4.5 - Role of the State in the Macroeconomy

Question 1

Types of expenditure

Answer 1

1. Capital government expenditure
2. Transfer payments
3. Current government expenditure

Question 2

Capital government expenditure

Answer 2

Spending on infrastructure and long-term assets that will be used over many years, such as building new roads and hospitals

Question 3

Transfer payments

Answer 3

Payments made by the government to individuals without any goods or services being received in return, such as unemployment and state pension

Question 4

Current government expenditure

Answer 4

Spending on the day-to-day running of government services, such as public sector wages or interest payments on national debt

Question 5

Composition and size of public expenditure

Answer 5

In most mixed and free economies, the lower the average income of the country, the lower the percentage of GDP spent by the government is likely to be. This is because poorer countries tend to have a lower tax revenue, due to avoidance, inefficiency at collecting and a smaller amount of wealth to tax

Question 6

Impacts of composition and size of public expenditure on productivity and growth

Answer 6

1. Free market economists argue that government spending is wasteful and causes inefficiency. However, the government is able to enjoy economies of scale when it provides goods, and this improves productivity
2. Education creates the human capital necessary for growth whilst the healthcare system reduces the number of days workers lose from serious illness. Spending on research and development may not be done by the private sector and the government will undertake it to give businesses a long term competitive edge
3. Government can create a multiplier effect and this can be
   focused on areas of the country with high unemployment, creating growth

Question 7

Impacts of composition and size of public expenditure on living standards

Answer 7

1. Government corrects market failure and provides public goods, which improves social welfare
2. Important since they reduce absolute poverty by providing benefits and basic goods, such as education and healthcare. In developing countries, governments do not have the resources to do this and this leads to malnutrition and poor water
3. Argued that the government will be inefficient at providing goods and services and will have a negative disincentive impact on workers, meaning that output overall is reduced and so living standards fall
4. Argued that the government suffers from the principal agent problem since they make decisions on behalf of the people and individuals may have spent that money differently. As a result, there is a loss in welfare and so a fall in living standards

Question 8

Impacts of composition and size of public expenditure on crowding out

Answer 8

1. The limited number of resources in the economy means that for every resource used in government spending, there are less resources available for the private sector. The result is that government borrowing crowds out private sector borrowing and spending and may lead to no real increase in AD
2. Free market economists argue that investment would be more efficient if done by the private sector and that the government targets investment poorly and is wasteful
3. The crowding out effect is felt most at full employment
4. When levels of unemployment are high then extra government spending could lead to crowding in where it encourages investment through the multiplier

Question 9

Crowding out

Answer 9

In order to spend money above their tax revenues, the government has to borrow from individuals and businesses. However, the amount of money in the economy available to borrow does not increase. The government will therefore be competing with the private sector for finance and will cause higher interest rates. This will discourage firms from investing and individuals from buying on credit

Question 10

Impacts of composition and size of public of public expenditure on the level of taxation

Answer 10

1. In most cases, where government spending is high, levels of tax must be high in order for spending to be sustainable. High levels of tax may have a disincentive effect
2. Oil-rich countries tend to be an exception, where revenue from oil can pay for most of government spending

Question 11

Impacts of composition and size of public expenditure on equality

Answer 11

1. Spending should increase equality as it leads to redistribution and helps to provide a minimum standard of living for the poorest in society. It ensures everyone has access to basic goods, such as education and healthcare, which will help give them a fair start in life

Question 12

Taxation

Answer 12

Tax is used to pay for the number of goods and services that the government provides. On top of this, tax can be used to correct market failure at a microeconomic level and to manage the economy and redistribute income at a macroeconomic one

Question 13

Progressive tax

Answer 13

Where those who are on higher incomes pay a higher marginal
rate of tax, they pay a higher percentage of their income on tax. Direct taxes tend to be progressive, for example income tax

Question 14

Regressive tax

Answer 14

Where the proportion of income paid in tax falls as the income of
the taxpayer rises. Those on higher incomes pay a smaller percentage of their income on the tax. Most indirect taxes are regressive, for example everyone pays the same rate of VAT and for those on higher wages this represents a small proportion of their earnings compared to those on low wages

