The Role Of The State In The Macroeconomy Flashcards
Tell me about the key elements of public finance
The three main components are public expenditure, taxation and public sector borrowing
Tell me the aspects of public finance: public expenditure
Current expenditure, capital expenditure, transfer payments
Tell me the aspects of public finance: taxation
Direct and indirect
Tell me about the aspect of public finance: public sector borrowing
Fiscal (budget deficit)
National debt
Expenditure by central and local government can be categorised into 3 distinct types:
Capital expenditure, current expenditure and transfer payments
What does capital expenditure relate to
This relates to expenditure on long term investment projects such as new hospitals and roads. It is often referred to as public sector investment.
What’s the objective of public expenditure
The objectives of public expenditure include the provision of public goods; defence and internal security; the provision of goods and services which yield external benefits and/or where there may be information gaps and asymmetric information, eg health and education; the redistribution of income; and expenditure to deal with external costs such as pollution and waste.
What’s current expenditure
This is day to day expenditure on goods and services, eg salaries of teachers and nurses and drugs used by the NHS.
What are transfer payments
These are payments made by the state (from tax revenues) to individuals in the form of benefits for which there is no production in return. Examples include child benefit, state pensions and the Jobseeker’s Allowance.
Transfer payments involve redistribution of income. Therefore they are not relevant to the calculation of a country’s national income.
What are the factors influencing the size and pattern of public expenditure:
The level of GDP
The size and age distribution of the population
Political priorities
Redistribution of income
Discretionary fiscal policy
Debt interest
Tell me about the reason for the changing size and composition of public expenditure: the level of GDP
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.
Tell me about the reason for the changing size and composition of public expenditure: the size and age distribution of the population
An increase in the size of the population (eg through immigrations) 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.
Tell me about the reason for the changing size and composition of public expenditure: political priorities
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.
Tell me about the reason for the changing size and composition of public expenditure: redistribution of income
Expenditure on those in relative poverty and on those with disabilities increased significantly in many countries before the 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.
Tell me about the reason for the changing size and composition of public expenditure: discretionary fiscal policy
The 2008 financial crisis led to the resurrection of fiscal policy as a means of macroeconomic management in many countries, although often only temporarily.
Tell me about the reason for the changing size and composition of public expenditure: debt interest
The massive increase in fiscal deficits from 2008 is leading to sharp rises in national debts in many countries. For example, Greece’s national debt as a proportion of GDP increased from over 125% in 2009 to 180% in 2015. In turn, this results in higher interest payments so that less money is available for public services.
What may affect the significance of differing levels of public expenditure as a proportion of GDP
Productivity and growth
Living standards
Crowding out
Level of taxation
Equality
How could productivity and growth be affected by the differing levels of public expenditure as a proportion of GDP, what would result from this?
Public expenditure on areas such as education, infrastructure and health might cause an increase in productivity and so result in a rightward shift in long run aggregate supply curve.
An increase in public expenditure will also cause an increase in aggregate demand because it represents an injection into the circular flow and so will have a multiplier effect on GDP. Therefore, higher public expenditure would cause an increase in economic growth.
How could living standards be affected by the differing levels of public expenditure as a proportion of GDP, what would result from this?
Higher public expenditure as a proportion of GDP could result in an increase in living standards if, for example, much of it went to the improvement of public services such as health and education, or to housing and infrastructure. However, this would not necessarily be the case if most went on defence or on interest payments on the national debt.
How could crowding out be affected by the differing levels of public expenditure as a proportion of GDP, what would result from this?
Increased public expenditure could cause crowding out. This might take two forms: resource and financial
What’s resource crowding out
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.
What’s financial crowding out
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.
How could the level of taxation be affected by the differing levels of public expenditure as a proportion of GDP, what would result from this?
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 the basis that the state is less efficient at allocating resources than the free market; that it gives consumers more choice in spending decisions; and that growth tends to be higher in countries in which public expenditure does not rise above 35% of GDP. However, Scandinavian countries have high living standards despite public expenditure being a relatively high proportion of GDP.
How could equality be affected by the differing levels of public expenditure as a proportion of GDP, what would result from this?
The impact of different levels of public expenditure on equality will also depend on the composition of that public expenditure. In countries in which public expenditure is weighted towards means tested benefits, social housing, education, health and subsidies on basic food items, income distribution is likely to be more evenly distributed than in countries where public expenditure is weighted more to defence, universal benefits and prestigious investment projects.
What are the three broad categories of tax
Progressive, proportional and regressive.
