The Role Of The State In The Macroeconomy- Theme 4

Question 1

What is capital expenditure?

Answer 1

This relates expenditure on long-term investment projects such as new hospital and roads. It’s often referred to as a public sector.

Question 2

What are the objectives of public expenditure?

Answer 2

• provision of public goods
• defence and internal security
• provision of goods and and services which yield external benefits and/or where there may be information gaps and asymmetric information
• redistribution of income
• expenditure to deal with external costs such as pollution and waste

Question 3

What is current expenditure?

Answer 3

This is day-to-day expenditure on goods and services eg salaries for teachers

Question 4

What are transfer payments?

Answer 4

These are payments made by the state to individuals in form of benefits for which there is no production in return. Examples include child benefit, state pensions and the job seeker’s allowance.

Question 5

How is the level of GDP a reason for the changing size and composition of public expenditure?

Answer 5

As income increases, so do expectations, and the demand for many government-provided services such as health and education rises more than proportionately because demand for them is income elastic.

Question 6

How is the size and age distribution of the population a reason for the changing size and composition of public expenditure?

Answer 6

An increase in size of population is likely to place extra pressure on public services, while an ageing population will increase demand for medical services and social services for the elderly.

Question 7

How are political priorities a reason for the changing size and composition of public expenditure?

Answer 7

A government in a developed country might place particular emphasis on improving the quality of health and education services, whereas the priority of a government in a developing country may be to improve infrastructure.

Question 8

How is the redistribution of income a reason for the changing size and composition of public expenditure?

Answer 8

Expenditure on those in relative poverty and on those with disabilities increased significantly in many countries before 2008 financial crisis. However, subsequent austerity measures aimed at reducing fiscal deficits have led to cuts in means-tested benefits such as tax credits and housing benefits, resulting in an increase in relative poverty.

Question 9

How is discretionary fiscal policy a reason for the changing size and composition of public expenditure?

Answer 9

2008 financial crisis led to resurrection of fiscal policy as a means of macroeconomic management in many countries, although often only temporarily.

Question 10

How is debt interest a reason for the changing size and composition of public expenditure?

Answer 10

The massive increase in fiscal deficits from 2008 is leading to sharp rises in national debts in many countries. In turn this results in higher interest payments so that less money available for public services.

Question 11

What is the significance of differing levels of public expenditure as a proportion of GDP on productivity and growth?

Answer 11

Public expenditure on areas such as education, infrastructure and health might cause increase in productivity and so result in rightward shift in long-run aggregate supply curve.
Increase in public spending use also cause increase in AD because it represents injection into circular flow and so will have multiplier effect on GDP. Therefore, higher public expenditure cause increase in economic growth.

Question 12

What is the significance of differing levels of public expenditure as a proportion of GDP on living standards?

Answer 12

Higher public expenditure as a proportion of GDP could result in an increase in living standards if, for example, much of it went to improvement of public services such as health and education, or to housing and infrastructure. However, this wouldn’t necessarily be the case if most went on defence or on interest payments on the national debt.

Question 13

What is the significance of differing levels of public expenditure as a proportion of GDP on resource crowding out?

Answer 13

Resource crowding out occurs when the economy is operating at full employment and an increase in public expenditure results in insufficient resources being available for the private sector

Question 14

What is the significance of differing levels of public expenditure as a proportion of GDP on financial crowding out?

Answer 14

Financial crowding out occurs when increased public expenditure or tax cuts are financed by increased public sector borrowing, so increasing the demand for loanable funds and driving up interest rates.

Question 15

What is the significance of differing levels of public expenditure as a proportion of GDP on the level of taxation?

Answer 15

Countries which have relatively low public expenditure as a proportion of GDP may also have relatively low levels of taxation. Some economists consider that this is desirable on basis that the state is less efficient at allocating resources than the free market; that it gives consumer more choice in spending decisions; and that growth tends to be higher in countries in which public expenditure doesn’t rise above 35% of GDP.

Question 16

What is the significance of differing levels of public expenditure as a proportion of GDP on equality?

