Unit 17: Government and Fiscal Policy

Question 1

Macroeconomic Policy

Answer 1

strategies taken by the government aimed to benefit the country

e.g. during the covid-19 pandemic the US launched stimulus packages like the CARES Act, which provided direct cash payment to households, enhanced unemployment benefits and financial support for firms

Question 2

Objectives of Economic Policy

Answer 2

1. Economic Growth
2. Low Unemployment
3. Price Stability
4. Healthy Balance of Payments
5. Balanced Government Budget
6. Safeguarding the Environment
   7.More Equal Distribution of Income

Question 3

Policies to achieve these Objectives

Answer 3

1. Demand-Side policies
2. Supply-Side policies

Question 4

Demand-Side Policies

Answer 4

focus on influencing the level of aggregate demand to achieve macroeconomic objectives.

1. Monetary Policy (Central Bank)
2. Fiscal Policy (Government)

Question 5

Monetary Policy

Answer 5

controls money supply and interest rates to influence demand.

e.g. in 2008, during the Global Financial Crisis, the Federal Reserve lowered interest rates to near 0 and implemented quantitative easing to stimulate borrowing and investment.

Question 6

Fiscal Policy

Answer 6

adjusts taxation and government spending to influence demand

1. Expansionary fiscal policy
2. Contractionary fiscal policy

e.g. during the covid-19 pandemic, governments like the US implemented fiscal stimulus packages, such as direct cash transfers, unemployment benefits, and increased healthcare spending to boost demand

Question 7

Expansionary Fiscal Policy

Answer 7

Economic growth is stimulated by increasing AD through increased government spending, tax cuts or both, putting more money into the economy to boos consumption and investment

e.g. during the covid-19 pandemic, governments globally implemented large-scale fiscal stimulus measures such as direct cash transfers, extended unemployment benefits, and business subsidies to mitigate economic downturn

Question 8

Contractionary Fiscal Policy

Answer 8

Reduced AD to cool down an overheating economy, control inflation or reduce budget deficits. The government cuts down on spending, raises taxes or both, reducing the flow of money in the economy.

e.g. During the 1990s the US government under president Clinton increased taxes and controlled spending, achieving a budget surplus to address inflation concerns and stabilize the economy

Question 9

Supply-Side Policies

Answer 9

aim to increase the economy’s productive capacity by improving efficiency, reducing costs and fostering innovation i.e. by increasing the aggregate supply

e.g. structural reforms, incentives, education, training and infrastructure investments

Question 10

Taxation

Answer 10

mandatory contribution levied on individuals and firms by the government

1. Direct taxes
2. Indirect taxes

Question 11

Direct taxes

Answer 11

levied on income, capital and wealth

e.g. income tax, social security contributions, capital gain tax, property transfer tax, inheritance tax, poll tax, property tax

Question 12

Indirect tax

Answer 12

levied on expenditure

e.g. VAT, customs duty, stamp duty, licenses, excise duty, green tax

Question 13

Arithmetic Effect

Answer 13

higher tax rates will automatically lead to higher revenue

Question 14

Economic Effect

Answer 14

change in tax rates can influence work incentives, investment decisions, consumption and production

Question 15

Loffer Curve

Answer 15

illustrates the relationship between tax rates and government revenue. It shows that there is an optimal tax rate that maximizes government revenue, beyond which increasing tax rates can actually reduce revenue due to negative economic effects.

Question 16

Market Distortion

Answer 16

occurs when taxes, subsidies or regulations disrupt the efficient functioning of markets, leading to an allocation of resources that deviates from what would occur in a free market leading to deadweight loss.

Question 17

Why Tax?

Answer 17

1. Controlling AD
2. Generate revenue to finance public and merit goods
3. Reduce consumption of demerit goods by increasing price through tax
4. Safeguarding the environment
5. Redistributing income

Question 18

Canons of Taxation (Adam Smith)

Answer 18

1. Equity i.e. burden of tax should be distributed according to people’s ability to pay

Vertical equity - taxes are apportioned fairly between rich and poor
Horizontal equity - people within the same category should pay relatively the same

2. Certainty - tax payer must know how much, when and how it should be paid
3. Convenience - taxes should be collected in a manner and time suitable to the taxpayer
4. Economy - cost of collecting tax should not exceed the revenue generated

Extra:
5. Simplicity
6. Difficult to evade
7. No disincentive effect

Question 19

Types of Tax

Answer 19

1. Progressive tax - as income increases, the percentage paid in tax also increases.

e.g. income tax

2. Proportional tax - as income increases, the percentage paid in tax stays the same.

e.g. corporate tax

3. Regressive tax - as income increases, the percentage paid in tax falls.

e.g. VAT

Question 20

Types of Government Expenditure

Answer 20

1. Recurrent expenditure - recurring spending necessary for the daily functioning of the government

e.g. salaries, social security, goods and services

2. Capital expenditure - spending on assets that provide long-term benefits intended to enhance productive capacity and support economic growth

e.g. infrastructure projects, education, healthcare facilities

3. Interest payment on public debt

Question 21

Redistribution of Income through Government spending

Answer 21

1. Social security - government will be transferring income from the working population to the dependent population
2. Public and merit goods - low income earners will benefit from these goods without paying taxes i.e. forced rider

e.g. children’s allowance, unemployment benefits, supplementary allowances, free public healthcare, free education and training programs, housing assistance (social housing and rent subsidies), pensions and retirement support

Question 22

Non-Discretionary Fiscal Policy

Answer 22

automatic mechanisms built into the economy that adjusts to changes in economic activity without requiring government action. These policies aim to stabilize the economy by influencing AD and mitigating fluctuations during economic booms or recessions

e.g. unemployment benefits - during a recession as unemployment rises, more individuals qualify for unemployment benefits. this automatically injects money into the economy, supporting consumer spending and stabilizing demand

e.g. progressive tax - tax revenues automatically fall during economic downturns and increase during booms, helping to moderate economic cycles