What’s progressive tax
This is 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.
What’s proportional tax
This is a tax in which the proportion of income paid in tax remains constant as income increases. For example, some countries eg Latvia, Estonia and Hong Kong have a flat rate of income tax.
What are regressive taxes
This is a tax in which the proportion of income paid in tax falls as income increases. Although governments do not deliberately set regressive taxes, some taxes have a regressive effect, most typically those on expenditure.
What do direct taxes tax
Income and wealth
What do indirect taxes tax
Expenditure
For direct taxes, where does the incidence of the tax fall, ie, who bears the final burden of paying the tax?
A direct tax is paid by a person on whom it is legally imposed. Therefore, the burden of the tax cannot be shifted to any other person.
For indirect taxes, where does the incidence of the tax fall, I.e who bears the final burden of paying the tax
The burden of an indirect tax may be shifted in whole or in part from the person on whom it is imposed to a third party. For example, a business may be legally responsible for paying VAT but part or all of the burden may be passed on to consumers.
Tell me examples of direct taxes
Income tax, capital gains tax, corporation tax
Tell me examples of indirect taxes
Value added tax, excise duties, tariffs.
List me the economic effects of changes in tax rates (indirect and direct)
Incentives to work
Tax revenues
Income distribution
Real output and employment
The price level
The trade balance
FDI flows
Tell me how changes in direct tax rates would effect: incentives to work
An increase in tax rates might have significant disincentive effects. For example, if the basic rate of income tax were raised, there would be less incentive for the unemployed or those not currently participating in the workforce to accept jobs. Similarly, if the 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.
Tell me how changes in direct tax rates would effect: tax revenues
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 the higher rate of income tax is increased, then there is likely to be an increase in tax avoidance (legal) and tax evasion (illegal) and a rise in the number of tax exiles. The Laffer curve shows this effect.
What does the Laffer curve look like
Tax revenue on y axis Tax rate (% ) on x axis
It’s like an n shape
If tax rates increase too much tax revenues will start to fall.
Tell me how changes in direct tax rates would effect: income distribution
Most countries have a progressive income tax system so that the proportion of income paid in tax increases as income increases. Consequently, income tax makes income distribution more equitable.
Tell me how changes in direct tax rates would effect: real output and employment
An increase in income tax rates would cause a fall in disposable income. In turn, this would cause a reduction in consumption and, therefore, a fall in aggregate demand. It may also be argued that the disincentive effects of higher income tax would cause a leftward shift in the aggregate supply curve. Both of these would, therefore, cause a fall in real output and an increase in unemployment.
An increase in income tax rates would cause a fall in disposable income. In turn, this would cause a decrease in consumption and, therefore, in aggregate demand. Consequently, the aggregate demand curve would shift to the left and real output would fall. The disincentive effect of higher income tax rates could cause the aggregate supply curve to shift to the left, so real output would ultimately decrease.
^ can be explained either way
Tell me how changes in direct tax rates would effect: the price level
The fall in aggregate demand (described before) would tend to depress the price level, although this may be offset slightly by a leftward shift in the aggregate supply curve resulting from an increased disincentive to work.
Tell me how changes in direct tax rates would effect: the trade balance
An increase in income tax rates would cause a fall in disposable income. In turn, this would cause a reduction in consumption and, therefore, a fall in imports. This would result in an improvement in the trade balance.
Tell me how changes in direct tax rates would effect: FDI flows
Higher income tax rates might act as a deterrent to FDI because entrepreneurs and senior managers from the global company would face a decrease in their disposable incomes, assuming they would be based in the country for which the FDI is destined.
Tell me how changes in indirect tax rates would effect: incentives to work
Indirect taxes have a less obvious impact on incentives to work than direct taxes. However, it is possible that an increase in indirect taxes will encourage people to work harder so that they can maintain their current standard of living.
Tell me how changes in indirect tax rates would effect: tax revenues
If VAT or other indirect taxes are increased then it is likely that tax revenues will increase. However, there is a danger that placing excessively high taxes on specific products might result in a fall in tax revenues. For example, high taxes on whisky in the UK resulted in less tax revenue, while high taxes on tobacco resulted in a considerable increase in smuggling.
Tell me how changes in indirect tax rates would affect: income distribution
Many indirect taxes have a regressive effect, ie people on low incomes pay a higher proportion of their incomes in indirect taxes than those on higher incomes. This is particularly true of specific taxes which are a set amount per unit. Consequently, indirect taxes usually make income distribution less equal.
