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

Macroeconomic Policies

Monetary Policy

Fiscal Policy

Fiscal Policy The manipulation of taxation, government expenditure and the government budget to influence the level of AD and other variables in the economy such as output & jobs Tax regime influences C & I, Government spending (G) has direct influence on AD Acts as an automatic stabiliser (see below) Associated with Keynesian economics

Fiscal Policy - purposes Reduce income inequalities. Redistribution of income through taxation, benefits and government spending on services Correction of market failure Encourage consumption of merit goods – e.g. spending on healthcare & education Provision of public goods – e.g. roads (quasi-public) Discourage consumption of demerit goods – e.g. provide information, police Regulation of economic activities – e.g. spending on legal system, introducing regulations & standards Influences AS through supply side policies e.g. spending on infrastructure, investing in transport systems / healthcare research

Reflationary or Deflationary Measures designed to increase AD are called REFLATIONARY Also called expansionary or loose fiscal policy Increase government spending (G) Reduce tax Measures designed to reduce AD are called DEFLATIONARY Also called contractionary or tight fiscal policy Cuts in government spending Rises in taxes

Fiscal Policy In Action AS Inflation Assume an initial equilibrium position with a level of National Income giving an unemployment rate of 5% (U = 5%) The rise in AD leads to an increase in real national income, ceteris paribus, unemployment would fall to 3% but at a cost of higher inflation AD=C+I+G+(X-M) Apart from G, C and I are also likely to be affected directly or indirectly by the policy change. If government ‘reduces taxes’ (remember the subtleties) and or increases spending, it will have various effects: AD therefore shifts to the right to AD1 2.5% 2.0% AD 1 AD U=5% U=3% Real National Income

How fiscal policy feeds through to the economy Boost to disposable income Adds to consumer demand Cut in personal Income tax Lower prices - leads to higher income Adds to consumer demand Cut in indirect taxes Expansionary Fiscal Policy Higher ‘post-tax’ profits for businesses Cut in Corporation tax Adds to business capital spending Adds to consumer demand Boost to disposable income of people with net savings Cut in tax on interest from saving Any injection into the circular flow of income will be reinforced by the MULTIPLIER EFFECT – although some increase will be dissipated by an increase in the price level

Discretionary Fiscal Policy Deliberate changes in government spending and taxation designed to influence aggregate demand Acting counter-cyclically Smooth out peaks and troughs of economic cycle to create greater economic stability

Discretionary Fiscal Policy Likely budget surplus Smooth out cycle -= create more stability Likely budget deficit = borrowing

Managing the Recession Examples of fiscal stimuli include: Reduction in VAT to 15% Car scrappage scheme (£2000 to trade in your old car) £500 million support for house building to deliver 1000s new homes, including £100 for green housing Double main capital allowance to 40% - enhanced tax relief to support investment

Automatic Stabilisers Forms of government spending and taxation that change automatically to offset fluctuations in economic activity Example Government spending on job seekers’ allowance falls automatically when economic activity increases When real GDP rises, so the government will receive more income tax revenue This fall in government spending and increase in tax revenue will reduce growth in AD and help prevent inflation

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 SPRING 2017 BUDGET – KEY POINTS

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

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

Breakdown of UK Government Spending in 2016-17 Social protection (welfare) is the largest single element of government spending, with the NHS and Education the biggest single departmental items.

Breakdown of UK Government Spending Social protection (including pensions) NHS Education Debt interest Police, law courts, prisons Defence

Government Spending - types Capital Expenditure Current Expenditure Current expenditure is recurring. The wages that will be paid to the nurses and doctors, and the money for drugs and the upkeep of a hospital will all be recurring and are recorded as current expenditure. Spending on running public services such as refuse collection, libraries, museums are all current expenditure This includes any spending that adds to the capital stock of the UK. Can be seen as 'once-and-for-all' expenditure Building new schools and hospitals count (although the wages of teachers and nurses do not) as do new roads and the investment by the government in a new nuclear deterrent.

Sources of UK Government Tax Revenues in 2016-17 Income tax and VAT are the two biggest sources of government revenues

Sources of UK Government Tax Revenues Income Tax VAT National Insurance Contributions Excise duties Corporation tax Council Tax and Business Rates

Types of Taxation Direct Taxation A direct tax is levied on the economic agent who pays it – individual/organisation - usually on incomes. Income tax – workers/householders – basic rate = 20% Corporation tax – on company profits – rate = 19% Tax on savings interest Property taxes, business rates…

Types of Taxation Indirect Taxation An indirect tax is levied on goods and service They can be passed on to others in the form of higher prices. Examples include: VAT – current rate = 20% Customs & Excise duty – taxes on specific products such as alcohol, cigarettes, petrol Tariffs – tax on imports

Progressive Taxation A progressive tax takes a higher percentage of tax from people with higher incomes. It means that the more a person earns, the higher his average rate of tax will be. The aim of progressive tax is: To help reduce inequality – taking lower average levels of tax from low wage earners, and taking more from higher taxes. To increase the incentive for people to take low paid jobs, e.g. move off benefits into work. If low income work has a low incidence of tax, it encourages people to enter the labour force and take a job.

Progressive Tax - Calculations Calculate the tax paid if income is (a) £9,999 (b) £15 000 (c) £38 000 (d) £90 000 (e) £200 000 Band Taxable Income Rate Personal Allowance Up to £11,500 0% Basic rate £11,501 to £45,000 20% Higher rate £45,001 to £150,000 40% Additional rate Over £150,000 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 £9 999 (b) £15 000 (c) £38 000 (d) £90 000 (e) £200 000 Income (£) Tax Rate(%) 0 – 10 000 10 001 + 25

Regressive Taxation The proportion of income paid as tax falls as income rises. The actual amount paid will rise! Calculate the tax paid if income is £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 they 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 Equity – tax payers should contribute in proportion to their ability/in proportion to their respective revenues/incomes. The tax should be fair. 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 manner 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 regardless of their 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