become stuck in this deflationary spiral (Japan has faced this problem over the last decades!).

Against this those who say that a deficit is a problem will point to the classical LRAS curve, which is perfectly inelastic and implies any increase in AD will, in the LR, only impact the price level. Hence increasing G or cutting tax to boost AD is a SR solution only and eventually only increases inflation.

Question 13

What are the solutions to a fiscal deficit?(4)

Answer 13

1. Cut government spending
2. Increase tax rates
3. Supply-side reform
4. Keynesian view

Question 14

How does cutting government spending help reduce fiscal deficit?(6,8)

Answer 14

1. Reduces budget deficit - less borrowing required = lower interest rates and lower future repayments - more expenditure on services in the future
2. Reduces danger of crowding out - resources become cheaper for private sector - shift right of AS - increase in Y
3. Reduces size of public sector - public sector not subject to market forces - inefficiency/waste - allocative inefficiency/x-inefficiency - low productivity - often used by politicians!
4. Impact more certain than tax rises - Laffer curve
5. Reduces possibility of gov failure - eg job seekers allowance encouraging unemployment
6. Impact on confidence - news reports about high deficit/”debt per person”

BUT:

1. Impact on AD - lower G = fall in AD - lower GDP/more unemployment
2. From above may push up deficit as a % of GDP - (this is more important than absolute figure - gives an idea of ability to repay) - partly as GDP is falling - partly as lower GDP leads to “automatic stabilisers” of lower tax receipts and more spending on areas like JSA.
3. Reduces quality and quantity of gov services - hits those most in need hardest - more inequality
4. Big impact on unemployment - gov largest employer - cutting spending = cutting services = cutting jobs - multiplier effect
5. If LR investment is cut will reduce AS in LR - funding for education/universities - health care - infrastructure
6. X-inefficiency often over rated - wastage savings made are rarely met
7. Does crowding out occur when there are unemployed resources?
8. Increased market failure - gov under provides goods with high external benefits (or lets the market under provide them!) - eg uni fees (external benefits/asymmetric information)

Question 15

How does increasing tax rates help reduce fiscal deficit?(4,3)

Answer 15

1. Reduces fiscal deficit - less interest to pay in the future - more for gov services or lower taxes in the future
   BUT: Laffer Curve
2. Lower inflation - reduced AD - AS/AD diagram - firms unable to raise prices
   BUT: increase in VAT/duties (even possibly corporation tax) pushes up firms costs and forces them to charge higher prices - increases inflation
3. Improves CA - lower growth = fewer M sucked in and lower inflation = UK products more competitive - more X, less M
   BUT: CA depends on a range of other factors - i/value of pound/productivity
4. Impact on distribution of income - generally higher (progressive) taxes seem as improving distribution (less gap, lower Gini), but it depends on the type of tax.
   BUT: Regressive taxes will have the opposite effect!

Against this, rising taxes has a number of issues:
1. Lower real disposable incomes - fall in C - fall in AD - AS/AD diagram - fall in GDP and so possible increase in deficit as a % of GDP
BUT: Fall in C depends on the size of MPC - depends which taxes are increased, poor have higher MPC, so regressive taxes have more impact on C

2. Reduced incentive to work - depends on marginal tax rate - less of extra money earned kept - reduces AS - impact of growth and inflation. There is a big conflict here with supply-side policies
   BUT: How strong is disincentive to work - will affect those at the extreme, but most cant find work?!?
3. Allocatively inefficient/government failure - prevents individuals and firms (S&D or price mechanism) determining how much money is spent/how many products are made in each market and implies the government picking a (politically motivated?) quantity.

Question 16

How does the supply-side reform help reduce fiscal deficit?(4)

Answer 16

The basic idea here is to reduce the cyclical deficit by encouraging supply side growth. The focus is on free market SSPs, so this has the added benefit of reducing government spending, so reducing the structural deficit and allowing a cut in taxes once the cyclical deficit is dealt with.

Typical SSPs would include:
1. Cutting Taxes (obvious conflict)
a) Cutting income taxes would increase the incentive to work and allow firms to pay lower real wages (while individuals still had the higher real disposable incomes). This reduction in production costs would shift out AS. At the same time it would help to boost consumption. Changing the brackets can also have this effect
BUT: There is very limited evidence this actually works. In 1950s-1970s many countries had very high marginal rates (over 90% in UK and US), yet enjoyed strong growth.
b) Cutting corporation tax, which allows firms to retain more profit and so both encouraging businesses to set up (increasing competition) and invest. These should both shift AS.
BUT: This is not certain. Firms may, instead, pay out larger dividends or save their extra profits (often via share buy-back schemes). This means there is no increase in investment

