4.5 Role of the state in the macroeconomy

Question 1

Capital government expenditure

Answer 1

Spending on long term investment goods such as new roads, schools and hospitals which will be consumed and provide benefits in over a year
Contributes to economic growth and productivity by enhancing a country’s physical and human capital

Question 2

Current expenditure

Answer 2

Consists of day to day government spending on recurring items, such as salaries, maintenance and operational costs
Running gov agencies e.g providing public services and covering welfare programmes like JSA
Maintains existing level of public services but does not typically contribute directly to long term economic growth

Question 3

Transfer payments

Answer 3

Government payments made to individuals or groups without any expectation of goods or services in return
e.g social welfare payments like pensions, subsidies to specific industries and grants to local governments
Redistributive in nature, aimed at providing support to individuals or entities in need

Question 4

Reasons for changing size and composition of public expenditure

Answer 4

Global context
In response to economic crises or changing economic conditions, governments may increase spending to stimulate growth or reduce spending to control deficits
Changing demographics, such as ageing population, can lead to increased spending on healthcare and pensions
Political ideologies can influence composition of pub expenditure, with some governments favouring social welfare programs and others emphasising defence or infrastructure

Question 5

Examples of pub expenditure as % of GDP

Answer 5

Higher
France - 58%
Italy - 56%
Japan (ageing population)

USA - 38% austerity adopted since 08’

Lower
2022 - Ireland (21.2%)
Lithuania (36.4%)

Question 6

Income and % of GDP spent by gov

Answer 6

The lower the average income in most mixed and free economies, the lower is likely to be the percentage of GDP spent by the government
This is because poorer countries tend to have lower tax revenue due to avoidance and inefficiency at collection.
Citizens in higher income countries demand more g+s from their gov which are income inelastic

However, amongst developed countries there are significant differences in the size of gov spending. This can be due to differing attitudes e.g USA and private healthcare

Question 7

Impact of spending on productivity and growth

Answer 7

Gov spending is wasteful and causes inefficiency according to free market economists
However, the gov can enjoy EOS when it provides goods improving productivity
They also provide infrastructure - improves efficiency of workers and geographical mobility
Education creates the human capital needed for growth whilst healthcare system reduces the num of days workers lose from serious illness
Spending on R+D may not be done by the private sector and gov can undertake this to give businesses long term competitive edge - improving quality of goods and encouraging innovation - dynamic efficiency
Spending creates multiplier effect which can be focused on areas of high unemployment creating growth

Question 8

Impacts of spending on living standards

Answer 8

Government corrects market failure and provides public goods which can help improve social welfare
They also reduce absolute poverty by providing benefits and basic goods such as education and healthcare
However, in developing countries, governments do not have the resources to do this and this leads to malnutrition, poor water etc
Government can be inefficient at providing g+s and will have a negative disincentive effects on workers meaning overall output is reduced and so living standards fall

Question 9

Principal agent problem

Answer 9

Government 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 fall in living standards.
However, the political system means that society decides the government and so therefore decides to an extent where it would like money to be spent

Question 10

Crowding out

Answer 10

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 I.R.
This will discourage firms from investing and individuals from buying on credit
The limited number of resources in the economy means that for every resource used in the government spending, there are less resources available for the private sector. The result is government borrowing crowds out private sector borrowing and spending and may lead to no real increase in AD
Free market economists argue that investment would be more efficient if done by private sector and that government targets investment poorly
Crowding out effect is felt most at full employment (not alway the case)

Question 11

Crowding out evaluation

Answer 11

Transfer payments have no impact on output and so would not cause crowding out as resources are simply taken from one group and given to another.
Moreover, when levels of unemployment are high then extra government spending could lead to crowding in where it encourages investment through the multiplier

Question 12

Level of taxation

Answer 12

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 disincentive effect

Question 13

Oil rich countries

Answer 13

Tend to be an exception from taxing high as revenue from oil can pay for most of government spending

Question 14

Equality

Answer 14

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

Question 15

Taxation

Answer 15

Critical for governments to raise revenue and achieve various economic and social objectives such as correct market failure etc

