Fiscal Policy Flashcards
(43 cards)
Government spending trend overtime
Has been generally increasing (especially spikes during wars), now around 40% of GDP
Now expected to fall slightly following aftermath of Covid
UK spending and receipts in 2023/24
Fiscal deficit - expenditure>tax rev (-£132bn)
Automatic stabilisers on the government budget during a recession
What school of thought and why?
Budget deficit will increase naturally.
B) Keynesian as counter-cyclical i.e increase deficits while in recession (benefits&less taxes), and surplus while in boom (more tax revenue through progressive system)
Discretionary measures also exist.
Name example
Con of discretionary measures
UK cutting vat from 17.5 to 15% in 2008
Inside lags - take time for government to act.
Government borrowing 2022-2023
B) Net debt vs net borrowing. Why is debt rising while net borrowing (fiscal deficit) falling.
Reduced the fiscal deficit (now at -£132bn) as receipts increased. As a result borrowing fallen (but still in deficit!)
B) We are not reducing debt, we are just reducing deficits. I.e still adding to the debt as still exp>tax! Only surpluses will reduce the debt!
So for 2023-24 fiscal deficit of £132bn.
How can a government spend more than they receive?
B) how much of total expenditure is it?
By borrowing i.e selling bonds (gilts)
B) So a liability on governments balance sheets since means they need to make repayments, 10% of their expenditure
Objectives of fiscal policy (6)
Revenue generation for public services
Address market failure (excise)
Redistribute wealth (prog tax)
To get re-elected
Promote macroeconomic stability (increase AD)
To meet fiscal targets
1st objective: Generate revenue
How is the best way to generate revenue, and evaluate
Windfall taxes - taxing profitable industries.
Eval: potentially damaging in long term
2nd objective of fiscal policy:
Address market failure: How?
Excise taxes on goods with negative externalities.
3rd objective: Redistribute wealth:
How is this done for example
Income tax is progressive - tax richest the most, to redistribute to poorer through benefit payments
5th objective: To get re-elected: how may they do this?
Run budget deficits (spend heavy and reduce taxes) to win election
(Eval: with rational consumers under neoclassical; stimulus has no multiplier effect since they expect taxes to rise in future since gov borrowing must’ve increased)
6th objective: Promote macroeconomic stability
E.g consider a fall in AD. What will be done to fiscal policy in a recession (Phillips curve diagram)
Fall in AD following recession
Respond by cutting taxes to increase consumption and increase GDP back to original point.
Keynesian view on deficit spending (3)
Borrow if necessary to recover from recession (the priority)
Unemployment costly (full employment objective)
Fiscal policy should be counter-cyclical: automatic stabilisers display this perfectly!
Neoclassical view (3)
Government intervention crowds out private spending by rising real interest rates.
Either raise revenue by tax or borrowing
Ricardian equivalence - Higher borrowing today implies higher taxes in future, consumers realise so don’t respond, so no multiplier effect to fiscal stimulus. (As shown in pre-2010 labour policy!)
6th objective (final): To meet fiscal targets: Why
Example of fiscal target
Give credibility to government (Neoclassical!!)
(Political/ideological reasons
To take heed of economic theory)
Example:
Gordon Brown’s golden rule 1977: reduce public debt below 40%.
Darling rule 2015: balance structural deficit (CABB) by 2015
Fiscal sustainability - deficit spending is useful but limited - government faces certain constraints on its capacity to borrow.
2 types of constraints
Formal/codified constraint e.g EU stability & growth pact: deficit can’t be more than 3% GDP
Informal - verdict of bond market if interest rates high, harder to borrow! Recall price-yield relationship, if price falls, interest is high, and so repayment cost for government issuing bonds will be high!
Fiscal sustainability linking to financial crisis
Example of informal constraint
Downgrade of US & UK government debt by credit risk companies.
(Gov less likely to repay off their debt, more risky investors, increase rates to compensate for default risk, increasing borrowing costs for gov, so not fiscal sustainable!!)
Governments budget constraints equation
Ptgt + (1+it)Bt-₁ = Bt + ΔMt + PtTt
Expenditure (includes interest debt accumulated from selling bonds they need to repay= revenue (from taxes and issuing bonds + money supply)
P- price level
g - real gov spending
i - nominal interest
B - no.of bonds issued
M - money supply
T - tax revenue
All at time t
Condition for sustainable fiscal policy
Debt to GDP ratio has to be less/equal than
Σ(1/1+i-π-y) Et (St+j/yt+j)
Et (St+j/yt+j) is expected future primary surplus to GDP ratio (primary surplus is budget - interest repayments)
y is output growth rate
If holds, fiscal policy is sustainable
Fiscal sustainability can exist with any debt-to-GDP as long as…
Expected future surpluses in future (pay back old debt and interest)
So sustainable with any debt-to-gdp as long as we expect to generate future surpluses.
How can we restore solvency i.e create future surpluses
Since agents are forward looking, we can use credible plan to adjust tax/expenditure. This increases expected future primary surplus
What eases the condition for fiscal sustainability (3)
(Makes it easier to sustain policy)
Lower nominal interest rate (i, in denominator so if smaller means RHS of equation is larger, which is favourable since needs to be >= debt-to-gdp ratio!)
Increase in inflation (π in equation, intuition as above)
Increase in output growth (y in equation, same intuition)
Cyclically adjusted budget balance (Keynesian)
Measures the budget balance we would get if real output took its natural level.
Key use of the cyclically adjusted budget balance
B) Keynesian view for CABB
Adjusts budget according to economic cycle.
Because unadjusted figures appear too gloomy (since less income tax and increase benefit payments), and too rosy during a boom.
B) Surplus in boom to anticipate and prepare for recession