Tell me how changes in indirect tax rates would affect: real output and employment
An increase in indirect tax rates would cause a fall in real income. In turn, this would cause a reduction in consumption and, therefore, a fall in aggregate demand. Consequently, real output and employment would fall.
Tell me how changes in indirect tax rates would affect: the price level
The fall in aggregate demand as a result of increased indirect tax rates would cause a fall in the price level. However, an increase in indirect taxes will raise the price of most goods and services. If workers and trade unions respond by demanding wage increases to compensate for price rises, then an inflationary wage price spiral could result.
Tell me how changes in indirect tax rates would affect: the trade balance
An increase in VAT or excise duties would have no impact on the trade balance. However, an increase in tariffs would reduce imports and so result in an improvement in the trade balance.
Tell me how changes in indirect tax rates would affect: FDI flows
Higher indirect tax rates might act as a deterrent to FDI because prices of finished products would be higher, so reducing the real income of consumers. However, if the product is primarily aimed at the export market, this may not be a significant consideration.
Tell me two other effects of an increase in indirect tax rates
An increase in indirect tax on a product will cause a leftward shift in the supply curve. The incidence of the tax on consumers and producers depends on the price elasticity of demand.
The price of the product will increase above marginal cost, so resulting in allocative inefficiency, unless external costs are associated with the production of the product.
What does fiscal policy refer to
Fiscal policy refers to the use of government expenditure and taxation in order to influence the level of economic activity in a country. From the 1980’s until 2008, it’s primary role was to ensure stable public finances. However, since 2008 it has once again assumed a role in macroeconomic management not only in the UK but also in China, the USA and a variety of other countries.
Key features of fiscal policy include:
Automatic stabilisers
Discretionary fiscal policy
What do automatic stabilisers relate to
They 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. These stabilisers help to reduce fluctuations caused by the trade/balance cycle. Examples include progressive taxation and welfare payments such as unemployment pay and various means tested benefits eg pension credits for elderly people living on low incomes.
What does discretionary fiscal policy refer to
Refers to deliberate changes in taxes and public expenditure designed to achieve the governments macroeconomic objectives. For example, the global economic crisis has led many countries to introduce a ‘fiscal stimulus’ to prevent severe recession. Typically, this has included: increases in public expenditure on infrastructure (roads and bridges in the USA); green technology and targeted subsidies to distressed industries (eg the car industry); and tax cuts.
What’s the fiscal (budget) deficit
This occurs when public expenditure (both current and capital) is greater than tax revenues. Public sector net borrowing is the official term used to describe a fiscal deficit.
What’s the official term for a fiscal deficit
Public sector net borrowing
What is the national debt also referred to as
Public sector net debt
What is national debt
The cumulative total of past government borrowing.
What’s the ‘structural’ fiscal deficit
The structural fiscal deficit is 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 is difficult to estimate precisely what this normal level would be.
What’s the ‘cyclical’ fiscal deficit
The part of the fiscal deficit associated with recession.
List me factors that influence the side and pattern of public expenditure and so fiscal deficit
GDP
The size and age distribution of the population
Discretionary fiscal policy
Debt interest
Tell me how GDP influences the size of fiscal deficits
During a recession, real GDP will be falling. In turn, public expenditure on automatic stabilisers will be rising while tax revenues will be falling. Consequently, fiscal deficits will be increasing. In contrast, during a period of rising real GDP, public expenditure on automatic stabilisers will be falling while tax revenues will be rising and so fiscal deficits will be increasing. However, the demand for many government provided services such as health and education rises more than proportionately because demand for them is income elastic, putting upward pressure on public expenditure.
Tell me how the size and age distribution of the population influences the size of fiscal deficits
An increase in the size of the population is likely to mean an increase in public expenditure on health, education and infrastructure. An ageing population will lead to an increase in the dependency ratio, ie fewer workers per pensioner. This implies lower tax revenue from workers combined with higher expenditure on pensions to retire people, so causing an increase in fiscal deficits.
Tell me how discretionary fiscal policy influences the size of fiscal deficits
The 2008 financial crisis led to the resurrection of fiscal policy as a means of managing the economy in several countries. In July 2015, South Korea pumped $10 billion into its economy to offset falling exports and an outbreak of Middle East respiratory syndrome (MERS)
Tell me how debt interest influences the size of fiscal deficits
The massive increase in fiscal deficits from 2008 in the uk and many developed economies led to sharp rises in these countries national debts. In turn, this is resulting in higher interest payments on the national debt.