2. Cutting Welfare Payments - this directly helps cut government spending and also has the same incentive effects of cutting income tax
   BUT: This will, inevitably, increase inequality. Moreover, many/most of those on benefits would like to work, but there are no jobs/AD is ‘too low’, so this just punishes them further.
3. Privatisation/Deregulation - this should help introduce greater competition into markets, so helping increase efficiency and so AS/GDP. It should also help cut government spending ‘propping up’ inefficient firms. Deregulation can also include removing the ‘red tape’ barriers to setting up and running a business, so reducing costs and encouraging new firms.
   BUT: In many countries most industries have been privatised! Similarly most regulations play a role in ensuring firms behave appropriately, so reducing regulations may cause other problems.
4. Reduce the National Minimum Wage/Trade Union powers - these measures would help firms lower wages, so reducing costs and so increasing AS. In addition if wage cuts lead to greater employment levels, then more wages may be paid in total, so increasing C
   BUT: The NMW/TUs play a useful role, especially in reducing the monopsonist power of firms in wage negotiations, in extreme cases cutting the NMW may lead to higher unemployment! Either way a lower NMW means some workers’ incomes are cut and so reduces C, reducing AD

In more general terms, there are other issues with SSPs. In particular the long time lag involved may mean they are not useful in the SR.

Question 17

How does the Keynesian approach help reduce fiscal deficit?

Answer 17

This approach is fundamentally different from all those above, in fact in many cases it is the opposite. The basic argument is that the government should focus on increasing AD/GDP and that this will reduce the debt/deficit as a % of GDP.

The Keynesian view then advocates increased government spending (especially on infrastructure/areas which boost AS) and reduced taxes. This seems counter-intuitive; these things will increase the deficit. However if the % increase in GDP caused by the boost to AD is greater than the costs of borrowing then the value of debt, as a % of GDP, will fall.

The Keynesian’s promote this under 2 circumstances:

1. The economy is in recession/has a large negative output gap - this means the government spending will not crowd out the private sector and has other benefits , associated with higher spending.
2. The government can borrow at low interest rates - this again means that the increased tax revenue, following the automatic stabilisers, may outweigh the serving costs and so the government debt falls.

For this reason Keynesians would promote greater spending in countries like U.K. and US (low borrowing costs/negative output gap) or even Greece (huge recession, although this means Greece would need a bailout/default!)

A graph of Percent change of GDP v Structural Fiscal Tightening in the eurozone 2008-2012 shows that the more tightening the lower the GDP growth.

The criticism:
Others criticise the Keynesian view; it is counter-intuitive. There are potential problems; those associated with high government spending or the dangers of high debt/opportunity cost of a deficit.
In addition the classical view of the LRAS is that it is perfectly inelastic. This means that any boost to GDP from increased AD will only be temporary and in the long term only SSPs can boost growth.

Question 18

Why has it been so difficult to reduce the fiscal deficit?(5)

Answer 18

The Coalition found it very difficult to reduce the fiscal deficit and have had to push back their targets. The Keynesians would say this is because their policy is basically wrong!

A number of factors made it difficult and pushed GDP down/increased the (cyclical) deficit:

1. The weakness of nominal GDP: the cash size of the economy (nominal GDP) fell far below pre-crisis expectations and also shrank in absolute terms between 2007-08 and 2009-10. Nominal GDP normally continues rising in recessions, even when real falls.
2. Stubbornly high consumer price inflation: consumer prices, which had been relatively contained prior to the crisis, rose significantly more than expected through to 2012-13, even though activity in the real economy was far weaker than expected.
3. The productivity puzzle: employment was weaker than forecast prior to the criss, but it has held up far better than anyone would have expected given the size of the fall in real GDP. So productivity - output per hour worked - was and remains very weak.
4. Falling real wages: average earnings have grown very slowly by historical standards, mirroring the weakness of productivity. Combined with stubbornly high consumer price inflation, this has seen real wages fall significantly since the outbreak of the crisis.
5. Weak asset markets: equity prices and property prices and transactions fell well short of pre-crisis forecasts.

Question 19

What government policies can a government use to stabilise the value of its currency?

Answer 19

They need to affect the supply and demand of the currency.
This can be done in 2 ways:
1. Increasing government demand for currency or decrease supply
- buy its own currency - sell foreign currency/gold
- less QE (print less money)
2. Encourage private sector to increase demand for the currency
- encourage FDI - via SSPs/tax breaks
- increase interest rates (hot money inflows) - lower inflation
- encourage exports - SSPs/tax breaks for exporters/free trade deals/lower inflation