4.2.5 – Fiscal and Supply-Side Policies

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    4.2.5.1 – Fiscal Policy

    Fiscal policy involves government spending and taxes. It can be used to
    influence the economy as a whole or individual firms and people
    • The policy stimulates AD
    o reflationary fiscal policy (expansionary policy)
    ▪ boosting AD to the right by increasing government spending or
    lowering taxes
    ▪ likely for gov to have budget deficit (Gov spending > Revenue)
    ▪ used during recession (negative output gap) increasing economic growth and reducing
    unemployment causing inflation raising imports damaging current account of the BOP
    o deflationary fiscal policy (contractionary policy)
    ▪ reducing AD to the left by reducing government spending or raising taxes
    ▪ likely for government to have budget surplus (Gov spending < Revenue)
    ▪ used during boom (positive output gap) reducing economic growth and increasing
    unemployment causing deflation reducing imports so improves current account of BOP
    • Governments fiscal stance or budget position describes whether their policy is reflationary (expansionary stance)
    or deflationary (contractionary stance) or neither. If a government has a neutral stance then gov spending and
    tax has no net effect on AD
    • The two important features of fiscal policy are
    o Automatic stabilisers – where governments policy automatically react to changes in the economic cycle
    ▪ During recession gov spending increases (JSA rises) and tax revenue falls (due to unemployment)
    ▪ During a boom, automatic stabilisers create budget surplus as tax revenue increases and gov
    spending on benefits falls
    o Discretionary policy – where governments deliberately change their level of spending and tax
    ▪ A government might spend on improving the country’s infrastructure or services and increase
    tax to pay for it
    ▪ A government might act because of economic situation e.g. during a recession the government
    might spend more and cut taxes to increase AD

    There are Different Types of Tax System
    Taxes should be cheap to collect, easy to pay and hard to avoid and they shouldn’t create disincentives
    • Governments may want taxes to achieve
    o Horizontal taxes – people with the similar income pay same amount of tax
    o Vertical taxes – people with different incomes meaning higher incomed people have greater ability to
    pay higher taxes so should pay more than those on lower incomes
    • Governments may want taxes promoting equality in an economy. This may mean
    o using taxes to reduce major differences in people’s disposable income
    o raising government revenue to pay for benefits and free services

    governments raise tax revenue through
    ▪ direct taxation – income tax
    ▪ indirect taxation – VAT
    • they also use different tax systems to achieve different economic objectives e.g.
    o recessive taxation – where an individual’s tax falls (as a percentage of
    income) as their income rises. Governments use it for supply side growth as there’s more incentive to
    work harder and earn more income, but may increase inequality.
    o progressive taxation – where an individual’s tax rises (as a percentage of income) as income rises. It’s
    used to redistribute income and reduce poverty so increases equality (tax achieves vertical equality)
    o proportional taxation – where everyone pays the same proportion of tax regardless of their income
    level. this tax system can achieve horizontal equity.
    ▪ Supporters of flat rate tax say it simplifies the tax system and reduced the incentive to evade
    and avoid paying taxes, and increase the incentive to earn more
    ▪ Flat rate taxes bring in less tax overall revenue than variable tax systems
    ▪ Flat free taxes don’t have vertical equity, but are made progressive through tax free allowances

    governments raise tax revenue through
    ▪ direct taxation – income tax
    ▪ indirect taxation – VAT
    • they also use different tax systems to achieve different economic objectives e.g.
    o recessive taxation – where an individual’s tax falls (as a percentage of
    income) as their income rises. Governments use it for supply side growth as there’s more incentive to
    work harder and earn more income, but may increase inequality.
    o progressive taxation – where an individual’s tax rises (as a percentage of income) as income rises. It’s
    used to redistribute income and reduce poverty so increases equality (tax achieves vertical equality)
    o proportional taxation – where everyone pays the same proportion of tax regardless of their income
    level. this tax system can achieve horizontal equity.
    ▪ Supporters of flat rate tax say it simplifies the tax system and reduced the incentive to evade
    and avoid paying taxes, and increase the incentive to earn more
    ▪ Flat rate taxes bring in less tax overall revenue than variable tax systems
    ▪ Flat free taxes don’t have vertical equity, but are made progressive through tax free allowances

