Government fiscal policy and the economy

Fiscal Policy and the Economy

AS Macro – Autumn

What is fiscal policy?• Fiscal policy involves the use of government spending, taxation and

borrowing to affect the level and growth of aggregate demand, output and jobs

• Fiscal policy is also used to change the pattern of spending on goods and services

• It is also a means by which a redistribution of income & wealth can be achieved for example by changing tax rates on different levels of income or wealth

• It is an instrument of micro-economic government intervention to correct for free-market failures such as pollution or the sub-optimal provision of public and merit goods

• Changes in fiscal policy affect aggregate demand (AD) and aggregate supply (AS)

Some key roles for fiscal policy

Financing key areas of government spending

Altering the distribution of income and wealth

Providing a welfare state safety-net for families

Managing the macroeconomic cycle

Improving country’s competitiveness

Tackle market failures through intervention

Direct and Indirect Taxation

• Direct taxation is levied on income, wealth and profit. Direct taxes include income tax, inheritance tax, national insurance contributions, capital gains tax, and corporation tax.

• Indirect taxes are taxes on spending – such as excise duties on fuel, cigarettes and alcohol and Value Added Tax (VAT) on many different goods and services

Micro recap – indirect taxes!

Quantity

S + Tax

An ad valorem tax when demand is inelasticA specific tax when demand is elastic

S + Tax

Micro recap – indirect taxes!

Quantity

S + Tax

An ad valorem tax when demand is inelasticA specific tax when demand is elastic

S + Tax

Justifications for taxation

• Revenue to pay for government spending – (e.g. on public and merit goods and services)

• Managing aggregate demand – To help meet objectives such as stable inflation and

growth

• Changing distribution of income and wealth – A progressive system of taxation can help bring

greater equality in income & wealth between households

Direct Taxes• Direct taxation is levied on income,

wealth and profit

• Direct taxes include – income tax

– national insurance contributions

– capital gains tax

– corporation tax

• The burden of a direct tax cannot be shifted

• Over the last twenty years in the British economy, there has been a shift towards indirect taxes

Tax Knowledge!Tax Tax rate (%, or level)

Income tax

Basic rateHigher rateAdditional rateVAT

National insurance contributions (employees)

Inheritance tax (threshold for paying = £325K)

Beer (duty per pint, 3.9% abv)

Cigarettes (duty on pack of 20, includes VAT)

Tax Knowledge!Tax Tax rate (%, or level)

Income tax

Basic rateHigher rateAdditional rate

20%40%45%

VAT 20%

National insurance contributions (employees) 12%

Inheritance tax (threshold for paying = £325K) 40%

Beer (duty per pint, 3.9% abv) 43p

Cigarettes (duty on pack of 20, includes VAT) £4.52

Income TaxComponent

Income tax free personal allowance* £9,440

Tax rate on taxable income:

Basic rate: 20% £0-£32,010

Higher rate: 40% £32,011- £150,000

Additional rate: 45% from 6 April 2013 Over £150,000

* The Personal Allowance reduces where the income is above £100,000 - by £1 for every £2 of income above the £100,000 limit.

The Effective Tax Rate in the UK

The total effective tax rate – is the total amount paid by households in both direct and indirect taxes as a percentage of their gross income.

The main tax revenues for the UKThere was a sustained rise in tax revenues during the long boom for the UK economy

Recession and slow recovery has hit tax receipts

How taxes and benefits affect the distribution of income

Average income per Quintile groups

household (£ per year)

Bottom 2nd 3rd 4th Top

Cash benefits 7 419 8 448 7 187 4 388 2 453

Benefits in kind 7 674 7 386 7 380 6 260 5 238

Direct taxes -1 306 -2 263 -4 781 -8 887 -19 905

Indirect taxes -3 400 -4 009 -5 206 -6 230 -8 743

Net position 10 387 9 561 4 580 -4 469 -20 958

Source: Office for National

Statistics

Taxes, welfare and income inequality Percentage shares of income for ALL households in 2012 Original Gross Disposable Post-tax income income income incomeQuintile group Bottom 3 7 8 7 2nd 7 11 13 12 3rd 14 16 17 16 4th 24 23 22 22 Top 51 43 41 42 All households 100 100 100 100 Decile group Bottom 1 3 3 2 Top 33 27 26 27 Gini coefficient (per cent) 52 36 32 36 Source: Office for National Statistics

