Topic 4.2 Fiscal Policy Flashcards
Fiscal Policy
The manipulation of government spending, taxation and the budget balance to influence the level of economic activity.
Average rate of tax (+ formula)
The amount of tax payed compared to their income
ART = Tax paid/Income x 100
Progressive tax
As income increases, average rate of tax increases. These are set in tax bands (so if you earn within a certain amount - a band - you pay that much % of tax and you only pay that % on the amount within the band).
0 - 12,000 0%
12,000 - 50,000 20%
If you make 14,000 then only 2000 is taxed at 20%.
Proportinal tax
As income increases, average rate of tax stays the same (e.g everyone has to pay 20%)
Regressive tax
As income increases, average rate of tax decreases. Any indirect taxes (tax payed is a fixed amount).
Direct tax
Taxes levied on the income of individuals or firms
Indirect tax
Taxes levied on goods/services (VAT, fuel duty, cigarette/alcohol duty).
Expansionary fiscal policy (graph)
This is fiscal policy that aims to stimulate economic activity (shift AD right).
1) Boosts Growth
2) Reduces unemployment
3) Increase inflation (not main thing as that’s monetary policy)
4) Redistributable income (spending on welfare)
LRAS curve and an AD curve shifting to the right from AD to AD1
What effect occurs during expansionary fiscal policy
The multiplier effect - an initial injection into the economy (government spending) leads to a proportionally larger increase in GDP. This means real incomes increase, more taxation collected which means more government spending continually increasing AD.
Examples of Expansionary fiscal policy
1) Reduction in income tax
2) Reduction in corporation tax
3) Increase in Government Spending
Expansionary fiscal policy side effect
A reduction in corporation tax incentivises investment which can increase the quality and quantity of factors of production within the economy.
Contractionary fiscal policy
This is fiscal policy that aims to decrease economic activity (shift AD left).
1) Reduces inflation (not main effect)
2) Reduces the budget deficit/national debt
3) Redistributable income (tax the rich)
4) Helps CA deficit (less income therefore less imports)
Examples of contractionary fiscal policy
1) Increasing income tax
2) Increasing corporation tax
3) Decreasing government spending
Confidence in government finances
This is a benefit of contractionary fiscal policy. Contractionary fiscal policy means that the government are increasing taxes and decreasing spending, so by achieving a budget surplus/reducing a budget deficit, it will promote greater confidence in the government, which can lead to an improvement in government credit ratings for their bonds as a less risky borrower therefore over time they can reduce coupon rates on bonds meaning that it becomes cheaper and easier for governments to borrow money in the future. A long-run benefit so they can more easily in the future fund projects.
Pros of contractionary fiscal policy
1) Confidence in government finances
2) Greater flexibility for expansionary fiscal policy (emergency funding for public services)
3) Lower inflation and CA deficit.
Cons of contractionary fiscal policy
1) It is a demand-side shock - causing unemployment and lower growth.
2) Microeconomic impacts
3) Constrains LRAS
4) Incentives distortion of increase tax (encourages economically inactive to stay that way). Seen from the Laffer curve
Microeconomic impacts due to fiscal policy
Think about changes in fiscal policy and how it affects the individual. For example a cut in government spending can lead to less funding for healthcare and longer waiting times at hospitals.
Laffer Curve
The laffer curve is an economic theory that suggests there’s an optimal tax rate that maximises government revenue and beyond that tax rate leads to reduced collected revenue. Causes: rich people leaving, poverty/welfare trap.
y-axis: tax revenue
x-axis: tax rate
Laffer curve: semi-circle
Poverty/Welfare trap
This is where you are better off on welfare than you are in work
Evaluation of contractionary fiscal policy
1) Is there a need? If govt finances are bad at the moment. Then agreeable. Vice versa
2) Debt to GDP ratio (national debt is debt:gdp. if this demand side shock causes a greater reduction in GDP then debt, then we don’t get much of the pros.) If you go too far with policies
3) Policy used (can only decrease G but keep T)
4) Stage of the economic cycle (at boom yes, at recession no)