    The UK Government uses Various Different Taxes
    • In the UK theres a sales tax called VAT (proportional tax = fixed percentage)
    o Its regressive as the percentage of total income that the rich spend is less than the poor
    o Therefore, the percentage of total income that the rich spend on VAT is less than the poor
    • A more progressive system of VAT may be to tax luxury goods at a higher tax rate
    • UK has a progressive income tax system
    o Theres a tax-free allowance of 11,000
    o Then individuals with low – middle income over the allowance get taxed 20% of income
    o Then higher incomed people are taxed at 40% over a certain threshold
    o Then the very highest incomed people are taxed over 45% on the income over a certain threshold
    The Size of Gov Spending Is Affected By Several Things
    • Size and structure of a country’s population will affect level of government spending
    o For e.g. country with large population may require greater government spending than country with
    small population and a country with an ageing population requires more state-provision healthcare
    1. Government policies on inequality, poverty and redistribution of income will alter amount of gov spending – this
    varies from government to government depending on political views.
    2. Fiscal policies governments use to tackle certain problems in a country will have an effect.
    o During a recession a government may increase public spending to encourage growth and reduce
    unemployment, but if these lead to large national debt then governments may reduce their spending
    Cyclical and Structural Budget Positions are Different
    • Structural budget position is a government’s long term fiscal stance – budget position over whole period of
    economic cycle including booms and recession
    • Cyclical budget position is a government’s short term fiscal stance – affected by where the economy is in the
    economic cycle. Automatic stabilisers create a surplus in a boom and a deficit during a recession
    • Expansionary cyclical budget position aka a cyclical budget deficit is balanced by a budget surplus during boom
    times (contractionary cyclical budget)
    • Expansionary Structural budget position adds to national debt. This is called a structural budget deficit.
    Large Budget Deficits Cause Big Problems
    1. a budget deficit (aka Public Sector Net Borrowing) must be paid for by public sector borrowing so government
    can spend more money than it receives in revenue
    2. in UK, the government can borrow money needed from
    i. UK banks – create deposits that government can spend
    ii. The private sector by selling Treasury Bills – paid off by government over period of time
    iii. Foreign financial markets
    3. This borrowing is fine in the short run to stimulate demand. But theres problems if theres excessive borrowing:
    a. It could cause demand-pull inflation, so its exports are less competitive as the currency value has fallen
    b. It causes interest rates to increase due to the inflation which discourages investment by firms
    4. Continued government net borrowing increases national debt (aka Public Sector Net Debt). A large and long
    national debt can cause several problems too:
    i. Reduce credibility of a country to firms and foreign countries so they stop lending money
    constraining countries growth
    ii. Future taxpayers are left with large interest payments on debt to pay off. Debt repayments have
    opportunity cost as future governments have to cut spending to pay off debt, damaging growth
    iii. A large national debt causes a rise in inflation and interest rates
    iv. A country with large debt is less attractive to FDI as its riskier for investment
    Methods to correct Budget Deficit depends on what kind of deficit it is:
    I. cyclical budget deficit is caused by recessions & occurs due to governments automatic stabilisers
    (when gov spending on benefits increases and tax revenue falls). This deficit is corrected when
    economy recovers again – deficit replaced by surplus
    II. Structural budget deficit is caused by excessive borrowing. This deficit is corrected by raising
    taxes or reducing gov public spending to may debt off. This could damage economic growth.

    Budget Surpluses Also Cause Problems
    1. Budget surplus more desirable than deficit
    2. This suggests taxes are too high or governments aren’t spending enough on the economy, so constrains growth
    3. Lowering taxes or increasing government spending would correct a budget surplus
    Governments Follow Fiscal Rules to Avoid Overspending
    • Golden rule = The government can borrow to invest in things like infrastructure (generates future growth) but
    not to fund current expenditure (e.g. wages
    • These fiscal rules help prevent continuous government borrowing and overspending to promote growth, which
    increases national debt and inflation. It creates economic stability avoiding uncertainty and fluctuating inflation
    • Fiscal rules influence the behaviour of business and consumer confidence in future economic stability
    • In 2010, UK government created the Office for Budget Responsibility (OBR)- an independent body that:
    o Publish reports analysing UK public spending, taxation and governments predictions of future spending
    o Assesses performances of government against the fiscal targets its set itself
    o Uses long term projections to analyse how sustainable government spending and revenue is
    • The OBR keeps the government fiscal policy under control
    Governments Use Fiscal Policy to Tackle Poverty
    • Fiscal policy can reduce poverty in a country. Ways governments can do this is though
    o Benefits
    o Provision of goods and services
    o Progressive taxation
    • Governments spending on benefits (JSA), pensions and disability benefits helps the unemployed and reduces
    absolute poverty
    • Governments also spend tax revenue on goods and services such as healthcare and education to increase access
    to these things
    • The provision of these goods and services might make labour more productive
    • Progressive taxation reduce poverty by reducing gaps between people’s disposable income – this revenue pays
    for benefits and state provision of goods and services
    • If fiscal policy creates growth this may reduce both relative and absolute poverty. Greater growth means more
    jobs, higher incomes and better standard of living

