Theme 4.5.1-3

Question 1

What is hysteresis?

Answer 1

This is when a significant economic downturn causes an extremely large recession (e,g 2008 financial crisis or COVID-19) which an economy may not be able to fully recover from, even in the long term.
As a result, the long term trend growth rate of the economy will decrease because the economy never fully recovered to the previous business cycle it was on.

Question 2

Why does the government spend money?

Answer 2

-Achieve macroeconomic aims
-Income redistribution
-Reduce information gaps
-Fund infrastructure developments
-Provide public goods
-Fixing negative externalities
-Spend on defences to increase security
-Ensure education and healthcare is provided

Question 3

What are the three types of gov expenditure?

Answer 3

● Capital government expenditure: Spending on investment goods such as new roads, schools and hospitals which will be consumed in the future.
-Current government spending: spending on goods and services that will be consumed within the next year, such as public-sector salaries.
-Transfer payments: where money is taken from one group and given to another, for example benefits and pensions.

● The government also has to spend money on interest payments for national debt. The ​current government expenditure is general government final consumption plus transfer payments plus interest payments.

Question 4

What are some major elements of gov spending by %?

Answer 4

In 2023, gov spending was projected to be £1150billion:
-Healthcare (19%)
-Education (12%)
-Defence (6%)
-Welfare (15%)
-Pensions (20%)

Question 5

What causes the theoretical relationship between real income and gov expenditure?

Answer 5

● In most mixed and free economies, the ​lower the average income of the country, the lower is likely to be the percentage of GDP spent by the government. This is because poorer countries tend to have a ​lower tax revenue​, due to avoidance, inefficiency at collecting and a smaller amount of wealth to tax.
-Moreover, citizens in higher income countries ​demand more services from their governments​; government provided goods are income elastic. For example, access to improving technologies means that more is demanded from the NHS compared to what would be demanded of state healthcare in poorer countries.

Question 6

Why does government spending differ between developed nations?

Answer 6

Different countries have different fiscal strategies. The USA’s gov expenditure makes up a smaller % of GDP as they have a strong belief that higher taxes and income distribution leads to less incentive to make profits, where as nations such as Norway have a much higher % of GDP as gov expenditure.

Question 7

How did the financial crisis in 2008 impact the spending of governments?

Answer 7

The ​Global Financial Crisis led to huge increases in government spending as governments had to increase welfare payments and some governments used taxpayer money to bail out the banks. In the UK, ​the government bought stakes in Lloyds and the Royal Bank of Scotland.
● However, ​since 2010 the UK government has been following a ​policy of austerity in
an attempt to reduce the debt. They have been consistently attempting to reduce expenditure where they can. Therefore, the size of spending depends on government aims.

Question 8

How can the dependency ratio impact gov spending?

Answer 8

● In the next decades, ​Europe and Japan will see pressure on government spending due to ​aging populations meaning larger pension bills and higher levels of care needed.

Question 9

What are the impacts of government spending on productivity and growth?

Answer 9

● Free market economists argue that government spending is ​wasteful and causes inefficiency. However, the government is able to enjoy ​economies of scale when it provides goods, and this improves productivity.
● They also provide the ​infrastructure​, such as roads, necessary for the economy to run efficiently.
● Education creates the ​human capital necessary for growth whilst the healthcare system reduces the number of days workers lose from ​serious illness​. Spending on research and development may not be done by the private sector and the government will undertake it to give businesses a long term competitive edge.
● Through spending, the government can create a ​multiplier effect and this can be focused on areas of the country with high unemployment, creating growth.

Question 10

What is the impact of government spending on the living standards?

Answer 10

● Government spending can cause large improvements in living standards. The government ​corrects market failure and ​provides public goods​, which improves social welfare.
● They are also important since they ​reduce absolute poverty by providing benefits and basic goods, such as education and healthcare. In developing countries, governments do not have the resources to do this and this leads to malnutrition, poor water etc.
● There is some debate about how much the government can contribute to improved living standards. It is argued that the government will be inefficient at providing goods and services and will have a negative disincentive impact on workers, meaning that output overall is reduced​ and so living standards fall.

Question 11

Why do some people argue the government suffers from the principle agent issue?