Answer 16

In countries in which public expenditure is weighted towards means-tested benefits, social housing, education, health and subsidies on basic food items, income distribution likely to be more evenly distributed than in countries where public expenditure is weighted more to defence, universal benefits and prestigious investment projects.

Question 17

Define progressive tax.

Answer 17

A tax in which the proportion of income paid in tax rises as income increases. Therefore, there are likely to be several tax bands eg. 10%, 20% and 45%, so that as income increases beyond a certain limit any further income is taxed at a higher tax rate.

Question 18

Define proportional tax.

Answer 18

A tax in which the proportion of income laid in tax remains constant as income increases. For example some countries have a flat rate of income tax.

Question 19

Define regressive tax.

Answer 19

A tax in which the proportion of income paid in tax falls a income increases. Although governments don’t deliberately set regressive taxes, some taxes have a regressive effect, most typically those on expenditure.

Question 20

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

Answer 20

Increase in tax rates might have significant disincentive effects. For example, if basic rate of income tax were raised, there would be less incentive for the unemployed or those not currently participating in workforce to accept jobs. If higher rate of tax were increased, then people might be less willing to do overtime and more inclined to reduce their working hours, retire early or not seek promotion.

Question 21

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

Answer 21

Some economists consider that, if tax rates are increased too much, tax revenues may actually fall because the disincentives to work are so great. If higher rate of income tax increased, then there’s likely to be increase in tax avoidance and tax evasion and a rise in number of tax exiles. The laffer curve shows that, if the marginal tax rate is T then tax revenues will be maximised. However, increase in marginal tax rate to V will result in reduction in tax revenues from R to S.

Question 22

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

Answer 22

Most countries have a progressive income tax system. Consequently, income tax makes income distribution more equitable.

Question 23

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

Answer 23

Increase in income tax rates would cause fall in disposable income. In turn, this would cause a reduction in consumption and, therefore, fall in AD. May also be argued that the disincentive effects of higher income tax would cause leftwards shift in AS curve. Both of theses would, therefore, cause fall in real output and increase in unemployment.

Question 24

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

Answer 24

Fall in AD would tend to depress price level, although this may be offset slightly by a leftward shift in the AS curve resulting from an increased disincentive to work.

Question 25

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

Answer 25

Increase in income tax rates would cause fall in disposable income. In turn, would cause reduction in consumption and, therefore, fall in imports. This would result in improvement of trade balance.

Question 26

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

Answer 26

Higher income tax rates might act as deterrent to FDI because entrepreneurs and senior managers from global economy would face a decrease in their disposable incomes, assuming they’d be based in the country for which the FDI was destined.

Question 27

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

Answer 27

Indirect taxes have less obvious impact ‘on incentives to work than direct taxes. However, it’s possible that increase in indirect taxes will encourage people to work harder so they can maintain their current standard of living.

Question 28

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

Answer 28

If VAT or other indirect taxes increased then it’s likely that tax revenues will increase. However, there’s danger that placing excessively high taxes on specific products might result in fall in tax revenues.

Question 29

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

Answer 29

Many indirect taxes have regressive effect. This is particularly true of specific taxes Which are a set amount per unit. Consequently, indirect taxes usually make income distribution less equal.

Question 30

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

Answer 30

Increase in indirect tax rates would cause fall in real income. In turn, this would cause reduction in consumption and, therefore, fall in AD. Consequently, real output and employment would fall.

Question 31

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

Answer 31

Fall in AD would cause fall in price level. However, increase in indirect taxes will raise price of most goods and services. If workers and trade unions respond by demanding wage increases to compensate, then inflationary wage-price spiral could result.

Question 32

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

Answer 32

Increase in VAT or excise duties would have no impact on trade balance. However, increase in tariffs would reduce imports and so improve trade balance.

Question 33

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

Answer 33

Higher indirect tax rates might act as deterrent to FDI because prices of finished products higher, so reducing real income of consumers. However, if product primarily aimed at export market, this may not be significant consideration.

Question 34

Define automatic stabilisers.

Answer 34

Relate to the fact that some forms of government expenditure and revenues from some taxes change automatically in line with changes in GDP and the state of the economy. Stabilisers help to reduce fluctuations caused by trade cycle.

