Fiscal Policy AS economics revision presentation on the operation of government fiscal policy – including changes in government spending, tax revenue and public sector borrowing

The Main Goals of Fiscal Policy The Treasury has outlined the main goals of fiscal policy to be the following: Over the medium term, ensure sound public (government) finances Ensure that government spending and taxation impact fairly both within and across generations Meet key spending and tax priorities without a damaging rise in the burden of government debt That those who benefit from public services also meet as far as possible the costs of the services they consume In the short run, fiscal policy should support monetary policy By allowing the automatic stabilisers to play their role in smoothing the economic cycle in the face of fluctuations in aggregate demand

Distribution of Public Spending

Government spending on education and health (% of GDP)

Composition of Government Spending Transfer Payments Social security payments Over £110 billion including Income support Jobseekers’ Allowance State Pensions Housing benefit / Council Tax Benefit Some benefits are means tested Others are universal or are based on national insurance contributions Current spending on goods & services (G) Capital Spending Infrastructural spending by the public sector Spending that results in the acquisition of assets

Recent trends in total UK government spending Government spending at current prices Government spending in real terms Government spending as a share of GDP £ billion (2001-02 prices) 1997-98 323.6 367.5 39.3 1998-99 333.3 368.5 38.4 1999-00 343.6 370.9 37.4 2000-01 366.8 387.2 38.1 2001-02  389.8 401.5  38.8 Projections 2002-03 419.9 39.8 2003-04 450.7 438.9 40.7 2004-05 479.6 455.3 40.9 2005-06 511.4 473.6 41.3

Why Do We Have Government Spending To pay for the provision of Public Goods Merit Goods Both goods may be under-provided/under-consumed by the free market leading to market failure To provide a basic system of welfare support / income replacement for low income households As a means of redistributing income within society Government spending can also be used as a tool to control aggregate demand (GDP) as part of macroeconomic policy

Taxation

Reasons for having taxation Revenue: To raise revenue to finance spending on goods and service by central & local government Managing AD: The government when managing the level of AD, output and prices uses taxation Changing the distribution of income and wealth: A progressive system of taxation can be utilized to achieve great equality in income & wealth between individuals and households Meeting environmental targets: Taxes can correct for externalities and other forms of market failure Helping the balance of payments: Import taxes may control imports and therefore help the country’s balance of payments and protect industries from overseas competition

Income tax and national insurance contributions Income Tax and Corporation Tax in the UK Data is for the tax year 2003-04 Income tax Personal tax-free allowance: under age 65 £4,615 p.a. Lower rate 10% Basic rate 22% Higher rate 40% Lower-rate limit (income above personal £1,960 p.a. Basic-rate limit allowance) £30,500 p.a. Corporation tax Rates: lower rate 0% small companies’ rate 19% standard rate 30%

Direct and indirect taxes Direct taxation Direct taxation is levied on income, wealth and profit while indirect taxation is levied on expenditure Direct taxes include income tax, national insurance contributions, capital gains tax, and corporation tax Indirect taxation Indirect taxes is levied on spending on goods and services Indirect taxes include VAT; excise duties on fuel and alcohol, car tax, betting tax and the TV licence VAT: An indirect tax at the rate of 17.5%, although domestic fuel is taxed at 5% Excise duties are specific duties. The main duties are placed on cigarettes, alcohol, and fuel

Tax revenues in 2002-03 (£ billion) Income tax 112.9 Inheritance tax 2.4 NICs 64.7 Spirits duties 2.3 VAT 63.5 Insurance premium tax 2.1 Corporation tax 29.2 Wine duties 1.9 Fuel duties 22.1 Customs duties and levies Business rates 18.4 Capital gains tax 1.6 Council Tax 16.7 Betting & gaming duties 1.3 Other taxes & royalties 10.8 Petroleum revenue tax 1.0 Tobacco duty 8.1 Climate change levy 0.8 Stamp duties 7.6 Air passenger duty VED 4.6 Landfill tax 0.5 Income tax credits 3.4 Oil royalties 0.4 Beer & cider duties 3.1 Aggregates levy 0.2

Government Taxes (2003-04)

Examples of indirect taxation Vehicle excise duty Standard rate £155 p.a. Small cars rate £100 p.a. Heavy goods vehicles (varies according to vehicle type and weight) £155-£9,250 p.a. Landfill levy £11 per tonne Low rate (inactive waste only) £2 per tonne Climate change levy (Came into effect on 1 April 2001) Electricity 0.43p/kWh Coal 0.15p/kWh Natural gas