Answer 11

It can be argued that the government suffers from the ​principal agent problem since they make decisions on behalf of the people and individuals may have spent that money differently. As a result, there is a loss in welfare and so a fall in living standards. However, the ​political system means that society decides the government and so therefore decides to an extent where it would like money to be spent (e.g to increase chance of reelection).

Question 12

What are the two types of crowding out?

Answer 12

Crowding out is a process in which an increase in government expenditure ‘crowds out’ private sector activity by raising the cost of borrowing.

This can either be resource crowding out, or financial crowding out.

Question 13

What is financial crowding out?

Answer 13

● In order to spend money above their tax revenues, the government has to ​borrow from individuals and businesse​s. However, the amount of money in the economy available to borrow does not increase. The government will therefore be competing with the private sector for finance and will cause ​higher interest rates​. This will discourage firms from investing and individuals from buying on credit.

Question 14

What is resource crowding out?

Answer 14

On top of this, the ​limited number of resources in the economy means that for every resource used in government spending, there are less resources available for the private sector. The result is that government borrowing crowds out private sector borrowing and spending and may lead to no real increase in AD.

Question 15

When is the effect of crowding out usually felt?

Answer 15

-● The crowding out effect is felt most at ​full employment​, but it is not always the case. Transfer payments have no impact on output and so would not cause crowding out as resources are simply taken from one group and given to another; the government isn’t taking resources from the economy.
● Free market economists argue that ​investment would be more efficient if done by the private sector and that the government targets investment poorly and is wasteful.

Question 16

What is crowding in?

Answer 16

-This is where a decrease in government expenditure will ‘crowd in’ private sector activity by lowering the cost of borrowing.
-It could also occur if high gov spending during times of high unemployment causes more private investment due to the multiplier effect.

Question 17

How does the government spending impact the level of taxation?

Answer 17

● In most cases, where government spending is high, ​levels of tax must be high in order for spending to be sustainable. High levels of tax may have a disincentive effect.
● Oil-rich countries tend to be an exception, where revenue from oil can pay for most of government spending.

Question 18

How does government spending impact equality?

Answer 18

● Spending should ​increase equality as it leads to redistribution and helps to provide a ​minimum standard of living for the poorest in society. It ensures everyone has access to ​basic goods​, such as education and healthcare, which will help to give them a fair start in life.

Question 19

What is taxation?

Answer 19

Tax is used to ​pay for the number of goods and services that the government provides​. On top of this, tax can be used to ​correct market failure at a microeconomic level and to manage the economy and redistribute income ​at a macroeconomic one.

Question 20

What are progressive taxes?

Answer 20

Progressive tax ​is where those who are on higher incomes pay a higher marginal rate of tax; they pay a higher percentage of their income on tax. Direct taxes tend to be progressive, for example ​income tax.​

Question 21

What are regressive taxes?

Answer 21

Regressive tax ​is where the proportion of income paid in tax falls as the income of the taxpayer rises. Those on higher incomes pay a smaller percentage of their income on the tax. Most indirect taxes are regressive, for example everyone pays the same rate of ​VAT ​and for those on higher wages this represents a small proportion of their earnings compared to those on low wages.

Question 22

What are proportional taxes?

Answer 22

Proportional tax is where the proportion of income paid on tax remains the same whilst the income of the taxpayer changes e.g. 10% of income is spent on tax, regardless of income. Everyone pays the same percentage of their income on the tax.

Question 23

How can changes in taxes impact the incentive to work?

Answer 23

● It is argued that high marginal rates of tax will ​discourage individuals from working​. Free market economists argue that the supply of labour is relatively elastic and a reduction in marginal taxes on income will lead to a significant increase in work as individuals work longer hours, accept promotions and more people join the workforce.
● High taxes on high income earners could encourage them to ​move abroad and taxes on the poor may lead to a ​poverty trap​.
● It is i​ncome tax ​which is important: high income tax reduces incentives more than high VAT. Thus, a switch from direct to indirect taxes may increase incentives.
● However, there is ​no hard evidence for this, and tax isn’t the only determiner, benefits schemes will also play a role.

Question 24

What are some examples of different countries with different tax revenues as a % of GDP which are still successful?

Answer 24

USA- tax 26% of GDP (low tax)
UK-tax around 35% of GDP
Denmark- Tax around 50% of GDP.