Progressive and regressive taxes

• With a progressive tax, the marginal rate of tax rises as income rises. I.e. as people earn more income, the rate of tax on each extra pound goes up. This causes a rise in the average rate of tax

• With a proportional tax, the marginal rate of tax is constant

• With a regressive tax, the rate of tax falls as incomes rise – I.e. the average rate of tax is lower for people of higher incomes

Data on Taxation and Incomes

Quintile groups of ALL households1

Percentages of gross income

Direct taxes

Income tax 3.5 4.8 8.5 12.1 17.3

Employees' NIC 1.3 2.4 4.0 5.5 5.5

All direct taxes 10.2 11.2 15.9 20.5 24.7

Indirect taxes

VAT 10.3 8.2 7.1 6.3 5.1

Duty on alcohol 1.5 1.1 1.0 0.9 0.7

Duty on tobacco 2.8 1.6 1.5 0.7 0.3

All indirect taxes 26.5 19.8 17.3 14.4 10.8

All taxes 36.6 31.0 33.1 34.9 35.5

Progressive

Direct taxes

Income tax 3.5 4.8 8.5 12.1 17.3

Employees' NIC 1.3 2.4 4.0 5.5 5.5

All direct taxes 10.2 11.2 15.9 20.5 24.7

Indirect taxes

VAT 10.3 8.2 7.1 6.3 5.1

Duty on alcohol 1.5 1.1 1.0 0.9 0.7

Duty on tobacco 2.8 1.6 1.5 0.7 0.3

All taxes 36.6 31.0 33.1 34.9 35.5

Progressive

Direct taxes

Income tax 3.5 4.8 8.5 12.1 17.3

Employees' NIC 1.3 2.4 4.0 5.5 5.5

All direct taxes 10.2 11.2 15.9 20.5 24.7

Indirect taxes

VAT 10.3 8.2 7.1 6.3 5.1

Duty on alcohol 1.5 1.1 1.0 0.9 0.7

Duty on tobacco 2.8 1.6 1.5 0.7 0.3

All taxes 36.6 31.0 33.1 34.9 35.5

Progressive

Regressive

Direct taxes

Income tax 3.5 4.8 8.5 12.1 17.3

Employees' NIC 1.3 2.4 4.0 5.5 5.5

All direct taxes 10.2 11.2 15.9 20.5 24.7

Indirect taxes

VAT 10.3 8.2 7.1 6.3 5.1

Duty on alcohol 1.5 1.1 1.0 0.9 0.7

Duty on tobacco 2.8 1.6 1.5 0.7 0.3

All taxes 36.6 31.0 33.1 34.9 35.5

Progressive

Regressive

Direct taxes

Income tax 3.5 4.8 8.5 12.1 17.3

Employees' NIC 1.3 2.4 4.0 5.5 5.5

All direct taxes 10.2 11.2 15.9 20.5 24.7

Indirect taxes

VAT 10.3 8.2 7.1 6.3 5.1

Duty on alcohol 1.5 1.1 1.0 0.9 0.7

Duty on tobacco 2.8 1.6 1.5 0.7 0.3

All taxes 36.6 31.0 33.1 34.9 35.5

Progressive

Regressive

Close to being proportional

Taxation and Aggregate DemandChanges in tax rates and tax allowances can have a direct and indirect effect on the level of aggregate demand

Government spending can be used to manage the level and growth of AD to meet macroeconomic policy objectives such as low inflation and higher levels of employment

When private sector demand for goods and services is low, the government needs to find a compensating source of demand to rebalance the economy – and the solution comes from the government in the form of higher borrowing or less saving.

