Fiscal Policy What you need to know: explain what is meant by the government budget identify the main sources of tax revenue and government expenditure in the UK economy distinguish between current and capital government expenditure distinguish between progressive, proportional and regressive taxation distinguish between direct and indirect taxation explain the features of a ‘good’ tax evaluate the advantages and disadvantages of a flat rate tax system

Fiscal Policy What you need to know: explain what is meant by the budget position/ fiscal stance distinguish between a budget surplus, a budget deficit and a balanced budget distinguish between the cyclical budget position and the structural budget position distinguish between an overall budget position and the budget position on current expenditure distinguish between a budget deficit and government debt explain what is meant by the national debt

Fiscal Policy explain how budget deficits can be financed evaluate policies to correct a budget surplus or deficit evaluate the consequences of government debt explain how discretionary fiscal policy may be used to improve macroeconomic performance evaluate the effectiveness of using fiscal policy to achieve the government’s macroeconomic objectives explain how fiscal rules can influence the behaviour or economic agents evaluate the effectiveness of fiscal rules.

Fiscal Policy The manipulation of taxation, government expenditure and the government budget to influence the level of AD and other variables in the economy.

Fiscal Policy - purposes Redistribution of income through taxation, benefits and government spending on services – reduce income inequalities. Changes in expenditure patterns Provision of merit and public goods – correction of market failure (micro) Regulation of economic activities – correction of market failure (micro) Influences AS through supply side policies

What is Fiscal Policy? Fiscal policy involves the use of government spending, direct and indirect taxation and government 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 e.g. spending on health care and scarce resources allocated to renewable energy Fiscal policy 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 market failures such as pollution or the sub-optimal provision of public and merit goods It is important to be aware that changes in fiscal policy affect both aggregate demand (AD) and aggregate supply (AS)

Government budget This sets out the government’s income and expenditure plans for the forthcoming year. Income raised via taxation Expenditure items – health, education, social welfare, defence, law and order, overseas development, infrastructure….

Government budget The government’s budget will indicate if a deficit or surplus is expected Deficits – require funding through borrowing Surpluses – enable repayment of previous borrowing/debt

Total UK Government Spending and Tax Revenue Source: International Monetary Fund, data from 2015 onwards is a forecast

Breakdown of UK Government Spending in 2015-16 Welfare protection is the largest single element of government spending, with the NHS and Education the biggest single departmental items.

Breakdown of UK Government Spending Social Support (including pensions) (40%) NHS (20%) Education (15%) Debt interest (7%) Police, law courts, prisons Defence (5%)

Government Spending Government spending is spending by the public sector on goods and services such as education, health care and defence Welfare Spending Transfer Payments Public Services Recurring spending State Investment Investment Projects Total UK government spending is forecast to be £745 billion in 2015 This is 43.1% of GDP. £50 billion or 7% will be on capital spending Spending on public services such as education & health is 22% of GDP

Government Spending Current Government spending Expenditure on goods and services to provide existing public sector services – education, health care, law and order.. Capital Government expenditure Expenditure on infrastructure investment – schools, hospitals, roads, railways…

Sources of UK Government Tax Revenues in 2015-16 Income tax and VAT are the two biggest sources of government revenues

Sources of UK Government Tax Revenues Income Tax (30%) VAT (20%) National Insurance Contributions (20%) Excise duties (10%) Corporation tax (8%) Council Tax and Business Rates

Taxation Direct Taxation A direct tax is levied on the economic agent who pays it – individual/organisation. Usually on incomes. Income tax – workers/householders Corporation tax – on company profits Tax on savings interest Property taxes, business rates…

Taxation Indirect Taxation An indirect tax is levied on goods and service – expenditure taxes. They can be passed on to others in the form of higher prices. VAT Sales Tax Customs and Excise duties Tariffs

Progressive Taxation The proportion of income paid in tax rises as income rises Calculate the tax paid if income is (a) £9999, (b) £15 000, (c) £38 000, (d) £90 000 and (e) £200 000 Income(£) Tax Rate 0 to 10 000 0% 10 0001 – 40 000 20% 40 001 – 100 000 40% 100 000 + 45%

Proportional Taxation The proportion of the tax paid remains constant as income rises. The actual amount paid will rise! Calculate the tax paid if income is (a) £9999, (b) £15 000, (c) £38 000, (d) £90 000 and (e) £200 000 Income (£) Tax Rate(%) 0 – 10 000 10 001 + 25

Regressive Taxation The proportion of the tax paid falls as income rises. The actual amount paid will rise! Calculate the tax paid if income is (a) £9999, (b) £15 000, (c) £38 000, (d) £90 000 and (e) £200 000 Income(£) Tax Rate 0 to 10 000 0% 10 0001 – 40 000 25% 40 001 – 100 000 20% 100 000 + 5%

Regressive Taxation Indirect taxes such as VAT have regressive effects because the account for a larger proportion of low income consumers’ expenditure/income Regarded as unfair/inequitable Or they don’t have to buy!