Despite this, all these countries have similar economic growth rates.

Question 25

Will higher tax rates always cause a higher tax revenue?

Answer 25

● The Laffer curve shows that a ​rise in the tax rate does not necessarily increase tax revenue​. If people were taxed at 100%, they would not do any work and this means that tax revenue is 0 at both 0% and 100%.
● Tax revenue will initially rise as the tax rate is increased but it will come to a point where revenue is maximised and will then fall. As tax rates rise, motivation and drive will fall so there will be a fall in output and there is an increased incentive to use tax avoidance and tax evasion. T​ i​ s the ​optimal tax level​, which maximises revenue.

Question 26

What is the substitution and income effect in relation to the taxation increases?

Answer 26

-Some argue that increases in taxation will cause the substitution effect, as when you are taxed more, the opportunity cost of not working is lower.
-Others argue is drives the income effect, higher taxes mean people have to ​work longer hours in order to maintain their income​ and so even increases the incentive work

Question 27

How does taxation affect income distribution?

Answer 27

● A ​progressive tax system will increase the equality of income distribution as more money is proportionally taken from the rich than from the poor. A ​regressive one will decrease income equality. Since direct taxes tend to be progressive and indirect taxes regressive, a move from indirect to direct taxes will improve equality.
● Inheritance taxes are the most progressive form of taxation. ​High corporation taxes take money from shareholders, who tend to be very well off, and give them to the government to spend on the poor.
● One problem with using tax to redistribute income is that it does not give the poor anything, so the ​system needs to be supported with benefits​.

Question 28

How does taxation affect real output and employment?

Answer 28

● Some taxes affect AD whilst others affect AS. A rise in direct taxes will reduce the level of disposable income an individual has, which will cause a fall in their spending and thus a ​fall in AD. It could also cause a fall in leftover profits for businesses and therefore a fall in investment. The effect this has on output will depend on where the economy is: whether it is at full employment or not.
● On top of this, higher indirect taxes and NICs increase costs for firms and this will decrease SRAS​. This impact will again depend on where the economy is producing.
● It can be argued that income taxes cause a ​disincentive to work and therefore reduce LRAS as the most skilled workers go overseas and more people become inactive.

Question 29

How does taxation affect the trade balance?

Answer 29

● A rise in taxes will decrease income and therefore decrease consumption (negative multiplier of withdrawal from circular flow of income), theoretically this will also mean ​consumers spend less on imports​. Imports in the UK have been found to be highly income elastic. As a result, the trade balance will improve in the short run.
● However, in the long run, lower AD will reduce businesses’ need to invest and this could ​reduce competitiveness​ meaning that exports decrease.

Question 30

How does taxation impact the price level?

Answer 30

-Taxes can impact LRAS, SRAS and AD. ​Therefore, these changes will impact price depending on where the economy is producing.
● Indirect taxes, particularly VAT, often cause ​cost push inflation.

Question 31

How does taxation affect FDI flows?

Answer 31

● Low taxes on profit and investment tend to ​encourage businesses to invest in a country since it will help them to see a higher level of return.
● The problem with this is that it can be a ​‘race to the bottom’ ​where countries have to continue to lower their taxes in order to make them the lowest to encourage investment; the eventual result is a fall in revenues for all countries.

Question 32

Why was the poll tax in the 1990s controversial?

Answer 32

-Although theoretically the idea of all recieving the same council tax was good as it was simple (which meant administrative costs were low), and all who voted were able to hold the council to feel accountable for their spending, as all had helped fund it.
-However, by charging all the same tax an extremely regressive impact was seem, as those who were on a lower income would see the poll tax make up more more of their income than someone on a high income.

Question 33

What are the likely impacts of indirect taxes rising?

Answer 33

-Cost push inflation as businesses pass on costs
-Less economic growth as demand and real incomes fall
-More unemployment as AD will fall
-Balance of trade - could go either way (depends if import reduction due to less spending or loss of international competitiveness is greater)
-Output gap - negative output gap will rise due to falling AD.
-Less business investment due to lower profits and weaker consumer spending
-Short-term improvement to fiscal budgets, but risk of long-term reduction if incomes fall.

Question 34

What are automatic stabilisers?

