Fiscal Policy

MACRO ECONOMICS

“in this world nothing can be said to be certain, except death and taxes.”

Benjamin Franklin (1789)

"The art of taxation consists in so pluckingthe goose as to obtain the largest possibleamount of feathers with the smallest possibleamount of hissing." (Colbert, 1665)

Jean-Baptiste Colbert was the controller general of finance (from 1665) and secretary of state for the navy (from 1668) under King Louis XIV of France. He carried out the program of economic reconstruction that helped make France the dominant power inEurope.

FISCAL

POLICY

Fiscal policy involves changes in government spending and taxation.

The government makes policy decisions (discretionary fiscal policy) to influence markets, and the wider economy, through using changes in government spending levels and/or changes in the level of taxation.

Fiscal policy affects predominantly the demand side of the economy, but can also have significant supply side effects. It is often referred to as demand side policy (Monetary policy is also demand side).

The government announces its public spending and taxation decisions in the annual budget.

If the government spends more, in the year, than it raises in taxation revenue, there would be a

If the government spends less than it raises in taxation revenue, there would be a

If the government spends roughly the same as it raises in taxation revenue, there would be a

Euro Government deficits

• http://www.bbc.co.uk/news/business-13366011

Does a budget deficit matter? • Potential Problems of a budget deficit

• Financing a deficit: A budget deficit has to be financed. Day- to- day the issue of new government debt to domestic or overseas investors can do this. But it may be that if the budget deficit rises to a high level, the government may have to offer higher interest rates to attract buyers of government debt. In the long run, higher government borrowing today may mean that taxes will have to rise in the future

• The National Debt: In the long run, a high level of government borrowing adds to the accumulated National Debt. This means that the Government has to spend more each year in debt-interest payments to holders of government bonds and other securities. There is an opportunity cost involved here because interest payments might be used in more productive ways, for example an increase in spending on health services. It also represents a transfer of income from people and businesses that pay taxes to those who hold government debt and cause a redistribution of income and wealth in the economy

• Wasteful public spending: Neo-liberal economists are naturally opposed to a high level of government spending. They believe that a rising share of GDP taken by the state sector has a negative effect on the growth of the private sector of the economy. They are sceptical about the benefits of higher spending believing that the scale of waste in the public sector is high – money that would be better off being used by the private sector.

• What is a government bond?• Governments borrow money by selling bonds to investors. A bond is an IOU. In return for the investor's cash, the

government promises to pay a fixed rate of interest over a specific period - say 4% every year for 10 years. At the end of the period, the investor is repaid the cash they originally paid, cancelling that particular bit of government debt.

• Government bonds have traditionally been seen as ultra-safe long-term investments and are held by pension funds, insurance companies and banks, as well as private investors. They are a vital way for countries to raise funds.

• What is a bond market?• Once a bond has been issued - and the government has the cash - the investor can hold the bond and collect the

interest every year until it is repaid. But investors can also buy and sell bonds that have already been issued on the financial markets - just like buying and selling shares on the stock market.

• The price of the bond will fluctuate as the outlook for interest rates changes. So, for example, if the markets think that interest rates are going to rise sharply, then the value of a bond paying a fixed rate of 4% for the next 10 years will fall. Bond prices will also fall if investors think that there is a risk of the government that issued the bond not being able to make the annual interest payment or repay it in full on maturity - and these are the fears which have been pushing down Spanish bond prices

• Why do bond markets matter?• Because they determine what it costs a government to borrow. When a government wants to raise new money, it

issues new bonds, and has to pay an interest rate on those bonds that is acceptable to the market. The yield at which the market is buying and selling a government's existing bonds gives a good indication of how much interest the government would have to pay if it wanted to issue new bonds. So, for example, Spanish 10-year bond yields have risen above 6% in recent years. That means that if the Spanish government wants to borrow new money from the bond market for 10 years, it would have to pay an interest rate on the new bond of more than 6%

Potential benefits of a budget deficit

• Government borrowing can benefit economic growth: extra capital spending that leads to an increase in the stock of national assets. Eg. higher spending on the transport infrastructure improves the supply-side capacity of the economy promoting long-run growth. Also increased spending on health and education can boost labour productivity and employment.

