Fiscal and Monetary Policy

• Government budget - a document that shows the government revenues and expenditure plans for the year ahead
• Fiscal policy (government budget) - presented each year as a balanced budget, a budget deficit, or a budget surplus

  • A balanced budget means that government revenue = government expenditure
  • A budget deficit means that government revenue < government expenditure
  • A budget surplus means that government revenue > government expenditure
• A budget deficit has to be financed through public sector borrowing

  • This borrowing gets added to the public debt
• Fiscal Policy - the use of government spending and taxation to influence the economy

  • Used to impact aggregate demand through taxes and spending
• Strengths of fiscal policy:

  • Spending can be targeted on specific industries
  • Short time lag as compared with monetary policy (effects of fiscal policy are seen sooner)
  • Redistributes income through taxation
  • Reduces negative externalities through taxation
  • Increased consumption of merit/public goods
  • Short term government spending can lead to an increase in the total supply of an economy
• Weaknesses of fiscal policy:

  • Policies can fluctuate significantly when new governments are elected
  • Long term infrastructure projects may lack follow-through
  • Increased government spending can create budget deficits
  • Repaying this debt may lead to strict policies on future generations
  • Conflicts between objectives
  • E.g. Cutting taxes to increase economic growth may cause inflation
• Expansionary Fiscal Policy - increase in government spending and/or tax cuts designed to increase aggregate demand = increase economic growth

  • lower taxes → savings increase → more money to spend → AD increased
  • increased govt spending → funds needed for consumers and businesses to purchase increases → AD increased
• Contractionary Fiscal Policy - decrease in government spending and/or raising taxes designed to decrease aggregate demand = decrease price level (slow inflation)

  • raise taxes → decreases money for spending → consumers and businesses spend less → AD decreases
  • decreases govt spending → reduces funds needed for consumers and businesses → AD decreased
  • used to slow down inflation
• Impacts of contractionary fiscal policy

  • Economic growth slows down
  • Inflation eases
  • Unemployment may increase as output is falling & fewer workers are required
  • Current Account Improves (with less income, imports may fall)
• Impacts of expansionary fiscal policy:

  • Economic growth increases
  • Inflation rises
  • Unemployment may decrease as output is rising which requires more workers
  • Current Account unsure - exports may rise due to new investments in the economy, but imports may rise due to higher income generated by the investment
  • Redistribution of income has increased & there is more equity in society
• Budget - relationship between govt revenue and govt spending

  • budget deficit - spending higher than revenue
  • budget surplus - revenue is higher than spending
• A budget deficit has to be financed through public sector borrowing

  • This borrowing gets added to the public debt
  • Public debt - accumulation of past government borrowing which has to be repaid with interest
• National debt - total amount the government borrowed over time.
• Public expenditure (government spending) - represents a significant portion of the total (aggregate) demand in many economies
• Public expenditure can be broken down into three categories:

  • Current Expenditures
  • Capital Expenditures
  • Transfer payments
• Current Expenditures - include the daily payments required to run the government & public sector

  • e.g. the wages & salaries of public employees such as teachers, police, members of parliament, military personnel, judges, dentists etc.
  • It also includes payments for goods/services such as medicines for government hospitals
• Capital Expenditures - investments in infrastructure & capital equipment

  • e.g. High speed rail projects, new hospitals & school, new aircraft carriers
• Transfer payments: Payments made by the government for which no goods/services are exchanged

  • e.g. unemployment benefits, disability payments, subsidies to producers & consumers etc.
  • This type of government spending does not contribute to GDP as income is only transferred from one group of people to another
• Nearly every economy in the world is a mixed economy & has varying degrees of government intervention
• One of the main forms of government intervention is taxation & there are many reasons why it is necessary

  • support firms
  • correct equity
  • correct market failure
  • support poorer households
  • collect government revenue
• Reason for Government Spending/Taxation

  • Influence Economic Activity - stimulate economic growth
  • Reduce Market Failure - spending on public goods and merit goods, managing social and private costs and benefits, regulating abuses of market power
  • Promote financial equity - through pensions, social housing, education, etc
  • Manage National Debt - paying off loans
  • Correct market failure - in many markets, there is a less than optimal allocation of resources from society's point of view
  • the government aims to subsidise merit goods & tax demerit goods to address this market failure
• Earn government revenue - governments need money to provide essential services, public & merit goods

  • revenue to fund this is raised through taxation
• Promote equity - the wealthy are taxed to provide funds that can be utilised in reducing the opportunity gap between the rich & poor
• Support firms - in a global economy, governments choose to support key industries as to help them remain competitive & taxation provides the funds to do this
• Support poorer households - poverty has multiple impacts on both the individual & the economy

  • Intervention seeks to redistribute income (tax the rich and give to the poor) so as to reduce the impact of poverty
• Main source of govt income is taxes
• Direct taxes - taxes imposed on income and profits

  • Paid directly to the government by the individual or firme e.g. income tax, corporation tax, capital gains tax, national insurance contributions, inheritance tax
  • Normally impacts income and profit
• Tax systems can be classified as progressive, regressive or proportional

  • most countries have a mix of progressive (direct taxation) & regressive (indirect taxation) taxes in place
• Indirect taxes - taxes imposed on spending

  • Person/Fim pays tax from own money
  • Normally impacts cost of production
• Progressive

  • as income rises, a larger percentage of income is paid in tax
  • takes a larger % of income from the rich
• Tax systems can be classified as progressive, regressive or proportional

  • most countries have a mix of progressive (direct taxation) & regressive (indirect taxation) taxes in place
• Regressive

  • As income rises, a smaller percentage of income is paid in tax
  • All indirect taxes are regressive
  • takes a larger % of income from the poor
• Proportional

  • As income rises, the same percentage ****of income is paid in tax
  • takes same % of income from rich and poor
• Progressive tax systems are built around the idea of marginal tax rate
• Marginal tax rates - amount of additional tax paid for every additional dollar earned as income

  • increases as income icnreases
• The calculation of an individual's personal income tax requires several calculations
• In order for the population to accept a tax system & pay into it, the taxes imposed need to be considered to be 'good'
• There are several principles which should be applied when developing a 'good' tax system (1)

  • Simple - taxpayers should know what, when, where & how to pay the tax
  • Fair (equity) - taxes should reflect a taxpayer’s ability to pay
  • progressive taxation aims to achieve this as the wealthy can afford to pay more than the poor do
  • Convenient - systems to collect payment should be easy & provide choice for taxpayers e.g. monthly payments spread over 12 months or tax collected by the employer each month before the salary is paid
• There are several principles which should be applied when developing a 'good' tax system (2)

  • Efficient - the management of the tax system by the government should not be overly expensive or wasteful
  • Fit for purpose - there should not be any unintended side effects of the system e.g. disincentivising workers from working
  • Flexible - it should be easy to adjust/change as required by changes in the economy
• Changes in direct & indirect tax rates influence a range of economic variables

  • The greater the size of the change, the greater the ripple effects felt by households, firms & the economy