Taxation and Aggregate DemandChanges in tax rates and tax allowances can have a direct and indirect effect on the level of aggregate demand – here are some examples

Income tax and disposable income

Corporation taxes and business investment Taxation of imports

National insurance and labour demand

VAT and consumer spending

Taxation and R&D spending

Direct tax cuts and ADGeneral

Price Level

Real National Output (Y)

Will tax cuts boost demand?

Taxation and Aggregate SupplyChanges in tax rates and tax allowances can have a direct and indirect effect on both short-run and long-run aggregate supply (SRAS and LRAS)

Work incentives Inward migration Capital investment

Enterprise / Entrepreneurship

Human capital spending Tariffs import costs

Taxation and Research Investment

The UK government has introduced a “patent box”, which provides tax incentives against future profits on drugs developed in the country

Britain’s main corporation tax rate is due to fall to 20 per cent by 2015, from 28 per cent in 2010 – this is a tax on business profits

The patent box offers a 10 per cent tax rate on patent profits

Taxation and Investment – Shale Gas

"I want Britain to be a leader of the shale gas revolution because it has the potential to create thousands of jobs and keep energy bills low for millions of people."

Taxation and Housing SupplyIt is widely accepted that there is a chronic shortage of new housing in the UK leading to deep problems of affordability.

The Royal Institute of Chartered Surveyors (RICS) has called upon the Chancellor, George Osborne, to provide VAT incentives to boost house building.

The industry body says that the tax system needs to be used to provide more incentives for the housing development industry, including the provision of VAT for building refurbishment and repair.

Besides a change in VAT, are there other tax changes that might stimulate an expansion in investment in new house-building?

The Overall UK Tax Burden

The tax burden is measured by total tax revenues measured as a share of GDP

Selected Indirect Tax Revenues

To what extent would tax reductions help to bring about stronger growth in the UK economy?

To what extentRequires good evaluationLots of uncertainty at the moment

Evaluate the point you are making in each paragraph!

Tax reductions1/ Which taxes might be cut?2/ Consumer or business taxes?

Stronger growth1/ Context – weak recovery2/ Short term growth?3/ Long term growth? Evaluate the point

you are making in each paragraph!

Stronger growth1/ Context – weak recovery2/ Short term growth?3/ Long term growth?

Different tax cuts for short and long term growth aims?

Consumer spending• Cuts in VAT or income tax to boost demand

Business investment• Lower corporation tax to increase investment

Lower employment taxes• Reduced national insurance taxes

Reductions in fuel / carbon taxes• Lower costs for businesses, less inflation

Low confidence – tax cuts likely to be saved

Direct tax cuts and ADGeneral

Price Level

Will tax cuts boost demand?

Businesses might invest overseas instead

Skills shortages limit employment creation

Conflicts with environmental policies

Lower taxes for businessesGeneral

Price Level

Can tax changes drive LRAS higher?General

Price Level

LRAS1 LRAS2

Good evaluation approaches

Tax cuts on their own are insufficient in the current UK economic context

Which tax cuts will boost short term growth?

Which tax changes might help long term competitiveness?

Consequences for other macro objectives?

AS Macro Course Support

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Economics of Government Spending

Welfare Spending

Transfer Payments

Public Services

Recurring spending (G)

Public Sector Capital Spending

Investment

Welfare Spending

Transfer Payments

Public Services

Investment

Welfare Spending

Transfer Payments

Public Services

Investment

Welfare Spending

Transfer Payments

Public Services

Investment

• Total public (government) spending in the UK will be £745 billion in 2015/16 • This is 43.1% of GDP• £50 billion or 7% will be capital spending

Main UK Departmental Spending (2013)Department £ billion

Work and Pensions 167,828

NHS (Health) 117,112

Education 66,954

Defence 37,338

Transport 17,043

Home Office 16,188

Communities and Local Government 15,410

Environment, Food and Rural Affairs 10,757

Culture, Media and Sport 9,519

Justice 8,505

International Development 5,923

Cabinet Office 5,722

Energy and Climate Change 3,141

Source: https://www.gov.uk/government/publications/public-expenditure-statistical-analyses-2013

Main UK Departmental Spending (2013)Department £ billion

Work and Pensions 167,828 Welfare spending

NHS (Health) 117,112

Education 66,954 State education

Defence 37,338

Transport 17,043

Home Office 16,188 Prisons, Policing etc.