• The budget deficit as a tool of demand management: Keynesian economists would support the use of fiscal policy to manage the level of AD. An increase in borrowing can be a stimulus to demand when other sectors of the economy are suffering from weak spending. The argument is that the government can and should use fiscal policy to keep real national output closer to potential GDP so that we avoid a large negative output gap. Maintaining a high level of demand helps to sustain growth and keep unemployment low

Types of TaxationDirect taxation –

are taxes imposed on income of individuals and firms, they include income tax and corporation tax.

Indirect taxation –

are taxes imposed on expenditure of individuals and firms on goods and services, they include excise duty and V.A.T. (value added tax).Taxes, and tax systems, can also be classed as progressive, proportional or regressive.

A progressive tax is…

one which takes a higher percentage of income from those who can afford to pay Eg?

A proportional tax…

takes the same percentage of income from all income groups Eg?

A regressive tax…

takes a greater percentage of income from those who are least able to pay. Eg?

More on the impact of different taxes later…

Reasons for Taxation?

To raise revenue for expenditure.

To influence economic activity to meet its major economic objectives.

To discourage consumption of demerit goods.

To redistribute income within the economy.

To discourage the purchase of imports.

To tackle the problem of external costs from, for example, pollution.

What makes a ‘good tax’?• Adam Smith’s ‘4 Canons of taxation‘

• equitable Taxes should be levied according to ability to pay

• economical The cost of collection must be low relative to the yield

• certain The timing and amount to be paid must be certain to the payer

• convenient The means and timing of payment must be convenient to the payer

• In addition:• A tax must not hinder efficiency or should involve the least

loss of efficiency• A tax should be compatible with foreign tax systems (in the

UK's case, with Europe's)• Tax should automatically adjust to changes in the rate of

inflation (particularly important in high inflation economies.• i.e. flexible and efficient

Why does the Government Spend? To provide essential services

To influence economic activity to meet its major economic objectives.

To encourage consumption of merit goods

To redistribute income within the economy

To fund provision of the welfare state and social security.

To encourage exports

It can also try to encourage domestic production of goods that have positive externalities

Government spending, also referred to a public expenditure, includes spending by central gov, local gov and public corporations.

Classifying Government Spending

Capital Expenditure – building a new school is an example, also improving capital by spending on roads and hospitals.

Current Expenditure – the spending required to run services and use the capital employed. Salaries of public employees (NHS, Education, Police, Local gov’t, Armed forces….) and materials used (books, medicines, stationary….) are forms of current expenditure.Transfer Payments – money transferred, by government, to individuals in the form of benefits. Transfers to the unemployed and the elderly are examples, JSA and pensions.Debt interest payments – these are made to the government’s creditors (holders of the government debt), interest paid on government bonds is one type of payment.

Non-exhaustive expenditure

Exhaustive expenditure

The revenues from some taxes and some forms of government expenditure can change automatically to stabilise fluctuations in real GDP. These are referred to as automatic stabilisers.

Example:

Automatic Stabilisers

Government revenue from income tax and VAT increases when real GDP rises. Government spending on unemployment benefit will fall as output and employment increases.

These changes in revenue and expenditure, that automatically occur, will act to stabilise real GDP. These stabilisers also work when there is a fall in real GDP, spending increases and tax revenue falls.

T-Taxation Revenue

G-Government Spending

0

Taxation Revenue and Government Expenditure (as % of GDP)

Real GDP

The effect of changes in economic activity, and/or government policy on tax revenue and government

spending

Yd Yb Ys

Deficit Surplus

If the government increases G , AD will increase.

As G is a component of aggregate demand, AD=C+I+G+(X-M).

AD should also increase when taxation falls. As taxation falls C and I is expected to increase, AD=C+I+G+(X-M).

Policies which seek to increase AD, are examples of Reflationary (or expansionary) fiscal policy.

Policies which seek to reduce AD are examples of deflationary (or contractionary) fiscal policy.