Answer 34

● Automatic stabilisers are mechanisms which reduce the impact of changes in the economy on national income; government spending and taxation are automatic stabilisers. In a recession, benefits increase as more people are unemployed and so the benefits are a stabiliser as it means that the overall fall in AD is reduced, preventing too much change in the economy. On the other hand, during a boom, tax increases as people have more jobs and higher incomes, and this tax reduces disposable income so decreases consumption and AD, meaning that demand doesn’t grow too high.

Question 35

What do automatic stabilisers achieve?

Answer 35

Automatic stabilisers ​cannot prevent fluctuations; they simply reduce the size of these problem and there can be negative aspects to these stabilisers. Benefits may act as a disincentive to work and lead to higher unemployment whilst high levels of tax can decrease the incentive to work hard.

Question 36

What is a discretionary fiscal policy?

Answer 36

Discretionary fiscal policy ​is the deliberate manipulation of government expenditure and taxes to influence the economy; expansionary and deflationary policies.

These fiscal policies played a key role in the UK economy following the 2008 crisis, as well as the 2020 COVID pandemic.

Question 37

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

Answer 37

● The ​national debt is the sum of all government debts built up over many years whilst a fiscal deficit​ is when the government spends more than it receives that year.

Question 38

What is the UK’s current national debt and fiscal deficit?

Answer 38

-In the 2023/4 financial year, the fiscal deficit was £84.6billion, 3.5% of GDP.

-National debt was £2,417.6billion, around 97% of GDP

-Japan has significant national debt for a developed nation, roughly 260% of GDP.

Question 39

What factors will influence the size of a national debt?

Answer 39

● If the government is continuously running a deficit, then the national debt will increase overtime. There is a consensus view from Jeremy Hunt that ​fiscal deficits over 3% will lead to growing national debt as a proportion of GDP​. It is only when the government runs a budget surplus that the size of the national debt decreases.
● Ageing populations tend to contribute to a high national debt since the government runs a structural deficit in order to fund their pensions and care and this leads to a high national debt.

Question 40

What is a cyclical deficit?

Answer 40

A ​cyclical deficit is the part of the deficit that occurs because government spending and tax fluctuates around the trade cycle. When the economy is in recession, tax revenues are low and spending is high creating a larger deficit.

Question 41

What is a structural deficit?

Answer 41

At the peak of the boom, there is no cyclical deficit; any deficit at this point is a structural deficit. The structural deficit is the fiscal deficit which occurs when the cyclical deficit is zero; it is long term and not related to the state of the economy.

Question 42

What is the actual deficit?

Answer 42

The ​actual deficit​ is the structural deficit plus the fiscal deficit.

Question 43

When will a structural surplus occur?

Answer 43

-Governments can have structural deficits, structural surpluses or structural balances.
-A structural surplus occurs when at the peak of the boom, there is an actual fiscal surplus whilst a structural balance occurs when at the peak of the boom, the actual fiscal balance is 0.

Question 44

What will be the impact of a sustained structural deficit?

Answer 44

-If the government has a structural deficit, it is likely that ​national debt will grow over time as the government has to consistently borrow money to finance spending.
-For this reason, it is argued that ​structural deficits need to be eliminated but this is difficult since it is ​impossible to know what part of the deficit is structural and what part of it is cyclical​, just as it is impossible to know the size of the output gap.

Question 45

What factors can influence the size of fiscal deficits?

Answer 45

-Trade cycle
-Unforeseen events
-Interest rates
-Privatisation
-Government aims
-Number of dependents
-High revenue from state-owned exports

Question 46

How can the trade cycle influence the size of fiscal deficits?

Answer 46

-One major factor which influences the fiscal deficit is the ​trade cycle​, as explained by the concept of cyclical and structural debts. During a downturn, government tax revenue decreases whilst government spending increases and so the deficit increases. ​
-In the UK, the fiscal deficit peaked in 2010 at 10.1% of GDP, just before the Tories Austerity plan began.

Question 47

How can unforeseen events impact the size of the fiscal deficit?

Answer 47

Unforeseen events​, such as natural disasters or recessions, lead to huge increases in spending which increase the deficit.

Question 48

How can interest rates influence the size of the fiscal deficit?

