Economics 9708

Lower Six

Fiscal Policy
1. Fiscal Policy: Fiscal policy refers to the use of government spending and taxation to
influence the overall state of the economy. It involves decisions made by the government
regarding how much money it will spend on various programs and services and how
much revenue it will collect through taxes.

2. Budget: A budget is a financial plan that outlines the government's expected revenue
and expenditure over a specific period, typically one year. It serves as a blueprint for
managing the government's finances and allocating resources to different sectors and
programs.

3. Budget Surplus: A budget surplus occurs when the government's revenue from taxes
and other sources exceeds its expenditures. In other words, the government collects more
money than it spends during a given period. A surplus can be used to pay off debt, invest
in infrastructure, or create a reserve for future needs.

4. Budget Deficit: A budget deficit, on the other hand, arises when the government's
expenditures exceed its revenue. It means that the government is spending more money
than it is collecting. To cover the deficit, the government may borrow money by issuing
bonds or take other measures such as reducing spending or increasing taxes.

5. Balanced Budget: A balanced budget occurs when the government's revenue equals
its expenditures. In this case, there is neither a surplus nor a deficit. Achieving a balanced
budget can be a fiscal policy goal for some governments, as it ensures that spending is in
line with revenue.

6. Automatic Stabilizers: Automatic stabilizers are features of the fiscal system that help
stabilize the economy without requiring explicit policy changes. They are built-in
mechanisms that automatically adjust government revenues and expenditures in response
to changes in economic conditions. Examples of automatic stabilizers include progressive
income taxes, which generate more revenue during periods of economic growth, and
unemployment benefits, which increase during economic downturns.

7. Cyclical Deficit: A cyclical deficit is a budget deficit that arises due to the economic
cycle. It occurs when the government's revenue decreases and spending increases as a
result of an economic downturn. During recessions, tax revenues tend to decline while
expenditures on unemployment benefits and other social programs increase, leading to a
cyclical deficit.

8. Structural Deficit: A structural deficit refers to a budget deficit that persists even
when the economy is operating at its potential level. It arises due to long-term structural
factors such as government spending commitments, tax policies, and demographic
changes. Unlike a cyclical deficit, a structural deficit does not disappear when the
economy recovers.

The difference between a cyclical and a structural budget deficit

XX shows a situation where there would be no structural deficit. This is because at the
full employment level of real GDP, Yfe, there is no budget deficit. However, if the
budget situation is shown by ZZ there would be a budget deficit at the full employment
level. At an income of Y1 the budget deficit is 0b. Of this, 0a is the cyclical deficit and ab
is the structural deficit

THE NATIONAL DEBT

National debt, also known as public debt or government debt, refers to the total amount
of money that a government owes to external creditors and its own citizens. It is the
accumulation of past borrowing by the government to finance budget deficits or cover
other financial obligations. The national debt is often expressed as a percentage of GDP.

The national debt tends to increase under certain circumstances, such as:

1. Budget Deficits: When a government spends more money than it collects in revenue, it
needs to borrow to cover the shortfall. This leads to an increase in the national debt.

2. Economic Stimulus: During economic downturns or recessions, governments may

implement fiscal stimulus measures, such as increased government spending or tax cuts,
to boost economic activity. This often requires borrowing and can contribute to a rise in
the national debt.

Advantages of having a large and increasing national debt:

1. Economic Growth: Borrowing can fund investments in infrastructure, education,

healthcare, and other areas that promote economic growth. These investments can
generate positive returns, increase productivity, and enhance competitiveness.

2. Stability and Confidence: Government debt instruments, such as treasury bonds, are
considered safe investments. They provide a stable and reliable source of income for
individuals, institutions, and foreign governments. This stability can foster confidence in
the economy and financial system.

3. Monetary Policy Flexibility: By issuing debt, governments can influence interest rates
and money supply through central banks. This flexibility allows them to implement
monetary policies to manage inflation, stimulate economic activity, or stabilize financial
markets.

Disadvantages of having a large and increasing national debt:

1. Interest Payments: A significant portion of government revenue may be allocated to

servicing the interest on the national debt. These interest payments can divert funds from
essential public services and programs, such as education, healthcare, and infrastructure.

