3.1 Fiscal Policy

Question 1

What is fiscal policy?

Answer 1

The manipulation of the overall level of government spending (G) and/or the overall level of taxation (T) in an economy, over a given period of time

Question 2

What is fiscal stance?

Answer 2

Refers to how a government’s level of spending and taxation affect aggregate demand and short run economic growth

Question 3

What is an expansionary stance and what does it mean?

Answer 3

• Government spending is higher than tax revenues
• Means the government is running a budget deficit (G>T)
• Budget deficit also known as “public sector net borrowing” (PSNB)

Question 4

What is a deflationary stance and what does it mean?

Answer 4

• Government spending is lower than tax revenue
• Means the government is running a budget surplus (G<T)

Question 5

What is a neutral stance and what does it mean?

Answer 5

• Government spending is equal to tax revenues
• Means the government is running a balanced budget (G=T)

Question 6

What is exhaustive spending?

Answer 6

Public sector spending on goods and services - directly affects AD

Question 7

What is non-exhaustive spending?

Answer 7

Public sector spending on transfer payments - indirectly affects AD

Question 8

What is current expenditure?

Answer 8

The acquisition by the government of goods and services for current use to directly satisfy the individual or collective needs of the community

Spending on goods and services to run public services and to maintain physical capital

Eg. Salaries of public employees, purchase of medicines,

Question 9

What is capital expenditure?

Answer 9

Government spending on goods and services intended to create future benefits

Eg. Infrastructure investment in transport

Question 10

What are direct taxes?

Answer 10

Taxes imposed on the income of individuals and firms

Includes income tax and corporation tax

Question 11

What are indirect taxes?

Answer 11

Taxes imposed on the expenditure of individuals and firms on goods and services

Includes excise duty (tax on specific products) and VAT

Question 12

What is a progressive tax?

Answer 12

A tax which takes a higher proportion of income in tax as income increases

Question 13

What is a proportional tax?

Answer 13

A tax which takes the same proportion of income in tax at all income levels

Question 14

What is a regressive tax?

Answer 14

A tax which takes a lower proportion of income in tax as income increases

Question 15

What are transfer payments?

Answer 15

Money transferred by the government to individuals in the form of benefits

Eg. JSA and state pensions

Question 16

What are debt interest payments?

Answer 16

Payments made to the government’s creditors (holders of the government debt)

Eg. Interest paid on government bonds

Question 17

Why does the government spend public money?

Answer 17

• To influence economic activity to meet its major economic objectives (aggregate demand)
• To encourage consumption of merit goods and those with positive externalities (subsidies and state provision)
• To provide essential services (public goods)
• To redistribute income within the economy (tax system and benefits)

Question 18

What does the Laffer Curve show?

Answer 18

A relationship between the rate of taxation and the tax revenue collected

• At a rate of 0% or 100%, tax revenue will be zero
• Suggests there is an optimum tax rate (t*) in between, where tax revenue is maximised

Question 19

What is the average tax rate?

Answer 19

The proportion of total taxable income paid in tax:

(Total tax paid/total income) x 100

Question 20

What is the marginal tax rate?

Answer 20

The proportion of tax paid on each additional £ earned

Question 21

What are criticisms of the Laffer curve?

Answer 21

• There is limited empirical evidence about whether an optimal tax rate actually exists
• It is unclear what the shape of the Laffer curve is
• Cuts in tax rates may cause people to opt more for leisure rather than increase hours of work
• A tax cut for the rich has implications for inequality

Question 22

What is the budget deficit?

Answer 22

The budget deficit represents the difference between government expenditure (G) and taxation revenue (T) over a period of time (usually a year)

Question 23

What is government debt?

Answer 23

The total amount of money owed by the government at a given point in time - the stock of total public debt

Question 24

What is the bond yield?

Answer 24

(Annual coupon payment / current market price) x 100

Question 25

What are automatic stabilisers?

Answer 25

When the revenues from some taxes and some forms of government expenditure change automatically to help stabilise fluctuations in economic activity / real GDP

Question 26

What do automatic stabilisers do when economic activity increases?

Answer 26

Automatic stabilisers tend to dampen down increases in AD; tax revenue increases and government expenditure falls as a proportion of GDP

Question 27

What do automatic stabilisers do when economic activity falls?

Answer 27

Automatic stabilisers tend to reduce the decline in AD; tax revenue falls and government expenditure increases as a proportion of GDP

Question 28

What is discretionary fiscal policy?

Answer 28

Changes to taxes and spending that may be implemented by the government in response to changing economic activity, to help achieve a specific policy objective

Question 29

What is the structural budget deficit?

Answer 29

The underlying fundamental imbalance in total government receipts and expenditures, where government expenditure (G) is greater than taxation revenue (T). It is NOT affected by the economic cycle. - Remains even at full employment/full capacity

Question 30

What is the cyclical budget deficit?

Answer 30

The part of the budget deficit that falls in the boom phase of the economic cycle and rises in the slowdown/recession phase. Is related to the size of the output gap.

Question 31

What is the overall budget balance?

Answer 31

The sum of the structural and cyclical parts

Question 32

What does the extent to which we should worry about a structural budget deficit depend on?

Answer 32

- How fast the economy is growing relative to the structural budget deficit -> if real GDP is growing faster than the structural budget deficit, the national debt will be falling as a proportion of GDP - If people have confidence in the government’s ability to repay their debt, then a deficit is unlikely to be a problem - If the structural budget deficit is growing faster than the economy, the debt to GDP ratio increases -> issuing more bonds -> higher yields which pushes up other interest rates (also means higher debt repayment) -> investment falls - called “crowding out” of private investment

Question 33

What are the advantages of fiscal policy?

Answer 33

- Automatic stabilisers - Dealing with deep recessions - fiscal policy can overcome a lack of AD through directly spending on goods and services - Direct impact of government spending - may have a greater impact on AD than monetary policy - Ability to target sectors/regions - can be more specific than monetary policy - Supply side effects - capital expenditure may increase the productive capacity of the economy over time

Question 34

What are the disadvantages of fiscal policy?

Answer 34

- Crowding out - if government pursues expansionary fiscal policy with a large budget deficit it will have to sell more government bonds -> can crowd out investment by private firms (think through chain of reasoning) - Time lags (discretionary fiscal policy - some months may pass before the effect of a change is felt - Public debt constraints - additional borrowing required to finance an increased budget deficit will force up the interest on debt -> may restrict additional levels of spending in the economy - Overcoming a lack of confidence - in a deep recession tax cuts may not be effective in increasing AD as it may not necessarily increase spending (MPC may fall and the multiplier effect will be smaller)

Question 35

What is an evaluative point for automatic stabilisers?

Answer 35

The extent to which a tax system leads to automatic stabilisers will depend on how the specific tax system used -> a more progressive tax system is more likely to lead to greater automatic stabilisation effects