Question 16

Progressive tax

Answer 16

Those on higher incomes pay a higher marginal rate of tax - pay higher percentage of their income on tax
e.g Direct tax (income)

Question 17

Regressive tax

Answer 17

Proportion of income paid in tax falls as the income of the taxpayer rises
Those on higher incomes pay smaller percentage of their income on tax
e.g indirect such as VAT

Question 18

Proportional tax

Answer 18

Where the proportion of income paid in tax remains the same whilst the income of the taxpayer changes e.g 10% of income is spent on tax regardless of income

Question 19

Incentive to work (tax changes)

Answer 19

High rates of direct tax will discourage individuals from working
High taxes on high income earners could encourage them to move abroad and taxes on poor may lead to poverty trap
High income tax reduces incentives more than high VAT

Free market 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
Increased VAT may mean that people have to work longer to maintain income so increase in incentive

Question 20

Income distribution (tax changes)

Answer 20

Progressive tax system will increase equality of income distribution as more money is proportionally taken from from rich than the poor
Regressive tax decrease income equality
Inheritance tax - most progressive from of tax
One issue with using tax to for redistribution is that it does not give the poor anything, so the system needs to be supported with benefits

Question 21

Real output and employment

Answer 21

A rise in direct tax will reduce the level of disposable income causes a fall in their spending and thus a fall in AD
Could also cause a fall in leftover profits for businesses and therefore a fall in investment
The effect this has on output will depend whether economy is at full employment or not
Higher indirect tax increases costs for firms and this will decrease SRAS. This impact will again depend on where the economy is producing.
It 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 22

Price level

Answer 22

Indirect taxes e.g VAT often cause cost push inflation. They can increase the costs of goods such as cigarettes and fuel if producers choose to past on costs to consumers
Since these are price inelastic, producers are likely to pass on costs of tax onto consumers

Question 23

Trade balance

Answer 23

A rise in taxes will decrease income and therefore decrease consumption.
Consumers will spend less on imports which have been found to be highly income elastic in the UK.
The trade balance will improve in the short run
However, in the long run, lower AD will reduce businesses need to invest and this could reduce competitiveness meaning that exports will decrease

Question 24

FDI flows

Answer 24

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
The problem with this is that it can be a race to the bottom where countries tend to continue to lower their taxes in order to make them the lowest to encourage investment - leading to a fall in revenues for all countries

Question 25

Automatic stabilisers

Answer 25

Mechanisms which reduce the impact of changes in the economy on national income Government spending on taxation are automatic stabilisers In recession, benefits increase as more people are unemployed and so the benefits are a stabiliser as it mean the overall fall in AD is reduced In a boom, tax increases as people have more jobs and higher incomes, and this tax reduces disposable income so decreases consumption and AD Cannot prevent fluctuations Benefits may act as disincentive to work and lead to higher unemployment whilst high levels of tax can decrease 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

Measurement of fiscal deficit and national debt

Answer 29

Measured in money terms or as a percentage of GDP GDP measure often more useful because it gives an indication of how easy it is to be for the government to finance a deficit or repay the national debt 2024-25 - expected uk deficit of 4.8% of national income

Question 30

Cyclical deficit

Answer 30

Part of the deficit that occurs because gov spending and tax fluctuates around the trade cycle Recession - tax revenues are low and spending is high creating a larger deficit No cyclical deficit at peak of boom (only structural)

Question 31

Structural deficit

Answer 31

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 32

Actual deficit

Answer 32

The structural deficit plus fiscal deficit

Question 33

Structural surplus

Answer 33

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

Question 34

Structural balance

Answer 34

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

Question 35

Structural deficit and national debt

Answer 35

If gov has structural deficit it is likely that national debt will grow overtime as the government has to consistently borrow money to finance spending Argued that structural deficits needs to be eliminated but is difficult to do since it is impossible to know what part of the deficit is structural and what part of it is cyclical - just as it impossible to know size of the output gap

