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

2. 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

3. Distribution of Public Spending

4. Government spending on education and health (% of GDP)

5. 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

6. 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
( prices)
323.6
367.5
39.3
333.3
368.5
38.4
343.6
370.9
37.4
366.8
387.2
38.1
 389.8
401.5
 38.8
Projections
419.9
39.8
450.7
438.9
40.7
479.6
455.3
40.9
511.4
473.6
41.3

7. 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

8. Taxation

9. 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

10. Income tax and national insurance contributions
Income Tax and Corporation Tax in the UK
Data is for the tax year
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%

11. 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

12. 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

13. Government Taxes ( )

14. 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

15. 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

16. 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.

17. 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)

18. Trends in the government tax burden

19. 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

20. Government budget balances

21. 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

22. Gross Government Debt

23. 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 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

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

25. 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%.

26. 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

27. 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