Illustrate and explain how the government could boost AD by using fiscal policy

1 page of A4

Include detail of how and why it could work to boost AD.

No evaluation yet!

AS/AD analysis- expansionary fiscal policy

Price

Level

Real GDP

AD

AD

LRAS

LRAS

0

AD1

AD1

An expansionary fiscal policy (reduced taxation/increased government spending) would lead to an increase in AD, shown by a shift to the right of the AD curve from AD to AD1. Attempting to reflate the economy (increase output, income and employment)

This policy would be particularly effective when the economy is operating under capacity/ less than full employment. If there is cyclical unemployment this policy could be considered.

AS/AD analysis- deflationary fiscal policy

Price

Level

Real GDP

AD

AD

LRAS

LRAS

0

A deflationary fiscal policy (increased taxation/reduced government spending) would lead to a decrease in AD, shown by a shift to the left of the AD curve from AD to AD1.Attempting to deflate the economy (reduce inflation and to improve competitiveness)

This policy is particularly effective when the economy is operating at full capacity/full employment.

If there is high inflation, and/or a current account (BOP) problem, this policy could be considered.

AD1

AD1

EFFECTIVENESS

OF FISCAL

POLICY

=Evaluation

Effectiveness of fiscal policy

Can target particular products (demerit and merit goods), areas of the country and groups within society.

Can influence every component of AD and also affect the quantity and quality of resources available (LRAS)

Can be used to redistribute income and wealth within society

Automatic stabilisers are evident (non- discretionary)

Can have a significant impact on the economy, especially when there is a large multiplier effect An initial change in AD can have a much greater final impact on the level of equilibrium NI- “one person’s spending is another’s income” (more to follow…)

Limitations of fiscal policy

It is difficult to estimate how much AD will alter as a result of fiscal policy measures.

Can be inflexible. Changes in taxes are generally announced annually and budget decisions may take some time to implement.

Fiscal policy measures often experience time lags. Not only in terms of their effect on AD but also the impact on LRAS. In addition- there is not necessarily a guarantee that increased health and education spending leads to an improvement in quality of the service.

Decisions may be based on inaccurate or insufficient information.

A measure or a range of measures designed to achieve one objective may have unintended adverse effects on other objectives. I.e., A reflationary fiscal policy designed to increase employment may also increase inflation and worsen our current account balance.

There may be disincentive effects both for firms and individuals (eg. Laffer curve… to follow…)

Crowding Out (G ‘crowds out’ I because increased G leads to increased interest rates which leads to a fall in I) more to follow…

Limitations of fiscal policy

Limitations of fiscal policy• The effectiveness of Fiscal policy will be

significantly influenced by the underlying economic conditions. The position of the AD and LRAS curves can be useful to consider when indicating how effective fiscal policy measures may be

• Using a Keynesian LRAS show when a rise in AD may not be effective at boosting real GDP and employment

• Now show a position when it will be most effective

Price

Level

Real GDP

AD1

LRAS

AD2

AD4

AD3

Y1 Y2 YFE

PL1

PL2

PL3

PL4

Price

Level

Real GDP

AD1

LRAS

AD2

AD4

AD3

Y1 Y2 YFE

PL1

PL2

PL3

PL4

Fiscal Policy

MACRO ECONOMICS

More detail…

• Crowding out…

Crowding Out• When governments run budget deficits in order to boost AD

and reduce unemployment there is a potential problem known as ‘crowding out’

• The “crowding-out hypothesis” became popular in the 1970s and 1980s when free market economists argued against the rising share of national income being taken by the public sector.