Tell me the factors influencing the size of national debts
The national debt of a country would be affected by the following:
Fiscal deficits or fiscal surpluses
Fiscal deficits might be caused by recessions
Tell me how fiscal deficits or fiscal surpluses can influence the size of national debts
If a 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 is likely to fall.
Tell me how the fact that fiscal deficits might be caused by recession is a factor influencing the size of national debts
Fiscal deficits might be caused by recessions, which would result in automatic stabilisers. Ie government expenditure on means tested benefits would increase, whereas tax receipts would fall. Further, fiscal deficits might arise because of ageing populations, which result in increased expenditure on state pensions, healthcare and social care.
How can a large national debt be justified
Some argue that, if the money is being used to finance improvements in infrastructure and other capital products, then a large national debt might be justified because it would be increasing a country’s future productive potential, so making it easier to repay in the future.
List me problems that may arise with large national debts
Opportunity cost
Crowding out
Danger of inflation
How is opportunity cost an issue of national debts
There is an opportunity cost for future generations. Interest payments on the national debt mean that less money will be available for public services.
How is crowding out an issue of large national debts
If the increasing size of the national debt is an indication of an increase in the size of the public sector, then resource or financial crowding out might occur.
How is the danger of inflation an issue with large national debts
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.
In the long run, future governments might be forced to raise taxes and/or cut public expenditure so that the national debt can be reduced.
Tell me about general measures to reduce fiscal deficits and national debts
To reduce fiscal deficits and national debts a government might increase taxes and/or reduce public expenditure. However, there is a danger that such austerity measures might make the situation worse if the fall in aggregate demand caused by such measures causes a significant fall in real output. The higher unemployment associated with a fall in real output would cause tax revenues to fall, while expenditure on means tested benefits would increase.
Tell me about measures to reduce poverty and inequality
Governments could take a variety of measures to reduce poverty and inequality, including:
Increase in means tested benefits
Increase in the progressiveness of the tax system, eg by increasing the rates of tax on higher incomes and/or by increasing the number of tax rates.
Increase in the national minimum wage
Subsidised housing for the very poor
Increased support for children from low income families, eg free childcare for the under 5s; pupil premium, i.e extra finance to schools based on the number of children from poor backgrounds.
Changes in interest rates and the supply of money are part of….
Monetary policy
Tell me what changing interest rates might achieve
Interest rate changes are used to influence the cost of money and, in many countries, to achieve the inflation target set by the government. For example, if the inflation rate is predicted to rise above its target, then the central bank would increase the base interest rate.
However, the use of interest rates has various disadvantages, eg the full effect of an increase in the rate of interest takes between 18 and 24 months to work through the economy; business costs rise; the exchange rate of the currency may increase, making a country’s goods less price competitive; and if confidence is high, businesses and consumers may continue to borrow and spend.
Tell me how changes in the money supply might be achieved
In recent years changes in the money supply have been achieved through quantitative easing. This relates to the action of the central bank in buying up government bonds and corporate bonds from the commercial banks and other financial institutions. This has the effect of increasing bank deposits, thereby giving banks the ability to lend more easily to private and business customers.
Why may changes in the money supply via quantitative easing be ineffective
Some argue that this policy is unlikely to be effective if the banks are risk averse and remain unwilling to lend unless the loan is risk free. There is also the danger that the increased supply of money in the economy could unleash a serious bout of inflation (based on the monetarist belief in the quantity theory of money). An increase in the money supply could also cause a depreciation in the exchange rate which, in turn, would result in an increase in net exports and so increase aggregate demand.
Define quantity theory of money
States that there is a direct and proportionate relationship between changes in the money supply and the price level.
Tell me about general measures to increase international competitiveness
Firms can improve the competitiveness of their products by investing in new capital equipment with the aim of raising productivity. They could improve the design and quality of their products through research and development. Governments can try to improve international competitiveness through a variety of supplyside policies.
Tell me some supply side policies to increase international competitiveness
Measures to increase occupational mobility, such as education and training schemes.
Macroeconomic stability, eg a low and stable inflation rate, sound public finances, a relatively stable exchange rate; steady economic growth.
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 for distribution to shareholders.
How may international agreements prevent countries increasing international competitiveness
It should be noted that international agreements are likely to prevent individual countries increasing their competitiveness by raising tariffs. For example, the UK cannot simply introduce tariffs on goods from other EU countries because of its legal obligations as a member of the EU. Similarly, most countries are members of the World Trade Organisation (WTO), whose rules prevent a country unilaterally imposing protectionist measures unless there is justifiable case.