Question 15

Proportional tax

Answer 15

Where the proportion of income paid on tax remains the same
whilst the income of the taxpayer changes e.g. 10% of income is spent on tax, regardless of income. Everyone pays the same percentage of their income on the tax

Question 16

Impacts of tax changes on incentives to work

Answer 16

1. Argued that high marginal rates of tax will discourage individuals from working. Free market economists argue that the supply of labour is relatively elastic and a reduction in marginal taxes on income will lead to a significant increase in work as individuals work longer hours, accept promotions and more people join the workforce
2. High taxes on high income earners could encourage them to move abroad and taxes on the poor may lead to a poverty trap
3. Can be argued that higher taxes mean people have to work longer hours in order to maintain their income and so even increases the incentive work

Question 17

Impacts of tax changes on tax revenues

Answer 17

1. The Laffer curve shows that a rise in the tax rate does not necessarily increase tax revenue. If people were taxed at 100%, they would not do any work and this means that tax revenue is 0 at both 0% and 100%
2. Tax revenue will initially rise as the tax rate is increased but it will come to a point where revenue is maximised and will then fall. As tax rates rise, motivation and drive will fall so there will be a fall in output and there is an increased incentive to use tax avoidance and tax evasion

Question 18

Laffer curve

Answer 18

Theory that shows the relationship between tax rates and tax revenue. It suggests that increasing tax rates beyond a certain point will decrease total tax revenue because it disincentivises work, production, and investment

Question 19

Impacts of tax changes on income distribution

Answer 19

1. A progressive tax system will increase the equality of income distribution as more money is proportionally taken from the rich than from the poor
2. A regressive one will decrease income equality. Since direct taxes tend to be progressive and indirect taxes regressive, a move from indirect to direct taxes will improve equality
3. Problem with using tax to redistribute income is that it does not give the poor anything, so the system needs to be supported with benefits

Question 20

Impacts of tax changes on real output and employment

Answer 20

1. Some taxes affect AD whilst others affect AS. A rise in direct taxes will reduce the level of disposable income an individual has, which will cause a fall in their spending and thus a fall in AD. It could also cause a fall in leftover profits for businesses and therefore a fall in investment. The effect this has on output will depend on where the economy is: whether it is at full employment or not
2. Higher indirect taxes and NICs increase costs for firms and this will decrease SRAS. This impact will again depend on where the economy is producing
3. Can be argued that income taxes cause a disincentive to work and therefore reduce LRAS as the most skilled workers go overseas and more people become inactive

Question 21

Impacts of tax changes on price level

Answer 21

1. Taxes can impact LRAS, SRAS and AD. Therefore, these changes will impact price depending on where the economy is producing
2. Indirect taxes, particularly VAT, often cause cost push inflation

Question 22

Impacts of tax changes on trade balance

Answer 22

1. A rise in taxes will decrease income and therefore decrease consumption, theoretically this will also mean consumers spend less on imports . Imports in the UK have been found to be highly income elastic. As a result, the trade balance will improve in the short run
2. However, in the long run, lower AD will reduce businesses’ need to invest and this could reduce competitiveness meaning that exports decrease

Question 23

Impacts of tax changes on FDI flows

Answer 23

1. Low taxes on profit and investment tend to encourage businesses to invest in a country since it will help them to see a higher level of return
2. Problem with this is that it can be a ‘race to the bottom’ where countries have to continue to lower their taxes in order to make them the lowest to encourage investment; the eventual result is a fall in revenues for all countries

Question 24

Automatic stabilisers

Answer 24

Mechanisms which reduce the impact of changes in the economy on national income; government spending and taxation are automatic stabilisers. In a recession, benefits increase as more people are unemployed and so the benefits are a stabiliser as it means that the overall fall in AD is reduced, preventing too much change in the economy. On the other hand, during a boom, tax
increases as people have more jobs and higher incomes, and this tax reduces disposable income so decreases consumption and AD, meaning that demand doesn’t grow too high

Question 25

Evaluation of automatic stabilisers

Answer 25

1. Automatic stabilisers cannot prevent fluctuations; they simply reduce the size of these problem and there can be negative aspects to these stabilisers. 2. Benefits may act as a disincentive to work and lead to higher unemployment whilst high levels of tax can decrease the incentive to work hard