• The view is that a rapid growth of G leads to a transfer of scarce productive resources from the private sector to the public sector

• Eg. The gov. run a budget deficit to boost AD. To finance the deficit the government will have to sell debt to the private sector

• Attracting individuals and institutions to purchase the debt may require higher interest rates. A rise in interest rates may crowd out private investment and consumption, offsetting the fiscal stimulus. (Financial Crowding Out)

Investment Theory• Planned investment is determined by the expected post-

tax real rate of return on capital projects• Interest rates may play an influential role – because

they represent the opportunity cost of funds used to finance investment

• Firms estimate the expected real rate of return on capital employed using expected revenue streams and cost projections

• This expected rate of return can then be compared to the prevailing real rate of interest (a measure of the opportunity cost of funding an investment project)

• A fall in interest rates decreases the cost of investment relative to the potential yield – planned investment projects on the margin may become financially worthwhile

• The rate of return on an investment is known as the MEC

Planned Capital Investment (Id)

Real Interest

Rate

R2

R1

I1 I1Q of loanable funds

Real Interest

RateS

R1

R2

D1 D2 I

By issuing gov bonds, the gov are essentially increasing the demand for savings or ‘loanable funds’.

This results in a rise in the real interest rate and a fall in investment as the cost of investment relative to the potential yield has risen

AD= C+I+G+(X-M)• The increase in G has resulted in a decrease in I and therefore

could end up reducing ADAD overall• Public sector investment has ‘crowded out’ private sector

investment• The Keynesian response to the crowding-out hypothesis is that

the probability of 100% crowding-out is extremely remote, especially if the economy is operating well below its productive capacity and if there is a plentiful supply of savings available that the government can tap into when it needs to borrow money. There is no automatic relationship between the level of government borrowing and the level of short term and long term interest rates.

• Neoclassical economists (opposed to use of demand management policies) argue that crowding out is a significant problem of increased G

The Multiplier• An initial change in AD can have a much greater final

impact on the level of equilibrium NI• This is because injections into the circular flow of

income stimulate further rounds of spending – in other words

• “one person’s spending is another’s income” • this can lead to a much bigger effect on equilibrium

output and employment.• The multiplier provides a measure of the magnitude of

changes in GDP caused by changes in AD • eg. if the multiplier is 3, an increased injection of $100m

will increase Y by $300m

Very Simple Circular Flow of Income Model

C

Wages, rent, interest and profit I+G+

X

S+T+M•Assume initial injection of G of $100m•This goes to firms, then consumers, then firms, then consumers and so on….•Each time the money is circulated some ‘leaks’ out of the flow, but still some of the additional money will be spent over and over, increasing GDP by more than $100m

Example• A large firm spends an $100m extra on a new factory. • Initially NI rises by $100m• This will set off a chain reaction of increases in expenditures.• Firms who produce the capital goods that are purchased will

experience an increase in their incomes and profits• If they in turn, collectively spend about 3/5 of that additional

income, then £60m will be added to the incomes of others. • At this point, NI has grown by $160m• The sum will continue to increase as the producers of the

additional goods and services realise an increase in their incomes, of which they in turn spend 60% on even more goods and services.

• The increase in NI will then be $196• The process can continue indefinitely. But each time, the

additional rise in spending and income is a fraction of the previous addition to the circular flow (there are withdrawals at every stage)

• Hence the initial injection of $100m results in NI rising by more than $100m

• The multiplier process requires that there is sufficient spare capacity in the economy for extra output to be produced.

• If aggregate supply is inelastic, the full multiplier effect is unlikely to occur, because increases in AD will lead to higher prices rather than a full increase in real national output.

• In contrast, when AS is perfectly elastic a rise in aggregate demand causes a large increase in national output.

AD= C+I+G+(X-M)

• Autonomous Spending= components of AD which do not depend on current domestic incomes (exogenous)

• Induced Spending= Components of AD which change in response to changes in income (endogenous)

• In the previous example the rise in G of $100m would be classified as autonomous, this further impacts on AD via increases spending by firms and consumers, the further impacts would be classified as induced

Showing the multiplier on a Keynesian AD/ AS diagram

Y1 Y2

Price Level

Real National Output

AD1 AD2 AD3

Y3

Due to the multiplier effect the rise in G causes induced spending of $300m

The initial rise in AD is due to the autonomous spending of the government of $100m

• The multiplier process also requires that there is sufficient spare capacity in the economy for extra output to be produced.

• If aggregate supply is inelastic, the full multiplier effect is unlikely to occur, because increases in AD will lead to higher prices rather than a full increase in real national output.