Features of a good tax Adam Smith’s Canons of Taxation – set out 4 characteristics of a good tax 1 Equity – tax payers should contribute in proportion to their ability/in proportion to their respective revenues/incomes. The tax should be fair. 2 Certainty – “the tax which each individual is bound to pay ought to be certain and not arbitrary.” The amount paid, time paid and method should be clearly understood so there is no disincentive effect or incentives for corruption.

Features of a good tax 3 Convenience – the time and manor of payment should be convenient to the payer. 4 Economy – costs of collection and administration should be minimised. Taxes should be simple and not open to interpretation – avoidance! http://www.yourarticlelibrary.com/economics/taxati on/top-4-principles-or-canons-of-a-good-tax- system/38120/

Features of a good tax Using these canons a tax may be assessed on: The incidence of the tax – the burden/share paid by different agents e.g. VAT shared between consumer and producer. Is this fair? Efficient implementation – cost of collection and incentives/disincentives i.e. impact on resource allocation in terms of investment and consumption.

Features of a good tax Trade – countries that trade closely or are members of trade blocs should have compatible tax rates – no unfair advantage. Inflation – tax changes should take account of inflation e.g. raising tax thresholds/tax free allowances or VAT rates adjusted so goods are affordable.

Flat - rate tax system A system of income tax in which each taxpayer pays the same rate of tax on income. It has a constant marginal rate – a proportional tax Advantages Certain – beneficial impact on incentives/disincentive Efficient to implement – low collection costs. Systems with multiple rates are expensive and complex – avoidance is encouraged! UK has a complex tax code. Evasion and avoidance are discouraged Incentives for high income groups to work and take risks – progressive taxes take away a larger % of incomes. Simple to administer and would raise revenue – opinion!

Flat - rate tax system Disadvantages Equity – inequitable. A progressive system enables redistribution from high income groups to lower income groups Low income groups would pay more – this depends on the rate and size of the tax free allowance Would not raise revenue/may fall – higher income groups pay more under a progressive tax system – opinion!

Flat - rate tax system “Currently the top 10% of all income tax payers in the UK pay about 59% of all income tax. They also pay tax at higher rates than anyone else. That is why they pay so more, but that's also because they earn more than most, of course. Under a flat tax system they would enjoy substantial - maybe massive - tax cuts. “ Source http://www.bbc.co.uk/news/uk-politics-22575135

Evaluate the advantages and disadvantages of a flat rate tax system Size/degree of impact – how significant are the advantages and disadvantages e.g. how much extra revenue will be raised? It may depend on the rate set – will it incentivise workers and entrepreneurs, will lower groups pay more/less? It may depend on the size of the tax free allowance. How far will it meet the canons of taxation? Flat rate tax systems – Baltic states, Ukraine, Russia

Budget position/fiscal stance This describes budget policy: Reflationary/expansionary stance increases AD. (G>T) Deflationary/contractionary stance decreases AD. (G<T) Neutral stance has no effect on AD (G=T) The balance between G and T will affect AD.

Budget position/fiscal stance Budget surplus Government expenditure is less than tax revenues in a single year i.e. expenditure > income. Budget deficit Government expenditure is greater than tax revenues in a single year i.e. expenditure < income. The difference = government borrowing – Public Sector Net Borrowing (PSBN) or Public Sector Net Cash Requirment(PSNCR)

Budget position/fiscal stance Balanced Budget Government expenditure equals tax revenues in a single year

Budget position/fiscal stance Structural budget position The government’s long – term fiscal stance i.e. the budget position over the whole of the economic cycle – through booms and recessions

Budget position/fiscal stance Cyclical budget position The government’s short – term fiscal stance as affected by the economic cycle. In a boom a budget surplus is likely i.e. G>T A contractionary budget position In a recession a budget deficit is likely i.e. G<T An expansionary budget position.

National Debt Total government debt over time – Public Sector Net Debt. The accumulated total borrowings of government over time – National and local and public corporations. If there is a long – term budget deficit, National Debt will increase

Overall budget position The fiscal stance in all aspect of the government budget including capital/infrastructure expenditure and current expenditure Capital expenditure – assets that last a long time!