Question 26

Discretionary fiscal policy

Answer 26

The deliberate manipulation of government expenditure and taxes to influence the economy; expansionary and deflationary policies

Question 27

National debt

Answer 27

The sum of all government debts built up over many years

Question 28

Fiscal deficit

Answer 28

When the government spends more than it receives that year

Question 29

Cyclical deficit

Answer 29

The part of the deficit that occurs because government spending and tax fluctuates around the trade cycle. When the economy is in recession, tax revenues are low and spending is high creating a larger deficit. At the peak of the boom, there is no cyclical deficit; any deficit at this point is a structural deficit

Question 30

Structural deficit

Answer 30

The fiscal deficit which occurs when the cyclical deficit is zero, it is long term and not related to the state of the economy

Question 31

Actual deficit

Answer 31

The structural deficit plus the fiscal deficit

Question 32

Structural surplus

Answer 32

Occurs when at the peak of the boom, there is an actual fiscal surplus

Question 33

Structural balance

Answer 33

Occurs when at the peak of the boom, the actual fiscal balance is 0

Question 34

Relationship between a structural deficit and national debt

Answer 34

If the government has a structural deficit, it is likely that national debt will grow over time as the government has to consistently borrow money to finance spending. For this reason, it is argued that structural deficits need to be eliminated but this is difficult since it is impossible to know what part of the deficit is structural and what part of it is cyclical, just as it is impossible to know the size of the output gap

Question 35

Factors influencing the size of fiscal deficits

Answer 35

1. Trade cycle 2. Unforeseen events 3. Interest rates 4. Privatisation 5. Government aims 6. Number of dependents

Question 36

How the trade cycle influences the size of fiscal deficits

Answer 36

As explained by the concept of cyclical and structural debts. During a downturn, government tax revenue decreases whilst government spending increases and so the deficit increases

Question 37

How unforeseen events influence the size of fiscal deficits

Answer 37

Natural disasters or recessions, lead to huge increases in spending which increase the deficit

Question 38

How interest rates influence the size of fiscal deficits

Answer 38

If interest rates on government debt increase, the amount the government pays in interest repayments increases and this is likely to increase the deficit. The impact of this will depend on how significant interest repayments are in the size of the deficit. Interest rates depend on market rates and the credit ratings of the government

Question 39

How privatisation influences the size of fiscal deficits

Answer 39

Provide one-off payments to the government which will decrease the deficit in the short term; it will depend on the value of the company sold

Question 40

How government aims influence the size of fiscal deficits

Answer 40

Important in the size of the deficit, as this will influence their fiscal policy, for example the austerity aim has helped to decrease the size of the deficit but attempting to increase AD would increase spending

Question 41

How the number of dependents influences the size of fiscal deficits

Answer 41

Affects both spending and tax revenues so influence the deficit

Question 42

Factors influencing the size of national debts

Answer 42

1. If the government is continuously running a deficit, then the national debt will increase overtime. There is a consensus view that fiscal deficits over 3% will lead to growing national debt as a proportion of GDP . It is only when the government runs a budget surplus that the size of the national debt decreases 2. Ageing populations tend to contribute to a high national debt since the government runs a structural deficit in order to fund their pensions and care and this leads to a high national debt

Question 43

Disadvantages of fiscal deficits and national debts

Answer 43

1. High levels of borrowing may raise interest rates in the economy since an increase in the demand for money will increase the price of money, i.e. interest rates. This could cause crowding out of the economy. However, this may not always be the case as the government may borrow from overseas and during a recession, private sector investment falls which means interest rates may remain unchanged 2. Countries have to spend a large amount of money on servicing their national debt through interest repayments, which has a high opportunity cost 3. High fiscal deficits can cause inflation. If the government increases their spending and there is no similar fall in private sector spending, AD will rise and this can be inflationary 4. High levels of debt tend to result in a reduced credit rating for the government. Lower credit ratings mean that lending to the government is riskier and so higher interest rates are demanded from lenders 5. If a government has borrowed from abroad, it may have difficulties getting enough foreign currency to make repayments on its debt. This could also cause problems for consumers as if there is not enough foreign currency, they will be unable to import goods