    4.2.5.2 – Supply Side Policies

    Supply-side Policies Aim to Increase Economy’s Trend Growth Rate
    • The aim of supply side policies is to expand productive potential (LRAS) or
    increase trend rate of growth for an economy
    o These policies are about the government creating the right conditions to
    allow market forces to create growth, rather than creating growth by increasing its
    spending
    • Supply side policies involve structural changes to the economy to allow it to work more
    efficiently and productively.
    o For e.g. they may do this by providing more incentives for firms to become more
    productive

    These policies are divided into free market and interventionist policies:
    • Free market supply side policies – aims to increase efficiency by removing things interfering with free market.
    They include tax cuts, privatisation and policies increasing labour flexibility
    • Interventionist supply side policies – aims to correct market failure. They include gov spending on education,
    subsidies for research and development, improved infrastructure (e.g. ports to help firms export goods) and
    industrial policy (policy to develop particular industry or sector e.g. through subsidies)
    1. The effects of these policies are generally macroeconomics – i.e. Their direct effects are usually on individual
    workers, firms or markets. However, these changes have powerful macroeconomic effect.
    2. Supply side policies make economy more robust and flexible
    Supply side policies can Increase the Efficiency of Various Markets
    Deregulation = reducing laws imposed by gov rules
    Privatisation = transfer of ownership of firm/ industry from public to private sector
    • Here are examples of supply side policies used in different markets:
    The Product Market :
    • Create incentives for firms to invest – tax breaks
    • Trade liberalisation – less trade barriers
    • Encourage Competition
    o Deregulation – more entrants more efficiency
    o Privatisation – effective if nationalised industries are inefficient
    o Contract services – gov asks private firms to do services (helps new entrants)
    The Labour Market
    • Reduce unemployment benefits – incentives for people to work
    • Reduce income tax – incentives for people to work
    • Improve education and training
    • Improve labour market flexibility
    • Reduce regulations of firms – reduce firms non-wage costs so employ more
    The Capital Markets
    • Deregulation of Financial Markets – makes them more efficient

    Suitable Demand-Side Policies Are Needed Alongside Supply-Side Policies
    1. Supply side policies aim to make economy more able to supply products, but for, maximum benefit there needs
    to be a demand for those products
    2. Nowadays demand and supply side policies are used together, but to achieve different aims
    o Supply side policies create long term growth
    o Demand side policies stabilise economy in the short term

    Theres Huge Potential Benefits of Supply-Side Policies
    • Increasing economy’s trend rate of growth
    o makes it easier for government to achieve its macroeconomic objectives, with less conflicts between
    objectives – which isn’t the case for demand side policies. For e.g.
    ▪ unemployment should fall as the economy grows and output expands
    ▪ cost pull inflation should be reduced, as greater efficiencies (lower costs) are achieved
    ▪ current account of the balance of payments should also improve due to more international
    competition
    Supply Side Policies Aren’t Perfect in Every Way
    1. it takes long time to see the results of supply-side policies, so doesn’t fix economy quickly
    o for e.g. it will take many years to see labour supply effects from improvement in education
    2. there can be unintended consequences – e.g. deregulation of financial markets could lead to excessive
    risk-taking which caused a recession like in 2008
    3. supply side policies can be unpopular and there are also concerns about whether some are inequitable (unfair)
    o for e.g. benefit cuts can lead to the poorest people in society worrying about ability to cope financially
    o greater flexibility in labour market and trade union reforms could lead to less job security
    So, while a government hopes improved economic performance will lead to greater prosperity overall in the long
    term, it can be very difficult in the short term to introduce some of these policies

     

     

     

     

     

     

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