• In contrast, when AS is perfectly elastic a rise in aggregate demand causes a large increase in national output.

Showing the multiplier on a Keynesian AD/ AS diagram

Y1 Y2

Price Level

Real National Output

AD1 AD2 AD3

The full effect of the multiplier can only be experienced when the price level is constant, the greater the price level increase, the smaller is the size of the multiplier effect

What are the two things to keep in mind when government plans to intervene to fill a deflationary

gap?

• It must estimate the gap between the equilibrium output and full employment output.

• It must estimate the value of the multiplier so it can judge the suitable increase in AD that is necessary to inject into the economy in order to fill the gap.

The government needs to consider…

• The higher the withdrawals (taxes, imports and savings), the lower the multiplicative effect of any given increase in government spending.

• Lower interest rates lower withdrawals• Lower income taxes will lower withdrawals• Barriers to trade will lower the withdrawals

• The concept of the multiplier process became important in the 1930s when John Maynard Keynes suggested it as a tool to help governments to achieve full employment.

• This macroeconomic “demand-management approach”, designed to help overcome a shortage of business capital investment, measured the amount of government spending needed to reach a level of national income that would prevent unemployment.

• More on the multiplier for HL next …

Calculating the size of the multiplier

• The size of the multiplier depends on what proportion of additional disposable income is spent on domestic goods and services this is known as the marginal propensity to consume (mpc)

• mpc= ΔC/ ΔYd

The multiplier= 1/ 1-mpc

Eg. If the mpc was 0.6 and there was an injection of $100m then the change to national income would be

$100 x (1/ 1-0.6)= $100 x 1/0.4= $100 x 2.5=$250m

Another way…

• The multiplier= 1/ mps + mpt + mpm• mps= marginal propensity to save• mpt= marginal propensity to tax• mpm= marginal propensity to import

• Note: mpc + mps + mpt + mpm = 1• The mps + mpt + mpm = mpw

• The smaller the value of the withdrawals the larger the value of the multiplier

• So changes to withdrawals (eg. change in tax rates) change the value of the multiplier

Activity  £6bn is due to be spent by the UK government in order to

prepare London for the 2012 Olympics. This will bring a significant multiplier effect upon the UK Economy.

 Example 1Assume that the mpc = 0.7Therefore change to national income following £6bn

injection-£6bn * 1/(1 – 0.7) = £19.9bn Example 2Assume that the mpc = 0.3Therefore change to national income following £6bn

injection-£6bn * 1/(1 – 0.3) = £8.6bn

The government needs to consider…

• The higher the withdrawals (taxes, imports and savings), the lower the multiplicative effect of any given increase in government spending.

• Lower interest rates will lower the MPS,• Lower income taxes will lower the MRT• Barriers to trade will lower the MPM.• All will lower the MPW and thus

increase the value of the multiplier.

More on Taxation…

• Recall…

• Taxes can be regressive, progressive or proportional…

Regressive Taxation• UK VAT is currently 20%• Almost all goods and services have this tax added to the selling price…• VAT is a regressive tax (as are almost all indirect taxes, eg, Malaysian Sales

tax)• A regressive tax means that as a persons income rises their average tax rate

falls.• Scenario 2 people both drive to work every day and purchase £100 of petrol

per week. £20 of this is VAT.• Person 1 earns £300 per week• Person 2 earns £600 per week• Person 1 has an average tax rate of (20/300) x 100 = 6.67%• i.e. this takes takes up 6.67% of their income• Person 2 has an average tax rate of (20/ 600) x 100 = 3.33%• i.e. this tax only takes up 3.33% of their income• Both are consuming the same amount of the good, but one is paying more in

tax (as a percentage of their income) than the other, is this fair?• Therefore we can see that as income rises the average amount paid in tax falls.• If this tax were to increase it would hit the person with the lower income the

hardest, increasing income inequality (generally seen as socially undesirable)

Progressive Taxation• Income tax in the vast majority of

countries is progressive• As income rises a higher percentage of

income is paid in tax• Some exceptions:• Saudi Arabia, 0% natives, 20%

foreigners• Qatar and UAE 0%• Kazakhstan 10% (proportional)• Czech Republic 15% (proportional)

UK Income taxRate 2012-13

Personal Allowance £8,105

Basic rate: 20% £0-£34,370

Higher rate: 40% £34,371-£150,000

Additional rate: 50%

Over £150,000

So someone earning £8,000 per year ( for example a student) will pay no tax.