Question 44

Advantages of fiscal deficits and national debts

Answer 44

1. Government borrowing can benefit growth if it used for capital spending since this will improve the supply side of the economy and thus reduce the deficit in the long term 2. Budget deficit can be used as a tool for short term demand management, Keynesians argue a deficit is acceptable to use as a stimulus in demand during recessions

Question 45

Use of policies to reduce fiscal deficits and national debts

Answer 45

1. UK government has been using a policy of austerity since 2010, where they attempt to decrease spending. It would also be possible to increase taxes. Both of these are unpopular, could limit growth, and reduce living standards and income equality 2. Opposition parties offer an alternative in the form of demand stimulus by high spending , which will cause economic growth and therefore bring about higher tax revenues. This will allow for budget surpluses and eventually a reduction of national debt 3. Another approach is to simply rely on automatic stabilisers to allow the economy to grow so national debt/fiscal deficit will reduce as a percentage of GDP

Question 46

Use of policies to reduce poverty and inequality

Answer 46

1. Government can use a progressive tax system which will produce a more equal distribution of income after tax. Inheritance taxes mean that wealth inequality will be reduced as less money can be passed on to the next generation. However, this tax is difficult to enforce as they are avoidable by careful tax planning 2. Can use government expenditure in the form of benefits and transfer payments, with Social security and National Insurance benefits now representing 30% of government spending in the UK 3. Government can also provide goods and services which give citizens equal opportunities and access to services they may not otherwise be able to afford, such as healthcare, education and housing. This helps to ensure that everyone is given an equal start in life, for example poor children do not lose out because their parents are unable to afford education. The problem with these is that they also benefit those on higher incomes and incur a high opportunity cost.

Question 47

Use of policies for external shocks

Answer 47

1. One example could be a commodity price shock , for example where oil prices greatly increase. The government could use expansionary policy to reduce the impact of a fall in GDP or they could use deflationary policy to reduce the impact on inflation 2. Another example may be a financial crisis, where the government can use expansionary policy to increase AD. It is estimated that shocks in the global economy accounted for about 2/3 of weakness in the UK output after the financial crisis, due to the impact on trade

Question 48

Impacts of transnational companies

Answer 48

1. TNCS can bring huge gains to an economy through their creation of jobs, the tax revenue they raise, the knowledge they bring and the investment they undertake 2. However, they can have a negative economic and social impact by destroying local culture, affecting the environment and withdrawing more in profits than they inject through investment. They also have a history of influencing politicians to take decisions that will favour their interests and are involved in tax avoidance

Question 49

Transfer pricing

Answer 49

One way for firms to engage in tax avoidance. This can occur if a firm produces a good in one country and then transfers it to another to make it into another good which it then sells. If taxes are higher in the first country than the second country, they can set a low price on the product made in the first country. The overall aim is to increase their profit made in the low tax country and decrease it in the high tax country and so overall reduce their tax bill

Question 50

Problems facing policy makers

Answer 50

1. Inaccurate information 2. Risks and uncertainties 3. External shocks

Question 51

Innacurrate information as a problem facing policy makers

Answer 51

Short term information, such as GDP figures for the previous month, are often inaccurate and so may mean that the government is unable to see if there are problems within the economy. Trying to cut down on tax evasion and avoidance is difficult as the government does not have the full picture on the level of avoidance, who it is that is avoiding the tax and the best way to reduce it. Also, full cost-benefit analyses can be time consuming and costly and it is impractical for the government to gain every single bit of information they need

Question 52

Risks and uncertainties as a problem facing policy makers

Answer 52

The government cannot accurately predict the future and so it is difficult for them to know whether extra spending is necessary etc. They can’t know the full impact of their decisions as consumers often react unexpectedly and this could undermine government policy. Managing risk is an essential part of good decision making

Question 53

External shocks as a problem facing policy makers

Answer 53

The government is unable to control and prepare for these external shocks; the best they can hope to do is lessen their impact. Since every situation is different, it may be difficult to know the best method to solve the problem. Policies employed by policy makers may not have their intended impacts and it may undermine current policies in place, for example Brexit has delayed government plans to balance the budget