Budget position on current expenditure Fiscal stance towards daily running costs of public services i.e. repeated expenditure on items that are used up. Golden rule – current expenditure should be funded from revenue not borrowing, capital expenditure(investment in infrastructure) can be funded from borrowing

Distinguish between… Reminder! Explain the difference between….. distinguish between a budget surplus, a budget deficit and a balanced budget distinguish between the cyclical budget position and the structural budget position distinguish between an overall budget position and the budget position on current expenditure distinguish between a budget deficit and government debt(National Debt!)

Financing budget deficits In the short run the government will pay for the deficit by borrowing. Longer term it may increase taxes or reduce government expenditure Austerity measures may be used that cut public sector expenditure on services

Evaluate policies to correct a budget deficit Increase taxes Will this be successful? It may be affected by: How far taxes are raised? Will tax rises create disincentives to work, invest or locate business in the UK? Will tax avoidance and evasion occur? In a recession is the tax base large enough to raise revenues?

Evaluate policies to correct a budget deficit Decrease government expenditure Will this be successful? Cuts in benefits may not be possible – inequitable or legal entitlement Productive potential may be reduced – education, health and infrastructure cuts This may create greater problems in the future Can cuts be made through efficiency savings

Evaluate policies to correct a budget deficit Improved long term competitiveness/efficiency Supply side policies to increase productive potential and widen the tax base. SEE SUPPLY SIDE POLICIES Long term Expensive May not work e.g. education

Evaluate policies to correct a budget deficit The measures used may depend upon: How large the deficit is a % of GDP How long the deficit has existed Is it cyclical and therefore may be corrected over the economic cycle, or is it structural i.e. permanent, even at full employment. Is the deficit caused by excessive expenditure and inefficiency/uncompetitiveness, or is it cyclical

Evaluate policies to correct a budget surplus Reverse the analysis and evaluation for a budget deficit i.e. increase government spending and reduce taxation. What would be the possible problems and benefits of doing this? A budget surplus suggests taxes are too high and government spending to low which can constrain economic growth. Since 1970, the government has had a surplus in only six years!

Evaluate the consequences of government debt Increased government borrowing From: Banks – creates deposits and may lead to an increase in the money supply which can be inflationary. Private sector – issuing Treasury Bills that are repaid after 3 months Foreign financial markets

Evaluate the consequences of government debt Since 1970, the government has had a surplus in only six years – it is normal for government to have to borrow money A rise in borrowing to fund extra government spending can have powerful effects on AD, output and employment when an economy is operating below full capacity output There is an automatic rise in the budget deficit to cushion the fall in AD caused by an external economic shock. A higher fiscal deficit is needed to lift AD back towards pre-recession levels If a fiscal stimulus works the budget deficit will improve as a result of higher tax revenues and reductions in welfare spending. A growing economy helps to shrink debt as a percentage of GDP It makes sense for a government to borrow money if interest rates are low and if the deficit is being used for investment

Evaluate the consequences of government debt Increased government borrowing In the short – run this may be beneficial as it increases AD. Excessive borrowing creates problems: May create demand pull inflation due to increases in bank deposits/money supply Interest rates may be increased to reduce inflation – reduced investment and appreciation of the exchange rate – export prices rise, import prices fall

Evaluate the consequences of government debt Increased National Debt Firms and foreign nationals may stop lending if they think the government cannot repay – default on debt. This constrains future growth. Future tax payers must pay more interest – opportunity costs of reduced expenditure elsewhere e.g. health and education – reduced economic growth. Higher future taxes. Fairness – future tax payers pay for current Government spending. The country is less attractive to foreign investment due to decreased economic activity in the domestic economy – consumption, investment, income levels…

Evaluate the consequences of government debt You need to consider the significance of the consequences: Are they large/small? Short – term/long – term? Was government debt cyclical or structural? Are austerity measures needed to reduce debt? Will they impact on future growth/productive capacity? What was the debt used for – to pay for current expenditure or to fund investment in capital/infrastructure? Current economic conditions – are they favourable to debt repayment?

Questions Analyse using a diagram how discretionary fiscal policy might be used to reduce inflation and imports into an economy. (8) Evaluate the effectiveness of discretionary fiscal policy in achieving a reduction in the level of inflation in an economy.(20) See pages 7 – 8 of Discretionary Fiscal Policy notes: Outline 3 fiscal rules that have been applied to the government’s budget. (3 x 2) Explain the purpose of fiscal rules. (4) Explain how fiscal rules might change the behaviour of economic agents. (4)