Question 36

Factors influencing size of fiscal deficits

Answer 36

Trade cycle During a downturn, government tax revenues decrease whilst government spending increases and so the deficit increases Unforeseen events Huge increases in spending which increase deficit Interest rates if I.R increase, the amount the gov pays in interest repayments increase and this is likely to increase deficit. But impact depends on significance of interest repayments in the size of the deficit, market rates and credit ratings of the government Privatisation Provide one-off payments to the gov which will decrease the deficit in the short term - depends on value of company sold Gov aims Influences fiscal policy High revenue from oil Runs a budget surplus so gov rev is important for size of deficit Number of dependents Affect spending and tax revenues

Question 37

Factors influencing size of national debt

Answer 37

Continuous deficit National debt will increase overtime Fiscal deficits over 3% generally will lead to growing national debt as a proportion of GDP Its only when gov runs a budget surplus that the size of national debt decreases Ageing population Contribute to high national debt since the gov runs a structure deficit ignorer to fund their pensions and care and this leads to a high national debt

Question 38

significance of fd and nd on interest rates

Answer 38

High levels of borrowing may raise interest rates since an increase in demand for money will increase the price of money. Will cause crowding out of the economy However, this may not always be the case as the government ay borrow from overseas and during a recession, private sector investment falls which means interest rates may remain unchanged

Question 39

Opportunity cost

Answer 39

Countries have to spend a large amount of money on servicing their national debt through interest repayments, which has high opportunity cost A primary budget deficit is the actual budget deficit but does not include interest repayments on the national debt The impact will depend on the level of interest rates and the size of the primary deficit compared to interest rates and size of primary deficit compared to interest repayments In liquidity trap, government has to borrow money to simply to finance day to day spending Argued that government should run a current budget surplus to enable it to invest for the future expect in recession where they can run a deficit to increase AD

Question 40

Current budget deficit

Answer 40

Problematic as it means future generations are forced to pay for todays expenditure If deficit is due to capital expenditure, the future generations benefit from increased spending and so their extra tax bull to pay for todays borrowing can be justified Value of debt tends to fall overtime because inflation erodes its value and because a country's GDP grows meaning the debt is easier to pay off, so this limits the impact on future generations

Question 41

Inflation (significance of fd and nd)

Answer 41

High fiscal deficit can cause inflation If gov increases spending and their is no similar fall in private sector spending, AD will rise and this can be inflationary If a gov is unable to borrow money, they will print more money and this can cause hyperinflation Printing money will not necessarily cause hyperinflation, it depends on how much is printed and where the economy is producing on the LRAS.

Question 42

Credit rating

Answer 42

High levels of debt tend to result in a reduced credit rating for the government Private sector companies estimate the likelihood that a government will default on its debt and give it a rating from AAA to D lower credit ratings mean that lending to the government is riskier and so higher interest rates are demanded from lenders However, in reality, it is not the size of the debt that influences the level of risk involved with the lending of money, it is whether the country has ever defaulted on their loads before and their current economic/ political climate

Question 43

Foreign currency

Answer 43

If government has borrowed from abroad, it may be difficult 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

Benefit growth

Answer 44

Gov borrowing can benefit growth if used for capital spending since this will improve the supply side of the economy and this reduce the deficit in the long term The 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 a recessions

Question 45

Austerity

Answer 45

Type of government fiscal policy Fiscal austerity is a policy approach that involves reducing government spending and or increasing taxes in order to reduce budget deficits and debt To improve financial health of gov by reducing its reliance on borrowing and stabilising its debt to GDP ratio Adopted by UK in 2010 in following expansionary fiscal policy used in 2008

Question 46

Issuing bonds

Answer 46

Gov can issue bonds to raise finance This is considered long term effective solution to eliminate gov debt However it can help avoid raising taxes in the short run The government has to pay interest to the investors who buys the debt which has to be repaid at some point

Question 47

Reliance on automatic stabilisers

Answer 47

Allows economy to grow so national debt/fiscal debt will reduce as a % of GDP Mainly approach that US took after the GFC and their economy recovered daily quickly