Question 35

Define discretionary fiscal policy.

Answer 35

Refers to deliberate changes in taxes and public expenditure designed to achieve the government’s macroeconomic objectives.

Question 36

Define fiscal deficit

Answer 36

Occurs when public expenditure is greater than tax revenues. Public sector net borrowing is the official term used to describe a fiscal deficit.

Question 37

Define national debt.

Answer 37

The cumulative total of past government borrowing. Also called public sector net debt.

Question 38

What is the structural fiscal deficit?

Answer 38

An estimate of how large the deficit would be if the economy were operating at a normal, sustainable level of employment and activity. However, it’s difficult to estimate precisely what this ‘normal’ level would be.

Question 39

What is the cyclical fiscal deficit?

Answer 39

This is a temporary deficit, which is related to the business cycle. A deficit might occur during recessions, when governments increase spending to stimulate the economy.

Question 40

How does falling GDP influence the size of fiscal deficits?

Answer 40

During recession, real GDP will be falling. In turn, public expenditure on automatic stabilisers be rising while tax revenues be falling. Consequently fiscal deficits increasing.

Question 41

How does rising GDPinfluence the size of fiscal deficit?

Answer 41

During period of rising real GDP, public expenditure on automatic stabilisers be falling while tax revenues rising so fiscal deficits be decreasing. However, demand for many government-provided services rises more than proportionately because demand for them is income elastic, putting upward pressure on public expenditure.

Question 42

How does the size and age of the population influence the size of fiscal deficits?

Answer 42

Increase in size of population likely to mean increase in public expenditure on health, education and infrastructure. Ageing pop lead to increase in dependency ratio. Implies lower tax revenues from workers combined with higher expenditure on pensions to retired people, so causing increase in fiscal deficits.

Question 43

How does fiscal deficits or fiscal surpluses influence the size of national debts?

Answer 43

If country had persistent fiscal deficits then the national debt would be increasing, whereas if there were persistent surpluses then the size of the national debt likely to fall.

Question 44

How is the size of the national debt affected by fiscal deficits might be caused by recessions?

Answer 44

Fiscal deficits might be caused by recessions, which would result in automatic stabilisers. Further, fiscal deficits might arise because of ageing populations, which result in increased expenditure on state pensions, healthcare and social care.

Question 45

What is the significance of the size of fiscal deficits and national debts in relation to opportunity cost?

Answer 45

There is opportunity cost for further generations. Interest payments on the national debt mean that less money will be available for public services.

Question 46

What is the significance of the size of fiscal deficits and national debts in relation to crowding out.

Answer 46

If the increasing size of national debt is an indication of an increase in the size of the public sector, then resource or financial crowding out could occur.

Question 47

What is the significance of the size of fiscal deficits and national debts in relation to danger of inflation?

Answer 47

If the rising national debt has been caused by successive fiscal deficits, then there is a danger that inflationary pressures will develop, since injections will be rising relative to leakages.

Question 48

What is the impact of measures to reduce fiscal deficits and national debts?

Answer 48

Government might increase taxes and/or reduce public expenditure. However, there’s danger that such austerity measures might make situation worse if fall in AD caused by such measures causes a significant fall in real output. Higher unemployment associated with fall in real output would cause tax revenues to fall, while public expenditure on means-tested benefits would increase.

Question 49

What is the impact of measures to reduce poverty?

Answer 49

• increase in means-tested benefits
• increase in the progressiveness of the tax system. Eg by increasing the rates of tax on higher incomes
• increase in national minimum wage
• subsidised housing for the very poor
• increased support for children from low income families.

Question 50

What is the impact of changes in interest rates ?

Answer 50

Used to influence cost of money and, in many countries, to achieve inflation target set by government. Use of interest rates has various disadvantages, eg. Full effect of an increase in rate of interest takes 18-24 months to work through economy; business costs rise; exchange rate of currency may increase, making country’s goods less price competitive; and if confidence high, businesses + consumers may continue to borrow + spend.