2. Burden on Future Generations: When a government borrows, it transfers the burden of

repayment to future generations. High levels of debt can limit the government's ability to
address future economic challenges or respond to unforeseen circumstances.
3. Vulnerability to Economic Shocks: A large debt burden makes a country more
susceptible to economic shocks, such as rising interest rates or a loss of investor
confidence. These shocks can lead to higher borrowing costs, reduced access to credit,
and financial instability.

The national debt to GDP ratio will be reduced if there is either some repayment of
the debt or if GDP rises.

TAXATION

Direct taxes and indirect taxes are two primary categories of taxes levied by
governments. They differ in terms of who bears the burden of the tax and how they are
collected. Ad valorem and specific indirect taxes, as well as sin taxes, are subcategories
of indirect taxes. Here's an explanation of each:

1. Direct Taxes: Direct taxes are paid directly by individuals or entities to the
government. The burden of the tax falls on the person or organization that is responsible
for paying it. Examples of direct taxes include income tax, corporate tax, property tax,
and wealth tax. These taxes are usually based on the ability to pay, with higher-income
individuals or businesses paying a higher percentage of their income or assets.

2. Indirect Taxes: Indirect taxes are imposed on the production, sale, or consumption of
goods and services. They are usually collected by an intermediary, such as a retailer, and
passed on to the final consumer. Indirect taxes can be divided into two types:

a. Ad Valorem Taxes: Ad valorem taxes are calculated as a percentage of the value of a

good or service. For example, value-added tax (VAT) is an ad valorem tax where the tax
rate is applied to the value added at each stage of production or distribution. If the VAT
rate is 10% and the final price of a product is $100, the tax would be $10.

b. Specific Indirect Taxes: Specific indirect taxes are fixed amounts imposed on a per-
unit basis. They are not directly tied to the value of the good or service. Examples include
excise taxes on specific products like gasoline, alcohol, tobacco, or luxury goods. For
instance, a government may impose a $2 tax per pack of cigarettes.
3. Sin Taxes: Sin taxes are a specific type of indirect taxes designed to discourage the
consumption of products deemed harmful to individuals or society, such as tobacco,
alcohol, and sugary beverages. Sin taxes aim to reduce consumption and mitigate the
associated health and social costs.

Advantages of Indirect Taxes over Direct Taxes:

1. Broad-based Taxation: Indirect taxes can be applied uniformly across a wide range of
goods and services. This allows for broader tax coverage and reduces the burden on
specific individuals or groups. It ensures a more equitable distribution of the tax
burden.
2. The main advantage claimed for indirect taxes is that they do not discourage effort,
innovation and saving

3. Simplicity and Ease of Collection: Indirect taxes are often easier to administer and
collect compared to direct taxes. They can be collected at the point of sale or production,
making the collection process relatively straightforward. This simplicity reduces
administrative costs and enhances efficiency.

4. Economic Efficiency: Indirect taxes can influence consumer behavior by altering the
relative prices of goods and services. By imposing higher taxes on certain products,
governments can encourage healthier choices or discourage the consumption of harmful
goods. This can lead to positive externalities, such as improved public health.

5. Elasticity of Demand: Indirect taxes often have a built-in elasticity of demand. When
the price of a product increases due to taxation, demand for that product may decrease.
This can generate additional tax revenue while allowing individuals to make more
informed choices about their consumption habits.

Disadvantages of Direct taxes

Higher direct taxes may put off some people from joining the labour force, may stop
some people working overtime and may encourage some people to cut the standard hours
they work. This is because the disposable income people earn for each hour they work
will be reduced.

High direct taxes may encourage tax avoidance and tax evasion as individuals and
businesses seek to minimize their tax liabilities within the confines of the law. This can
lead to revenue loss for the government and undermine the effectiveness of the tax
system.

PROGRESSIVE, REGRESSIVE AND PROPORTIONAL TAXES

While indirect taxes are regressive, direct taxes are usually progressive. A progressive
tax is one that takes a higher percentage of a person or firm’s income as that income rises
(Taxing more on the rich than the poor).