Effects of an indirect tax – using supply & demand analysis A specific tax when demand is elastic An ad valorem tax when demand is inelastic S + Tax Price S + Tax Price S1 S1 P2 P2 P1 D1 P1 D1 Q2 Q1 Quantity Q2 Q1 Quantity

Progressive and regressive taxation Progressive 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 earned goes up This causes a rise in the average rate of tax (the percentage of income paid in tax) Proportional taxes With a proportional tax, the marginal rate of tax is constant. For example, we might have an income tax system that applied a standard rate of tax of 25% across all income levels Regressive taxes 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 In the UK, most examples of regressive taxes come from excise duties of items of spending such as cigarettes and alcohol.

Evaluation: Direct versus Indirect taxation Case For Indirect Taxation Case Against Indirect Taxation Changes in indirect taxes are more effective in changing the pattern of demand for particular goods and services Many indirect taxes have regressive effects on certain consumers and thus make the distribution of income more unequal Indirect taxes are a useful instrument in controlling and correcting for externality effects Raising indirect taxes can cause cost-push inflation as producers pass on higher taxes to retailers Indirect taxes are less likely to distort the choice between work and leisure and therefore undermine work incentives Revenue streams are uncertain particularly when inflation is low or there is an recession when consumer demand falls Indirect taxes can be changed more easily – providing the government with increased flexibility Indirect taxes provide an incentive to save (and avoid the tax)

Trends in the government tax burden

Government borrowing and the effects of fiscal policy Revision presentation on government borrowing and the effects of fiscal policy on aggregate demand and aggregate supply

Government budget balances

The budget deficit / surplus The public-sector net cash requirement is how much the government needs to borrow each financial year The national debt is the total amount of borrowing undertaken by the government that has not yet been repaid. In other words, it is the sum of all outstanding central government debt The budget surplus of the last few years has allowed the government to reduce the national debt The big risk for the government is that an economic slowdown will cause public sector finances to worsen again, just at the time when planned spending increases are coming on stream

Gross Government Debt

Fiscal policy and aggregate demand Traditionally fiscal policy has been seen as an instrument of demand management Fiscal policy can be used “counter-cyclically” to help smooth out some of the volatility of output From 2001-2003 there has been a huge fiscal stimulus to the UK economy through substantial increases in government spending on transport, health and education The Keynesian school argues that fiscal policy can have powerful effects on aggregate demand, output and employment, particularly when the economy is operating well below full capacity national output

Negative output gap LRAS General Price Level P1 P2 AD1 SRAS AD2 Y2 Y1 Yfc National Income

Automatic and discretionary changes in fiscal policy Discretionary fiscal changes are deliberate changes in direct and indirect taxation and govt spending Automatic fiscal changes are changes in tax revenues and government spending arising automatically as the economy moves through stages of the business cycle Automatic stabilizers help to reduce the volatility of the business cycle A fast-growing economy tends to lead to a net outflow of money from the circular flow Conversely during a slowdown or a recession, tax revenues fall and the government automatically injects extra welfare spending into the economy and normally ends up running a larger budget deficit. According to recent work by economists at the OECD, if the government allows the automatic stabilizers to work, the amplitude of the business cycle can be reduced by over 30%.

The fiscal policy transmission mechanism Cut in personal income tax Boost to disposable income Adds to consumer demand Cut in indirect taxes Lower prices – higher real incomes Adds to consumer demand Expansionary Fiscal Policy Adds to business capital spending Cut in corporation tax Higher “post tax” profits for businesses Cut in tax on interest from saving Boost to disposable income of people with net savings Adds to consumer demand

Fiscal policy and aggregate supply Labour market incentives: Cuts in income tax / higher allowances might be used to improve incentives for people to seek work and also as a strategy to boost labour productivity Capital spending. Lower rates of corporation tax and other business taxes might be used to stimulate a higher level of business investment Entrepreneurship and new business creation: Government spending might be used to fund an expansion in the rate of new small business start-ups and to attract inflows of foreign direct investment Research and development and innovation: Government spending, tax credits and other tax allowances could be used to encourage an increase in business sector research and development Human capital of the workforce: Higher government spending on education and training (designed to boost the human capital of the workforce) and increased investment in health and transport can also have very important supply-side effects