Question 51

What is the impact of changes in the money supply?

Answer 51

Have been achieved through quantitive easing, this has the effect of increasing bank deposits, thereby giving banks the ability to lend more easily to private and business customers. Some argue policy unlikely to be effective if banks are risk averse + remain unwilling to lend unless loan risk free. Also danger that increased supply of money in economy could unleash a serious bout of inflation. Increase in money supply could also cause depreciation in exchange rate which would result in increase in net exports and so increase AD.

Question 52

Define quantitive easing.

Answer 52

Relates to action of the central bank in buying up government bonds and corporate bonds from the commercial banks and other financial institutions.

Question 53

What is the quantity theory of money?

Answer 53

States that there is a direct and proportionate relationship between changes in the money supply and the price level.

Question 54

What is the impact of measures to increase international competitiveness?

Answer 54

• firms can improves competitiveness of products by investing in new capital equipment with aim of raising productivity. Could improve design + quality of products through R+D. Governments can improve international competitiveness through supply-side policies:
• measures to increase occupational mobility, such as education + training schemes
• macroeconomic stability
• public sector reform aimed at reducing red tape
• government expenditure to improve infrastructure
• privatisation
• incentives for investment, such as tax breaks if companies use profits for investment rather than distribution to shareholders.

Question 55

What are the characteristics of external shocks?

Answer 55

• sudden increase in oil prices
• a severe weather event such as tsunami which has implications for global economy or a long-lasting drought affecting crops across the world
• major financial crisis which has repercussions for the global banking system
• wars and civil unrest which disrupt transport links
• cyber-attacks which have implications for communications globally.

Question 56

What are the policy responses to external shocks?

Answer 56

Policy response will vary according to situation and priorities of policy makers. In 2008 financial crisis, there was a coordinated monetary policy response, which meant that many central banks slashed their base interest rates. In the UK base rate was cut to 0.5% in March 2009. In addition, many governments adopted a fiscal stimulus involving cuts in taxes and increase in public expenditure. These measures were designed to prevent a 1930s style depression.

Question 57

Explain the regulation of transfer pricing as a measure to control global companies or TNCs operations.

Answer 57

Global companies may own various subsidiary companies which adopt pricing policies for transactions between these subsidiaries that are aimed at minimising tax liability. They do this by ensuring most profit made in countries in which corporation tax and other taxes are lowest. In practice it’s very difficult for an individual government to regulate transfer pricing without global agreements.

Question 58

Explain limits to government ability to control global companies.

Answer 58

Many TNCs are ‘footloose’, I.e. they can move easily from one country to another to take advantage of lower operating costs. Further, their investment decisions may have a significant impact on the economy of a country. Consequently, it’s very difficult for any individual government to control these global companies.

Question 59

How is inaccurate information a problem facing policy makers when applying policies?

Answer 59

Information regarding GDP, the balance of payments on current account and retail sales is notoriously inaccurate and subject to subsequent revisions. This can make it very difficult for policy makers to devise appropriate policies, given that they may be working with data which don’t accurately reflect state of economy.

Question 60

How are risks and uncertainties a problem facing policy makers when applying policies?

Answer 60

There’s considerable uncertainty about the possible long-run impact of quantitive easing in the eurozone. Some monetarist economists argue that it could risk unleashing a massive bout of inflation (because money supply being increased), while others consider that previous experience in other countries suggests that it will have little effect on economy.

Question 61

How is the inability to control external shocks a problem facing policy makers when applying policies?

Answer 61

Policy makers usually unable to predict external shocks or their potential consequences. As a result, it may be difficult for them to formulate appropriate policy responses. Such external shocks could include a sudden and dramatic increase in oil and commodity prices; the exit of a country from the eurozone; or political conflict.

Question 62

What is the laffer curve?

Answer 62

The Laffer Curve is a (supposed) relationship between economic activity and the rate of taxation which suggests there is an optimum tax rate which maximises total tax revenue.
The Laffer Curve concept infers that a tax rate cut could lead to an increase in tax revenue, or a decrease in tax revenue, depending whether you have already passed the ‘optimal tax rate’