theme 4- 4.5 the role of the state in the macroeconomy Flashcards
3 aspects of public finance
- public expenditure (state spending)
- taxation
- fiscal deficits (public sector borrowing) and national (public sector) debt
public expenditure definition
expenditure by central govt, local authorities and public sector organisations
3 broad elements of public expenditure
- capital expenditure- long term investment expenditure on capital projects e.g. HS2
- current expenditure- govt’s day to day expenditure on goods and services e.g. wages and salaries of civil servants
- transfer payments- made by the state to individuals without any exchange for goods and services used to redistribute income e.g. state pensions
factors affecting the size of public expenditure
- amount of GDP (high = more tax revenue for more expenditure
- demand for public services (= income elastic)
- size and age distribution of the pop (more people increases demand for public expenditure)
- state of the economy (recession = rise in spending due to automatic stabilisers)
- interest on national debt
- rate of inflation
- political priorities (e.g. may wish to improve public services)
objectives of public expenditure
- as a means of managing the economy (part of fiscal policy)
- provision of goods yielding external benefits or where there are info gaps
- to deal with external costs from production and consumption
- redistribution of income
- defence and internal security
- provision of public goods
reasons why social protection, heath and education spending has increased in its share of total govt expenditure in recent yrs
- increased payments for housing benefits as a result of rising rents
- increased expenditure on tax credits
- the ageing pop
- an increase in the number of children of school age
- 2020 COVID pandemic e.g. furlough scheme paid 80% of the wages of 8 million workers
the significance of differing levels of public expenditure as a proportion of GDP- productivity and growth
if a country’s public expenditure is a relatively high portion of GDP its productivity and economic growth rates may be relatively low as there is an absence of the profit motive and competition in the public sector
the significance of differing levels of public expenditure as a proportion of GDP- living standards
impact depends on the composition of public expenditure e.g. more on health vs more on defence
the significance of differing levels of public expenditure as a proportion of GDP- crowding out
structural deficits could imply that the size of the public sector is increasing which could cause resource or financial crowding out
resource crowding out definition
occurs when the economy is operating at full employment and the expansion of the public sector means there is a shortage of resources in the private sector
financial crowding out definition
occurs when the expansion of the state sector is financed through increased govt borrowing
-> causes an increased demand for loanable funds, which drives up interest rates and crowds out private sector investment
the significance of differing levels of public expenditure as a proportion of GDP- level of taxation
if public expenditure is a high proportion of GDP then it is likely taxation will also be a high proportion
the significance of differing levels of public expenditure as a proportion of GDP- equality
research suggests that higher public spending is associated with greater equality e.g. Sweden
BUT = not always true as some countries have both high public spending and a significant degree of inequality
objectives of taxation
- to raise revenue to finance public expenditure
- defence and internal security
- to redistribute income
- to internalise external costs
- to influence the pattern of expenditure
- as a means of managing the economy (fiscal policy)
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
direct taxes definition
taxes on income and wealth
indirect taxes definition
taxes on expenditure
examples of direct taxes UK
income tax- progressive + levied at 20%, 40%, 45% (biggest proportion of tax revenue)
corporation tax- proportional on company profits- 19% in 2020
capital gains tax- tax on the increase in value of assets between the time they are bought and when they are sole e.g. on shares
examples of indirect taxes UK
VAT- ad valorem tax (% of £ of product)
excise duties- usually specific taxes e.g. a set amount per unit of product
tariffs- taxes on imports
effects of changes in direct tax rates- incentive to work
high income tax = disincentive to work as:
- unemployed and economically inactive would be less willing to take jobs
- workers currently employed may be less willing to do overtime, more likely to reduce working hrs, more likely to retire early, less willing to apply for a promotion
effects of changes in direct tax rates- tax revenues
increases in tax rates = cause tax revenues to fall
explained through Laffer curve
tax revenue increases up to a point before it falls
several reasons:
- increased disincentives to work
- an increase in tax avoidance
- increase in tax evasion
- rise in number of tax exiles
effects of changes in direct tax rates- income distribution
increasing income tax rates = make the tax system more progressive, making income distribution more equitable
effects of changes in direct tax rates- real output and employment
higher rates of income tax would cause a fall in disposable income, consumption and AD
may also cause a fall in AS
-> fall in real output and employment
effects of changes in direct tax rates- the price level
fall in AD following higher income tax rates would cause a fall in the price level
may be partially offset by any fall in AS but the impact of the leftward shift of the AD curve is likely to be more significant
effects of changes in direct tax rates- the trade balance
increase in income tax rates will reduce disposable income
-> cause a fall in consumption, resulting in a decrease in imports
-> improvements to a deficit in the trade balance
effects of changes in direct tax rates- FDI flows
increase in direct taxes is likely to deter inward FDI
increase in income tax rates is also likely to deter inward FDI as disposable income would fall, causing a decrease in consumption
effects of changes in indirect tax rates- incentives to work
increase in VAT rate may cause an incentive to work more as workers will try to maintain living standards by working longer hrs
effects of changes in indirect tax rates- tax revenues
if VAT is higher then tax revenues will increase as it is applied to most goods and services
effects of changes in indirect tax rates- income distribution