In the case of a regressive tax, a smaller percentage of income is taken as income rises.
(Taking more on the poor than the rich).

A proportional tax is a fixed percentage tax, for example a 20% income tax. The tax rate
does not change as income changes.

MARGINAL AND AVERAGE RATES OF TAXATION

The marginal rate of taxation (mrt) is the proportion of extra income taken in tax. For
example, if a person earns an extra $100 and $30 is taken in tax, the marginal tax rate is
$30/£100 = 0.3. This can also be expressed as 30%.

The average rate of taxation (art) is the proportion of a person’s total income that is
taken in tax. If a person earns £50 000 and pays £10 000 in tax, the average tax rate is 0.2
or 20%.

In the case of a progressive tax, the marginal tax rate is higher than the average tax rate.
The proportion of tax people would pay on extra income would be greater than the
proportion they pay on the total amount they earn.

In contrast, in the case of a regressive tax, the marginal tax rate is lower than the average
tax rate. The relationship is also different in the case of a proportional tax. In this case,
the marginal tax rate equals the average tax rate.

The reasons for taxation

 To raise revenue to finance government spending on merit goods, such as

education, and public goods, such as defence.
  To influence aggregate demand. If the government wants to reduce aggregate
demand it will raise tax rates and/or increase the tax base. If it wants to increase
aggregate demand, it will do the reverse.
 To redistribute income from the rich to the poor. A progressive income tax may
be used to distribute income more evenly. Such a tax narrows the gap between the
disposable income of rich people and people on low incomes. The gap could be
further narrowed by the government using some of the tax taken from rich people
to provide cash benefits to those on low incomes.
 Taxes are imposed to discourage the consumption of certain products. These may
be imports. A government may be concerned that the country is spending more on
imports than it is earning from selling exports.
 Taxes may also be imposed on demerit goods in order to improve people’s health
and the environment

GOVERNMENT SPENDING

Government spending can be broadly categorized into three main components: transfer
payments, current spending, and capital spending. Here's an explanation of each category:

1. Transfer Payments:
Transfer payments refer to government expenditures that involve the redistribution of
income or wealth from one group to another without the production of goods or services.
These payments typically aim to provide social assistance, support specific groups, or
address income inequalities. Examples of transfer payments include:

- Social Welfare Programs: This includes payments made to individuals or households to

support their basic needs, such as unemployment benefits, welfare payments, pensions,
and disability benefits.
- Subsidies: Subsidies are financial assistance provided to individuals, businesses, or
industries to promote specific activities. Examples include agricultural subsidies, housing
subsidies, or subsidies for renewable energy projects.
- Grants and Scholarships: Governments may provide grants and scholarships to
individuals or organizations to support education, research, or community development
initiatives.

2. Current Spending:
Current spending refers to government expenditures on day-to-day operations and
ongoing expenses necessary for the functioning of the government and the provision of
public services. It includes expenses such as:
 - Public Sector Salaries and Benefits: This involves payments made to government
employees, including salaries, pensions, healthcare benefits, and other allowances.
- Administrative Expenses: Administrative expenses cover the costs associated with
running government offices, maintaining facilities, purchasing supplies, and other
operational costs.
- Public Services: Current spending also encompasses expenditures on essential public
services such as healthcare, education, public safety, transportation, and social services.
These expenses cover the costs of operating hospitals, schools, police departments,
transportation networks, and other public service providers.

Current spending is recurrent and is required to sustain the ongoing operations of the
government and the delivery of public services.

3. Capital Spending:
Capital spending, also known as investment spending, refers to government expenditures
on long-term physical assets and infrastructure that provide lasting benefits to society.
This category includes expenditures on:

- Infrastructure Development: This involves investments in building and maintaining

public infrastructure, such as roads, bridges, railways, airports, ports, water supply
systems, and public buildings.
- Public Facilities: Capital spending may also include investments in public facilities such
as schools, hospitals, libraries, parks, and cultural centers.
- Equipment and Technology: Expenditures on acquiring machinery, equipment, and
technological resources required for public services or government operations also fall
under capital spending.