Can the UK change its exchange rate
It is not correct to suggest that ‘the UK government could devalue its currency’ because the pound is a floating currency. Also, since the Bank of England is independent, the government cannot directly engineer a depreciation in the exchange rate of the pound through a reduction in interest rates because control over interest rates is no longer in its hands.
External shocks to the global economy may take a variety of forms. Examples include:
A sudden increase in oil prices
A severe weather event such as a tsunami which has implications for the global economy or a long lasting drought affecting crops across the world
A 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
How can policy responses vary
The policy response will vary according to the situation and priorities of policy makers. It should be remembered from theme 1 that economists are unable to conduct laboratory experiments, so policies used at one time in one set of circumstances may have a different impact than exactly the same policy measures used at a different time.
In the 2008 financial crisis, there was a coordinated monetary policy response, which meant that many central banks slashed their base interest rates. In the UK, the base rate was cut to 0.5% in March 2009. In addition, many governments adopted a fiscal stimulus involving cuts in taxes and increases in public expenditure. These measures were designed to prevent a 1930s style depression.
Tell me two measures to control global companies’ (transnationals’) operations
The regulation of transfer pricing
Limits to government ability to control global companies
Tell me about the regulation of transfer pricing as a measure to control global companies (transnational) operations
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 that the most profit is made in the countries in which corporation tax and other taxes are lowest. In practice, it is very difficult for an individual government to regulate transfer pricing without global agreements.
Tell me about the limits to government ability to control global companies
Many transnational (global) companies are ‘footloose’, ie they can move easily from one country to another to take advantage of lower operating costs, eg wages, corporation tax, labour and environmental regulations. Further, their investment decisions may have a significant impact on the economy of a country. Consequently, it is very difficult for any individual government to control these global companies.
Tell me three problems facing policy makers when applying policies
Inaccurate information
Risks and uncertainties
Inability to control external shocks
Tell me how inaccurate information is a problem facing policy makers when applying policies
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 do not accurately reflect the state of the economy.
Tell me how risks and uncertainties is a problem facing policy makers when applying policies
Some commentators consider that the financial crisis has had long term repercussions for savings and investment. Such uncertainties make it more difficult for policy makers in formulating economic policy.
Similarly, there is considerable uncertainty about the possible long run impact of quantitative easing in the eurozone. Some monetarist economists argue that it could risk unleashing a massive bout of inflation (because money supply is being increased), while others consider that previous experience in other countries suggests that it will have little effect on the economy.
Tell me how the inability to control external shocks is a problem facing policy makers when applying policies
Policy makers are 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.
The public sector plays a significant role in the macroeconomy in which type of countries
In many developed economies.
What was the UK public expenditure in 2014/15 as a % of GDP
45%
What are the three distinct forms of public expenditure
Capital (on long term projects such as roads) Current (day to day expenditure) Transfer payments (expenditure for which there is no production in return)
What are the three different categories of taxes
Progressive
Proportional
Regressive
What are the two different types of tax
Direct (on income and wealth)
Indirect (on expenditure)
The relationship between public expenditure and tax revenues is expressed in terms of…
A fiscal surplus or fiscal deficit
What does fiscal policy involve
Fiscal policy involves the use of changes in public expenditure and taxation to influence the level of economy activity
What does monetary policy involve
Involved the use of changes in interest rates and money supply to influence the levels of economic activity.
What do supply side policies involve
Designed to influence the supply side of the economy through increasing competition and incentives aimed at increasing productivity.
What are the two key characteristics of public goods
Non excludability, ie it is impossible to prevent people from consuming a product once it is provided
Non rivalry ie consumption by one person does not limit consumption by others
How would an increase in income tax affect the opportunity cost of work
When income tax rises, people will substitute away from work to leisure because the opportunity cost of work is now lower, ie the loss of earnings from work is now lower (this is called the substitution effect)
How would an increase in income tax rates affect the value of the multiplier
It would cause the value of the multiplier to fall because leakages would have risen.
How would public finances be affected by a recession
It is likely that public finances would deteriorate: automatic stabilisers mean that government expenditure on social benefits for the unemployed would increase, while tax revenues would fall (not only from incomes but also from a reduction in revenues from expenditure taxes eg VAT, and from corporation tax)
What factors might limit the effectiveness of monetary policy
Banks might be charging considerably higher interest rates on loans from the Bank of England’s base rate. Further, banks may be unwilling to lend if they consider the risks of non repayment to be too great. A lack of confidence might mean that firms and consumers are unwilling to borrow.