Question 48

Default on loans

Answer 48

One way to reduce national debt but the economic cost of this is so large that the governments only default it if it is their only option Russia and Argentina have defaulted on their debts in the past

Question 49

Policy to reduce poverty and inequality

Answer 49

Progressive tax system which will produce a more equal distribution of income after tax Inheritance tax means that wealth inequality will be reduced as less money can be passed on to the next generation Tax means that money can be taken from the rich and given to the poor However, this tax is difficult to enforce as they are avoidable by careful tax planning

Question 50

Benefits

Answer 50

Policy to reduce inequality Universal benefits are available to everyone who meet a certain criteria, respective of personal income Means tested benefits are only available to people who have sufficiently low levels of income/wealth. They are targeted at people who need the most help and provide a safety net/minimum standard of living and are better at improving inequality as they directly affect the poor However benefits may reduce incentive to work, especially if they can earn a similar amount on benefits to what they could in work The extent to which governments should use spending to redistribute income is highly controversial, particularly with high levels of national debt and austerity as seen in the UK

Question 51

Transfer payments as a mean of reducing inequality

Answer 51

Gov can provide goods and services which give citizens equal opportunities and access to services they may not otherwise be able to afford, such as healthcare and eduction This helps ensure that everyone is given an equal start in life e.g poor children will not lose out if their parents cannot afford them eduction Problem with these is that they also benefit those on higher incomes and incur an opportunity cost UK - free healthcare however in USA and other countries not the case

Question 52

Reduce wage differentials

Answer 52

A national minimum wage will improve the incomes of the poor whilst maximum wages or pay ratios will reduce the incomes of the rich and could even mean companies increase the pay of their lowest income However minimum wage may cause unemployment (firms cut back on costs) and maximum wages may lead to loss of most skilled workers (brain drain) Equal pay legislation will prevent inequality between men and women or between different ethnic groups Trade union friendly legislation will allow the wages of their workers to rise and those in unions are more likely to be paid low so this will improve equality Employers can be forced to provide benefits to their workers such as sickness benefits, pensions and medical care which will increase wages

Question 53

Access to education and training

Answer 53

Improvements to access will prevent children from poorer backgrounds achieving less than others which would reduce their earning potential Government attempted this through additional funding and easier access to universities (contextual grades)

Question 54

Price controls

Answer 54

On essential goods, such as housing, bus fares, bread, electricity etc Will increase spending power of the poor However this could cause excess supply and may lead to the development of black markets

Question 55

Trickle down

Answer 55

Concept argues that increasing the incomes of the rich will lead to an increase in the income of the poor The rich create jobs by spending their money and employing others and reducing their income would reduce employment and lead to lower loving standards Also believed that inequality is necessary to encourage people to work hard and therefore increase their income

Question 56

Law of diminishing marginal utility

Answer 56

Suggests that redistribution increases total utility and therefore is better allocation of resources The higher the spending of an individual, the less satisfaction gained from spending an extra pound £10 a week given to a poor family increases the satisfaction more than £10 given to rich family would High growth rates of nordic countries where redistribution is high suggests that it is not negative for economic growth

Question 57

Changes in interest rates and the supply of money

Answer 57

Monetary policy to stimulate economy and raise government revenue e.g low interest rates This encourages spending and investment, in order to try and boost economic growth Quantitative easing Used typically when interest rates are very low and cannot be lowered much further The bank buys assets in the form of government bonds using the money they have printed electronically This is then used to buy bonds from investors which increases cash flow in the financial system This encourages lending to firms and individuals since it makes the cost of borrowing lower The theory is that this encourages more investment, more spending and higher growth Could cause inflationary pressures

Question 58

Measures to increase international competitiveness

Answer 58

The cheaper the relative unit labour costs, the more competitive the country in manufacturing China, India and more have lower labour costs to a lot of production requiring manufacturing has moved abroad Unit labour costs rise when wages increase at faster rate than productivity. Chinas large population means low wage costs but rise of consumer spending has driven wages up Countries such as Germany are famous for producing high quality engineered goods, such as cars so consumers might be willing to pay more for them