Communities and Local Government 15,410

Environment, Food and Rural Affairs 10,757

Culture, Media and Sport 9,519

Justice 8,505 Legal system

International Development 5,923 Includes overseas aid

Cabinet Office 5,722

Energy and Climate Change 3,141

Source: https://www.gov.uk/government/publications/public-expenditure-statistical-analyses-2013

Welfare Benefits

Cash welfare benefits in 2012 were worth an average of:

£7,419 for each family in the bottom 20% of the UK income distribution

• Welfare benefits provide a safety-net for people/families on low incomes• Some benefits are universal whereas others are means-tested (linked to income)

Welfare CapIn 2010 the Government announced an intention to cap total household benefits at £500 per week for a family and £350 per week for a single person with no children from April 2013 (implementation was subsequently delayed)

Economic Importance of Government Spending

Component of

aggregate demand

Regional economic

impact

Essential public goods

Achieving more

equity in society

Component of

aggregate demand

Regional economic

impact

Achieving more

equity in society

Component of

aggregate demand

Regional economic

impact

Achieving more

equity in society

Component of

aggregate demand

Regional economic

impact

Achieving more

equity in society

Government spending as % of GDPIs there an optimum size of government spending for an economy such as the UK?

“We are sticking to the task. But that doesn't just mean making difficult decisions on public spending. It also means something more profound. It means building a leaner, more efficient state. We need to do more with less. Not just now, but permanently” David Cameron, November 2013

Government spending in real termsThe boom years for rising state spending have come to an end – the Coalition government have introduced a period of fiscal austerity with cuts in government spending planned

“If we don't get a grip on government spending, there will be no growth.”

George Osborne, 2011

“If we don't get a grip on government spending, there will be no growth.”

George Osborne, 2011

“The danger of having no growth, or little growth, for a long time is high; you get a number of vicious cycles which come into play…You're playing with fire when you get to low growth rates”

Government spending and taxation

Discuss the effectiveness of cuts in government spending as a means of meeting the

government’s macroeconomic objectives

• Scrapping investment projects – job losses, impact on potential GDP, negative multiplier effects

Argument 1: Depends on where cuts are made

• Will other components of AD help to compensate? E.g. Exports? Consumer spending?

Argument 2: Depends on how deep cuts are

• Euro economy is in crisis? • Government has already lost AAA credit rating despite cuts

in government spending

Argument 3: Depends on external economic events

Government Spending and JobsWhat are the possible relationships between the rate of unemployment and the level of government spending?

Recession and the Fiscal Deficit

• Global financial crisis + deep recession large fall in tax revenues

• Higher government spending

• Huge rise in fiscal deficit

• UK already had a deficit before the recession

The Economics of Budget Deficits

Government borrowingThe budget deficit is the amount that the government needs to borrow each year to finance state spending

The case for budget deficit reduction

• High debt threatens stability and recovery

• Government wants credibility in financial markets

• Higher future taxes will squeeze the private sector

• Inequitable to leave future generations with debt

• Doubts about effectiveness of stimulus policies

Deficits and Debt

On average, the loans used to finance Britain’s national debt run for ten years.

When bonds expire, the Treasury has to raise more money at the interest rate demanded by international markets

Borrowing Money – Bond Yields for the UK

UK Government Bond YieldsBond yield: the annual interest rate on debt

Counter-arguments to fiscal austerity

• UK should take advantage of low interest rates to fund crucial infrastructure

• Economy remains depressed and unemployment is high. Spending needed to create jobs

• Sensible fiscal stimulus policies are self-financing – they create extra tax revenue

• Poor households and families with children will bear the brunt of austerity – it is making inequality worse

Debt Interest PaymentsIn 2011, the UK government was spending near £1 billion each week in debt interest payments

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