ONS has found that the impact of VAT is broadly regressive so an increase of VAT would make income distribution less even
effects of changes in indirect tax rates- real output and employment
higher VAT -> fall in real income -> fall in consumption and AD -> reduction in real output and employment
for businesses higher VAT would increase costs causing a fall in AS -> reduction in real output and employment
effects of changes in indirect tax rates- the price level
short run effect of an increase in indirect taxes is to increase the price level
BUT taxes are a leakage of the circular flow, so higher indirect taxes will cause a decrease in AD and therefore fall in the price level in the long term
effects of changes in indirect tax rates- the trade balance
reductions and abolition of tariffs if price elastic will increase the value of imports and AD will fall
effects of changes in indirect tax rates- FDI flows
if a country significantly raises indirect taxes, global companies may be deterred from investing in that country as the tax rise may lead to a fall in domestic demand for the country’s goods
automatic stabilisers definition
changes in govt spending or in tax revenue that occur automatically as GDP rises or falls, without deliberate govt action
examples of automatic stabilisers
in a recession, unemployment increases, so the govt spends more on benefits (this is automatic)
tax revenues will fall as less people are working so revenue from income tax will be less, VAT receipts = lower as people spend less, + less corp tax as company profits are lower
discretionary fiscal policy definition
occurs when the govt intervenes in the economy by changing taxes or govt expenditure
this influences economic activity
distinction between fiscal deficit and national debt
a fiscal deficit implies that public expenditure is greater than tax revenues
national debt is the cumulative total of outstanding past govt borrowing owed to holders of govt bonds
distinction between structural and cyclical deficits
the govt’s finances change in line with the trade cycle i.e. expected to deteriorate in a recession -> referred to as cyclical deficits and not seen as a problem as expected to rectify themselves in times of prosperity
structural deficit remains when an economy is operating at a normal sustainable level
factors influencing the size of fiscal deficits
- state of the economy
- political priorities
- demographic factors
- external shocks
- efficiency of tax collection
- amount of tax evasion and avoidance
in a particular yr, deficit may be reduced due to one-off factors e.g. privatisations
factors influencing the size of national debts
- fiscal deficits/surpluses
- wars
- economic crises e.g. 2008 GFC, 2020 COVID pandemic)
- measures adopted by the govt which create immediate and long term obligations
meaning of the size of fiscal deficits
fiscal deficits as a proportion of GDP is more significant that the absolute size of the deficit as it gives a better indication of the ability of the country to finance the debt and repay it
possible effects of a persistent structural deficit and increasing national debt
- loss of the country’s AAA rating, which could mean higher interest rates when it borrows
- crowding out
- inflation as net injections will increase
- a fall in confidence, leading to a fall in FDI
- rising interest payments on the national debt
- places an increased burden on future generations
reason why structural deficits and rising national debt may not be seen as a problem
if it was caused by significant investment on infrastructure and/or on education and health as such expenditure would increase long run aggregate supply
fiscal and monetary policy distinction
changes in fiscal policy involve changes in public expenditure and taxation whereas monetary involves changes in interest rates and the money supply
BUT distinction is getting blurred due to quantitative easing
exchange rate policy
involves deliberate manipulation of the exchange rate in order to influence the competitiveness of a country’s goods and so effect its level of economic activity
supply-side policies
involve measures to increase efficiency, productivity and international competitiveness
direct controls by the government in macroeconomic policy
used to control prices or wages in an economy
e.g. used to control energy prices in the UK and some food prices in Venezuela
measures to reduce a fiscal deficit
- reduce public expenditure and/or increase taxes
- implement policies to increase economic growth- some economists argue this will reduce fiscal deficit as a proportion of GDP
measures to reduce poverty and inequality
- improve quality of education and training for the poor
- make the tax system more progressive
- increase inheritance taxes
- increase the number and range of means-tested benefits
- implement measures to decrease unemployment
- introduce/increase national minimum/living wage
quantitative easing impacts
designed to make it easier and cheaper for businesses to borrow from banks
BUT -> may cause inflation and a depreciation in the exchange rate
Modern Monetary Theory (MMT) and govt debt
suggests that an economy with its own currency can accumulate as much debt as it wishes as the central bank can always increase the money supply to pay the interest of the national debt
problems with MMT and govt debt
while possibly feasible in the ST, problems may arise if interest rates and the rate of inflation increase
BUT inflation may not occur if there is enough spare capacity in the economy
example of an external shock and policies to deal with it
shock = a sudden increase in the global oil/commodity price in general
policy = increase in interest rate
impact= reduction in consumption, investment, exchange rate appreciation leading to a fall in AD and rate of inflation
measures to control global companies’ operations- regulation of transfer pricing
very difficult for govts to regulate
attempts are being made to seek international agreement to ensure that global companies pay a fair amount of tax in the countries they operate in
measures to control global companies’ operations- limits to govt ability to control global companies
they may:
- be ‘footloose’ i.e. move easily from country to country to find low wage labour
- have a monopoly on tech and intellectual property
- threaten to withdraw investment
problems facing policy makers when applying policies
- inaccurate info- e.g. forecasts = notoriously inaccurate
- risks and uncertainties- uncertainties are indefinite/incalculable so can’t be eliminated or insured against
- inability to control external shocks as most are difficult to predict and existing policies may be inappropriate to deal with it