Question 59

Currency manipulation

Answer 59

Used by china to increase international compteiviness Devalued the renminbi in order to make their relative export price lower however this is not policy relevant for countries with floating exchange rates

Question 59

Lowering corporation tax

Answer 59

Used by UK 2021 - 19% - 17% to increase international competitiveness Should help increase inward investment Supply side policies Furthermore, simplifying business regulation for businesses so it is cheaper and easier to meet environmental targets and create new jobs Should help encourage investment and innovation so domestic firms can become more internationally competitive

Question 59

Join WTO

Answer 59

Sign trade agreements to increase international competitiveness

Question 59

Responding to commodity price shock

Answer 59

Oil prices increase greatly Gov can use expansionary policy to reduce the impact of a fall in GDP of deflationary policy to reduce impact on inflation

Question 59

Responding to financial crisis

Answer 59

expansionary policy to increase AD

Question 59

Brexit

Answer 59

Interest rates lowered to improve confidence but then raised to deal with inflation caused by the falling value of the pound

Question 60

TNC

Answer 60

Transnational companies Can bring huge gains to an economy through their creation of jobs, the tax revenues they raise, the knowledge they bring and the investment they undertake Can have negative social and economic impact by destroying local culture, affecting environment and withdrawing more in profits than injection through investment Also have history of influencing politicians to take decisions that will favour their interests and are involved in tax avoidance

Question 61

Joint company with local partner

Answer 61

Some developing countries don't allow TNC's to set up in their country without first setting up a joint company with local partner, meaning that some profits are retained within the country and knowledge/tech is transferred Many governments use import contracts with TNCs meaning that at least some part of the value of the order must be manufactured in the country

Question 62

Transfer pricing

Answer 62

Transfer pricing is a way for firms to engage in tax avoidance Occurs if firm produces a good in one country and then transfers it to another (low tax) to make it into a good which it then sells for a low price 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 bills

Question 63

Regulating transfer pricing

Answer 63

UK - companies which don't allocate sufficient profits are challenged by HMRC and this has led to billions of pounds earn in taxes OECD - Transfer pricing guidelines on cross border services, intangibles, cost contribution arrangements and advance pricing guidelines (modified in 2010) Arms length principle - aim for the price to be the same as if the two parties were independent of each other

Question 64

Ability to control global companies

Answer 64

Difficult for individual governments to control TNC's Small countries earn less in revenue than a TNC earns in profits May need TNCs to sustain the country - bring in the most investment of the country EU suffers from legal tax avoidance schemes where costs revenues and profits are routed through Ireland and then sent to tax haven like Bahamas

Question 65

Solutions to taxation

Answer 65

Difficult as they require worldwide agreement However, any solution which would benefit country like UK would lead to possess for countries like the Bahamas and Ireland There is also division within countries e.g Democrats vs Republicans Division allows TNCs to be able to prevent any agreement they do not like through immense lobbying Solutions are also time consuming and costly

Question 66

Inaccurate information

Answer 66

Problem facing policy maker Short term info such as GDP figures for previous month are often inaccurate and so government may be unable to see if there are problems within the economy Cutting down on avoidance/evasion is difficult as the government does not have full picture of level of avoidance, who is avoiding and best way to reduce it BoE makes decisions based on past data but trends in economy change so data may be outdated and an inaccurate picture of where economy is heading especially with interest rates so low Full cost benefit analysis can be time consuming and costly and impractical for gov to gain every single bit of info they need

Question 67

Risks and uncertainties

Answer 67

Gov cannot accurately predict future and so it is difficult for them to know whether extra spending is necessary Can't know full impact of decision as consumers often react unexpectedly and could undermine gov policy Managing risk is essential for good decision making

Question 68

External shocks

Answer 68

Gov is unable to control and prepare for these external shocks - the best they can do is lessen impact Very unique so difficult to know best method to solve problem Policies employed by policy makes may not have their intended impacts and it may undermine current policies in place e.g Brexit delayed gov plans to budget