Answer 48

If interest rates on government debt increase, the amount the government pays in interest repayments increases and this is likely to increase the deficit. The impact of this will depend on how significant interest repayments are in the size of the deficit. Interest rates depend on market rates and the credit ratings of the government. ​
-7% of all UK government spending is on interest repayments of loans.

Question 49

How can one-off events such as privatisation influence the gov budget?

Answer 49

-Events like ​privatisation provide one-off payments to the government which will decrease the deficit in the short term; it will depend on the value of the company sold.

Question 50

How can the government aims influence the fiscal deficit?

Answer 50

-Government aims are important in the size of the deficit, as this will influence their fiscal policy, for example the austerity aim has helped to decrease the size of the deficit but attempting to increase AD would increase spending. ​
-The austerity policy managed to reduce the fiscal deficit by 75% since 2010.

Question 51

How can high export revenues influence the government budget?

Answer 51

Many countries with ​high revenues from oil​, for example the OPEC countries, run a budget surplus and so government revenue is important in the size of the deficit.

Question 52

How can the number of dependents in an economy influence the size of the fiscal deficit?

Answer 52

Factors such as the ​number of dependents ​in a country affect both spending and tax revenues so influence the deficit.

Question 53

What is the ‘Golden rule of fiscal policy’ used by the Labour Party between 1997-2010?

Answer 53

This was a rule stating that over the economic cycle, net government borrowing will be for investment only, and not current spending.

This meant that future taxpayers would only have to pay the tax to make up for borrowing of money which was invested to help them, rather than borrowing to benefit the population at the time of the borrowing.

Although this wasn’t a hard set law, a failure to follow the plan by the Labour party would’ve seen a fall in trust from the public.

Question 54

What is the significance of the fiscal deficit and national debt on the interest rates?

Answer 54

-High levels of borrowing may ​raise interest rates ​in the economy since an increase in the demand for money will increase the price of money, i.e. interest rates. This could cause crowding out of the economy.
-However, this may not always be the case as the government may borrow from overseas and during a recession, private sector investment falls which means interest rates may remain unchanged.

Question 55

What is the significance of debt repayments from fiscal deficits and national debt? (Golden rule of fiscal policy)

Answer 55

Countries have to spend a large amount of money on ​servicing their national debt through interest repayments, which has a high opportunity cost. ​The UK spends £70 billion a year to service its debts but this is small as a percentage of GDP​. A primary budget deficit is the actual budget deficit but does not include interest repayments on the national debt. The impact will depend on the level of interest rates and the size of the primary deficit compared to interest repayments.
-This bought about the argument of the ‘Golden Rule of fiscal policy’, and an accumulation of debt can only be justified if it is spent to invest for the future generations.

Question 56

What is the significance of fiscal deficits and national debt on inflation?

Answer 56

-High fiscal deficits can cause ​inflation. If the government increases their spending and there is no similar fall in private sector spending, AD will rise and this can be inflationary.
-More dangerously, if a government is unable to borrow money, they will print more money and this can cause ​hyperinflation as in Germany in 1923 or Zimbabwe in 2008​.
-Printing money (QE) will not necessarily cause hyperinflation, it depends on how much is printed and where the economy is producing on the LRAS.

Question 57

What is the significance of national debt and fiscal deficit on a reduced credit rating for the government?

Answer 57

-Private sector companies estimate the likelihood that a government will default on its debt and give it a rating from AAA to D. Lower credit ratings mean that lending to the government is riskier and so higher interest rates are demanded from lenders.
-However, in reality, it is not the size of the debt that influences the level of risk involved with the lending the money, it is whether that country has ever defaulted on their loans before and their current economic/political climate.

Question 58

What is the significance of fiscal deficits and national debt on accessing foreign currency?

Answer 58

If a government has borrowed from abroad, it may have difficulties getting ​enough foreign currency to make repayments on its debt. This could also cause problems for consumers as if there is not enough foreign currency, they will be unable to import goods.

Question 59

What is the potential significance of fiscal deficits and national debt on growth?

Answer 59

-On the other hand, government borrowing can ​benefit growth if it used for capital spending since this will improve the supply side of the economy and thus reduce the deficit in the long term.
-On top of this, the budget deficit can be used as a tool for short term demand management: Keynesians argue a deficit is acceptable to use as a stimulus in demand during recessions.