Someone earning £10, 000 per year will pay no tax on the first £8,105, then 20% tax on the remaining £1895. Therefore they will pay £379 tax. Their highest marginal tax rate is 20%. Their average tax rate is £379/ £10, 000 x 100 = 3.79%

UK Income taxRate 2012-13

Personal Allowance £8,105

Basic rate: 20% £0-£34,370

Higher rate: 40% £34,371-£150,000

Additional rate: 50%

Over £150,000

So someone earning £8,000 per year ( for example a student) will pay no tax.

Someone earning £10, 000 per year will pay no tax on the first £8,105, then 20% tax on the remaining £1895. Therefore they will pay £379 tax. Their highest marginal tax rate is 20%. Their average tax rate is £379/ £10, 000 x 100 = 3.79%

Calculate the following

• The total tax per year• The highest marginal tax rate• The average tax rate• For someone earning…• £25, 000 a year• £35, 000 a year• £100, 000 a year• £150, 000 a year• £151, 000 a year

Chargeable Income Calculations (RM) Rate %

Tax(RM)

0-2500 On the First 2,500 0 0

2,501-5,000 Next 2,500 1 25

5,001-10,000 On the First 5,000Next 5,000 3

25150

10,001-20,000 On the First 10,000Next 10,000 3

175300

20,001-35,000 On the First 20,000Next 15,000 7

4751,050

35,001-50,000 On the First 35,000Next 15,000 12

1,5251,800

50,001-70,000 On the First 50,000Next 20,000 19

3,3253,800

70,001-100,000 On the First 70,000Next 30,000 24

7,1257,200

Exceeding 100,000 On the First 100,000Next RM 26

14,325..........

How much tax would someone earning RM120, 000 per year pay in tax?What is their highest marginal rate of tax?What is their average rate of tax?

ActivityIncome Bracket Tax Rate

$0 - $10, 000 0%

$10, 0001- $20, 000 15%

$20, 001- $35, 000 25%

$35, 001 + 40%

Annual income level Annual spending on goods and services

Sara $14, 500 $13, 000

Kathryn $29, 000 $24, 000

Natalie $43, 000 $35, 000Calculate the income tax bill for each personCalculate the average tax rate for each person. Is it more or less than their marginal tax rate?Assume the spending on goods and services does not include taxes. If they pay 20% in indirect taxation on their spending, calculate how much indirect tax each person will pay. What percentage of their income do they pay in indirect taxes?Is each tax progressive, regressive or proportional, explain why.

ActivityIncome Bracket Tax Rate

$0 - $10, 000 0%

$10, 0001- $20, 000 15%

$20, 001- $35, 000 25%

$35, 001 + 40%

Annual income level Annual spending on goods and services

Sara $14, 500 $13, 000

Kathryn $29, 000 $24, 000

Natalie $43, 000 $35, 000Calculate the income tax bill for each personCalculate the average tax rate for each person. Is it more or less than their marginal tax rate?Assume the spending on goods and services does not include taxes. If they pay 20% in indirect taxation on their spending, calculate how much indirect tax each person will pay. What percentage of their income do they pay in indirect taxes?Is each tax progressive, regressive or proportional, explain why.

Next Topic…

• Supply side policy

HL ‘Paper 3’ Topic references for year 12 examRead p83- 84 and p96 &97

• Paper 3 is the paper with the calculations• Go through your syllabus. Anything we

have covered could be in the exam.• See the HL topics in your book, plus the

exercises we did in class and the HL assessment for more detail on the structure of the paper.

• You will have 1 hour and answer 2 questions (no choice of questions) similar to the HL assessment we did