Capital spending aims to enhance economic productivity, improve public services, and
contribute to long-term economic growth and development. These investments typically
have a longer lifespan and contribute to the physical assets of the government.

Exhaustive and non-exhaustive government spending are two different approaches to budgeting
and allocating resources by the government. Here's an explanation of the differences between
these two types of spending:
1. Exhaustive Government Spending: Exhaustive government spending refers to the allocation
of funds that fully deplete or exhaust the available resources. In this approach, the government
allocates a fixed amount of money towards specific programs, projects, or initiatives. Once the
allocated funds are spent, there are no additional resources available for further spending in that
particular area. Examples of exhaustive spending include fixed budget allocations for
infrastructure development, defense spending, or healthcare programs.

2. Non-Exhaustive Government Spending: Non-exhaustive government spending, also known

as non-rivalrous spending, involves the allocation of funds that do not deplete or exhaust the
available resources. In this approach, the government invests in initiatives that have the potential
to generate ongoing benefits without a fixed budget constraint. Non-exhaustive spending often
focuses on areas such as education, research and development, or public goods like parks and
libraries. These investments can create long-term benefits and do not require a fixed amount of
funding in the same way as exhaustive spending.

The key distinction between exhaustive and non-exhaustive spending lies in the nature of
resource allocation. Exhaustive spending implies a fixed budget that is fully utilized, while non-
exhaustive spending allows for continued investment beyond a specific budgetary limit.

Reasons for government spending

 To influence aggregate demand and so the level of economic activity. If private sector
spending is thought to be too low, a government may decide to inject more spending into
the economy.
 A government may use its spending to increase aggregate supply. Government spending
on education, healthcare and infrastructure can raise an economy’s productive potential.
 Income redistribution
 Governments also spend on merit and public goods in order to overcome market failure.
 In practice, governments may also spend to win political popularity so that they can stay
in power. Government spending in a number of countries regularly rises just before an
election.
 Governments may also be influenced by pressure groups that encourage them to spend
more on, for instance, the environment.
EXPANSIONARY AND CONTRACTIONARY FISCAL POLICY

Expansionary fiscal policy is designed to increase aggregate demand. This can be

achieved by a government increasing its spending and/or cutting tax rates or the tax base
and may aim for a budget deficit.
Contractionary fiscal policy is intended to lower the growth of aggregate demand. This
time, the government will reduce its spending and/or increase taxes and may aim for a
budget surplus

Deliberate changes in government spending and taxation can be referred to as

discretionary fiscal policy.

Automatic stabilizers
Automatic stabilisers are forms of government spending and taxation that change,
without any deliberate government action, to offset fluctuations (changes) in GDP. For
example, during a recession, government spending on unemployment benefits
automatically rises because there are more unemployed people. Tax revenue from
corporate tax, income tax and indirect taxes will fall automatically as profits, incomes
and expenditure decline.

From the diagram above, it can be seen that the economy is operating below full
employment at Y with a significant gap between government spending and taxation. As
GDP rises, government spending on benefits falls while tax revenue rises with more
people in employment and so receiving more income.

The impact of expansionary and contractionary fiscal policy on the macroeconomy

Governments may use contractionary fiscal policy tools to reduce demand-pull inflation.
Income tax rates may be increased, the threshold at which people start paying the tax may
be reduced and the tax base may be widened.

Higher taxes and lower government spending may reduce aggregate demand, or at least,
the growth of aggregate demand.

Raising income tax to reduce demand-pull inflation may not go as planned. This is
because workers may seek higher wages to maintain their disposable income. If their
wage claims are granted, firms’ costs of production may increase. Higher costs can
generate costpush inflation. Higher income tax rates may also, as noted earlier, create
disincentive effects. Some workers may respond to a reduction in disposable income by
leaving the labour force. Other workers may emigrate to countries with lower tax rates.
This will reduce the economy’s productive capacity and so reduce aggregate supply.
Expansionary fiscal policy may be used to increase the country’s output and to raise
employment. The above diagram shows higher aggregate demand raising the country’s
output from Y to Y1.