2.5 Fiscal policy and supply side policies Flashcards
(50 cards)
Fiscal policy
the use of taxation and government spending to achieve policy objectives
direct tax
a tax which cannot be shifted by the person legally liable to pay the tax onto someone else. They are normally levied on income and wealth.
Income tax
a direct tax levied on personal income
Income tax threshold
the level of income above which people pay income tax
Indirect tax
a tax which can be shifted by the person legally liable to pat the tax onto someone else, for example through raising the price of a good being sold by the taxpayer. They are normally levied on spending
Progressive tax
a tax when, as income rises, a greater proportion of income is paid in taxation
proportional tax
a tax when, as income rises, an equal proportion of income is paid in taxation
regressive tax
a tax when, as income rises, a smaller proportion of income is paid in taxation
wage elasticity of supply of labour
proportionate change in supply of labour following a change in the wage rate
laffer curve
- a curve which shows the levels of tax revenue relative to the income tax rate
- if tax cuts cause incomes to rise (due to incentives) proportionally more than the tax rate has fallen, tax revenues will increase
- if tax increases cause income to fall proportionally more than the tax rate has risen, then tax revenues will decrease
Describe the shape of an individual workers labour supply curve
- workers face an opportunity cost - labour vs. leisure
- an individual has a backward bending supply curve
- at a certain point hourly wage rate will be large enough to cause people to want more leisure hours, since leisure time is a normal good
Why collect taxes? (4)
- to pay for government expenditure
- to correct market failures such as externalities
- to manage the level of spending in the economy
- to redistribute income
policy instrument
a tool or set of tools used to try and achieve a policy objective
Balanced budget
occurs when government spending equals government revenue (G=T)
budget deficit
occurs when government spending exceeds government revenue (G>T)
budget surplus
occurs when government revenue exceeds government spending (G<T)
public sector borrowing
borrowing by the government and other parts of the public sector to finance a budget deficit
national debt
the amount of accumulated debt, resulting from past government borrowing, that is owed by the UK government
multiplier
the relationship between an initial change in aggregate demand and the resulting usually larger change in national income
cyclical unemployment
those unemployed because there is a lack of economic activity in the economy and their labour is not demanded due to the existence of sticky wages (e.g. during a recession)
contractionary policies
policies aimed at reducing aggregate demand
expansionary policies
policies aimed at increasing aggregate demand
Describe expansionary fiscal policy
- budget deficit (G>T)
- lower taxes increases disposable incomes, C↑, AD↑
- increased government spending on services in the economy creates new jobs
You’ve correctly identified the main mechanisms of expansionary fiscal policy. Here’s a more detailed explanation suitable for AQA A Level Economics:
Expansionary Fiscal Policy: Boosting Aggregate Demand
Expansionary fiscal policy involves the government taking actions to increase aggregate demand (AD) in the economy. This is typically done during periods of low economic growth or recession to stimulate economic activity and reduce unemployment. The main tools of expansionary fiscal policy are:
a) Budget Deficit (G > T):
The Action: Expansionary fiscal policy often leads to a budget deficit, where government spending (G) exceeds government tax revenue (T). The government finances this deficit through borrowing (issuing government bonds).
Rationale: The aim is to inject more money into the circular flow of income than the government is withdrawing through taxation.
b) Lower Taxes Increases Disposable Incomes, C↑, AD↑:
The Action: The government can reduce various types of taxes, such as:
Income tax: Lowering income tax increases households’ disposable income (income after tax).
Corporation tax: Reducing corporation tax increases firms’ after-tax profits.
Value Added Tax (VAT): Lowering VAT reduces the price of goods and services.
Impact on Consumption (C): With more disposable income, households have greater purchasing power and are likely to increase their consumption (C) of goods and services.
Impact on Investment (I): Lower corporation tax can incentivize firms to increase investment (I) as their profitability rises. Reduced VAT can also stimulate demand, encouraging investment to meet that demand.
Impact on Aggregate Demand (AD): Since consumption (C) and investment (I) are components of aggregate demand (AD = C + I + G + (X-M)), a rise in either or both will lead to an increase in Aggregate Demand (AD↑), causing the AD curve to shift to the right.
c) Increased Government Spending on Services in the Economy Creates New Jobs:
The Action: The government can directly increase its spending (G) on various goods and services, such as:
Infrastructure projects: Building roads, schools, hospitals, etc.
Public services: Employing more teachers, nurses, police officers, etc.
Welfare payments: Increasing unemployment benefits or other transfer payments.
Direct Impact on AD: Increased government spending is a direct injection into aggregate demand, leading to an increase in AD (AD↑) and a rightward shift of the AD curve.
Creation of New Jobs: Government spending on services, particularly public sector employment and infrastructure projects, directly creates new jobs. This reduces unemployment and further boosts incomes and consumption through the multiplier effect.
Multiplier Effect: The initial increase in government spending leads to higher incomes for those employed. These individuals then spend a portion of their increased income, leading to further increases in spending and income throughout the economy. This is known as the multiplier effect, which can amplify the initial impact of the fiscal stimulus.
In summary, expansionary fiscal policy aims to stimulate economic activity by increasing government spending and/or reducing taxes. These actions lead to higher disposable incomes, increased consumption and investment, and direct increases in government demand, all of which contribute to a rise in aggregate demand and can help to close a recessionary gap in the economy.
Important Considerations for AQA A Level Economics:
Time Lags: Fiscal policy changes can take time to be implemented and for their effects to filter through the economy.
Crowding Out: Increased government borrowing to finance a budget deficit could potentially lead to higher interest rates, which might discourage private sector investment (“crowding out”).
Government Debt: Persistent use of expansionary fiscal policy can lead to a significant increase in national debt.
Ricardian Equivalence: Some economists argue that consumers, anticipating future tax increases to pay for current government borrowing, may save rather than spend any increase in disposable income from tax cuts, reducing the effectiveness of the policy.
Effectiveness Depends on the State of the Economy: Expansionary fiscal policy is generally considered more effective during periods of significant economic slack (high unemployment, low capacity utilization).
How can fiscal policy be used to influence AS?
- The government could reduce income and corporation tax to encourage spending and investment.
- The government could subsidise training or spend more on education. This lowers costs for firms, since they will have to train fewer workers. Spending more on healthcare helps improve the quality of the labour force, and contributes towards higher productivity.
- Governments could spend more on infrastructure, such as improving roads and schools.