Question 23

Discretionary Fiscal Policy

Answer 23

involves deliberate actions by the government to influence economic activity. Changes in tax rates and/or government spending to influence AD, i.e. Expansionary/Contractionary Fiscal policy

e.g. many countries implemented large discretionary fiscal packages to counter the economic effects of the pandemic (CARES Act), the EU also launched 750 billion euros recovery fund, focusing on grants and loans to member states for economic recovery

Question 24

The Budget

Answer 24

financial plan that outlines an individual organization or government’s expected income and expenditures over a specific period. It helps allocate resources efficiently, set financial goals and ensure spending aligns with priorities.

Question 25

Surplus

Answer 25

a surplus occurs when income or revenue exceeds expenses or expenditure over a given period.

Question 26

Deficit

Answer 26

a deficit occurs when expenses or expenditures exceed income or revenue during a specific period. 1. Structural Deficit 2. Cyclical Deficit

Question 27

Structural deficit

Answer 27

occurs when a government's regular spending consistently exceeds its revenues, even during periods of strong economic growth. This deficit is due to fundamental issues in fiscal policy, such as persistent overspending or insufficient tax revenue. solely determined by discretionary fiscal policy, independent from business cycles, does not vary with national income.

Question 28

Cyclical Deficit

Answer 28

occurs when government revenues fall, or expenditure rise temporarily due to the effects of the economic cycle, such as a recession. This deficit is expected to diminish or disappear when the economy improves. solely determined by automatic stabilizers, dependent on business cycles

Question 29

National Debt

Answer 29

accumulation of past budgets less surpluses (total obligations due to creditors)

Question 30

Public Sector Borrowing Requirement (PSBR)

Answer 30

measure of the government's borrowing needs. It reflects the total amount the government needs to borrow from the financial markets to meet its obligations, excluding the borrowing related to the government's financial transactions. increases during a recession

Question 31

Public Sector Debt Repayment (PSDR)

Answer 31

refers to the amount of money the government needs to pay in order to reduce or service its existing debt. It is the cost of paying back the money the government has already borrowed. increases during economic booms

Question 32

How does the government borrow money

Answer 32

by issuing bonds or government securities to the banking sectors, non-baking public or overseas. 1. Treasury bills (short-term) 2. Malta Government (long-term)

Question 33

Interest on internal debt

Answer 33

transfer of money from tax payers to stock holders. If stockholders are few and taxpayers are many, income inequality increases as it would simply imply a transfer of money from the many to the few

Question 34

Government Spending Multiplier

Answer 34

economic concept that measures the impact of a change in government spending on the overall economy. 1. Initial increase in government spending e.g. by building infrastructure 2. Income generation - people who receive this government spending, earn income. They will typically spend a portion of this income on goods and services. 3. Further rounds of spending - this spending generates further income and additional rounds of spending, which continue to circulate through the economy, leading to a total increase in economic activity larger than the original government spending. k=change in Y/change in G k=1/MPS

Question 35

Tax Multiplier

Answer 35

measures the effect of a change on the economy after a change in tax. 1. Decrease in taxes - when taxes are reduced, households have more disposable income to spend on goods and services. This increase in consumption can lead to an increase in GDP as firms respond to higher demand by producing more. 2. Increase in taxes - an increase in taxes reduces disposable income, leading to a decrease in consumption which can slow down economic activity and reduce GDP Tax multiplier = -MPC/MPS

Question 36

Balanced-Budget Multiplier

Answer 36

refers to the effect on GDP when the government changes its spending and taxes by the same amount, in a way that keeps the budget balanced. an equal increase in government spending and taxes will increase income by the same amount as the increase in government spending.

Question 37

Lump sum

Answer 37

Parallel shift independent of income does not effect tax revenue.

Question 38

Proportional

Answer 38

Pivoting dependent of income therefore weaker multiplier.

Question 39

National income at full employment

Answer 39

1. Deflationary/ Recessionary gap 2. Inflationary gap

Question 40

Deflationary gap

Answer 40

short for of national expenditure below national income at full employment. Apply expansionary fiscal policy.

Question 41

Inflationary gap

Answer 41

Excess of national expenditure over national income at full employment. Apply contractionary fiscal policy.

Question 42

Negative output gap

Answer 42

Difference between current national income and full employment.

Question 43

Positive output gap

Answer 43

Difference between current national income and full employment.

Question 44

Problems associated with Fiscal Policy

Answer 44

1. Fiscal Drag - rising income leads to an increase in tax liabilities 2. Resource crowding out 3. Financial crowding out 4. Inflation 5. Incentives

Question 45

Interest on National Debt

Answer 45

the amount of money that a government must pay to its creditors for borrowing funds. governments borrow money by issuing bonds or treasury bills

Question 46

Balance of Payments

Answer 46

comprehensive record of all economic transactions between a country and the rest of the world over a specific period. These transactions include the trade of commodities, capital movements and financial transfers.

Question 47

Welfare Gap

Answer 47

refers to the disparity in the distribution of welfare benefits or the quality of welfare services across different groups within a society

Question 48

Problem with state pension provision

Answer 48

State pension provision faces multiple challenges, ranging from sustainability issues caused by an aging population to the need for equitable distribution of benefits across gender and income groups. Governments must find a balance between ensuring adequate pension levels and maintaining the financial viability of pension systems. Reforms may include increasing the retirement age, adjusting pension benefits to account for inflation, improving coverage for informal workers, and ensuring better management and accountability within pension systems.