Fiscal Policy Government Spending and Taxation

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Fiscal Policy (Government Spending and Taxation)

• A2 economics revision presentation on the
  operation of government fiscal policy including
  changes in government spending, tax revenue and
  public sector borrowing

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The Main Goals of Fiscal Policy

• The Treasury has outlined the main goals of
  fiscal policy to be the following
• Equity concerns
• To ensure that government spending and taxation
  impact fairly both within and across generations
• Funding government spending
• To meet the governments key spending and tax
  priorities without a damaging rise in the burden
  of government debt
• The Benefit Principle
• To ensure that those who benefit from public
  services also meet as far as possible the costs
  of the services they consume
• Macroeconomic Stability
• Fiscal policy is now designed to support monetary
  policy in smoothing the path of aggregate demand
  over the economic cycle

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Distribution of Public Spending
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Government spending on education and health ( of
GDP)
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Composition of Government Spending

• Transfer Payments
• Social security payments
• Over 110 billion including
• Income support
• Jobseekers Allowance
• State Pensions
• Housing benefit / Council Tax Benefit
• Some benefits are means tested
• Others are universal or are based on national
  insurance contributions
• Current spending on goods services (G)
• Capital Spending
• Infrastructural spending by the public sector
• Spending that results in the acquisition of
  assets

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Recent trends in total UK government spending
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Why Do We Have Government Spending?

• The provision of public and merit goods
• The redistribution of income and wealth
• Welfare benefits reduce income inequalities and
  relative poverty by providing a basic minimum
  level of income for those out of employment and
  also income replacement for those who have
  recently been made redundant.
• Influencing regional resource allocation and
  industrial efficiency
• This is achieved via regional policy, which aims
  to reduce regional economic disparities within
  the UK
• Influencing the level of economic activity
• Changes in government spending impact directly on
  aggregate demand and can therefore be used as a
  tool of macro-economic demand-management

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Government Spending An Optimal Level?

• One debate is about how high public spending
  should be relative to national output (GDP)
• In the United States and many Asian countries,
  government spending is less than 30 of GDP
• In European countries, such as Germany and
  Sweden, it has been as high as 40-50
• Some economic studies suggest that lower public
  spending relative to GDP results in higher rates
  of economic growth in the long run, though this
  conclusion is controversial
• Certainly, over the years, much public spending
  has been highly inefficient hence the current
  Labour governments concern to maximise the
  volume of output from extra spending in health
  and education

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The Private Finance Initiative (PFI)

• Private Finance Initiative in 1992 as a way of
  funding infrastructure developments without
  running up excessive public sector debts
• Examples of PFI projects include hospitals,
  prisons, railways, laboratories, schools, defence
  facilities and integrated information systems for
  government departments.
• Under a PFI, private sector companies borrow the
  cash to build and run new hospitals, schools and
  prisons for a period of up to 60 years
• The main objection to the PFI has revolved around
  a fundamental question. How can private sector
  firms finance major public infrastructure
  projects more cheaply than the government when it
  costs them more to borrow?
• Supporters of the PFI arguing that the evidence
  of PFI projects completed so far is that they
  enjoy a clear lead over conventional government
  procurement in delivering big capital projects on
  time and to specified budgets

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Taxation
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Reasons for having taxation

• Revenue
• To raise revenue to finance spending on goods and
  service by central local government
• Managing AD
• The government when managing the level of AD,
  output and prices uses taxation
• Changing the distribution of income and wealth
• A progressive system of taxation can be utilized
  to achieve great equality in income wealth
  between individuals and households
• Meeting environmental targets
• Taxes can correct for externalities and other
  forms of market failure
• Helping the balance of payments
• Import taxes may control imports and therefore
  help the countrys balance of payments and
  protect industries from overseas competition

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Income tax and national insurance contributions
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Income Tax
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Direct and indirect taxes

• Direct taxation
• Direct taxation is levied on income, wealth and
  profit while indirect taxation is levied on
  expenditure
• Direct taxes include income tax, national
  insurance contributions, capital gains tax, and
  corporation tax
• Indirect taxation
• Indirect taxes is levied on spending on goods and
  services
• Indirect taxes include VAT excise duties on fuel
  and alcohol, car tax, betting tax and the TV
  licence
• VAT An indirect tax at the rate of 17.5,
  although domestic fuel is taxed at 5
• Excise duties are specific duties. The main
  duties are placed on cigarettes, alcohol, and fuel

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Tax revenues in 2002-03 ( billion)
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Government Taxes (2003-04)
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Examples of indirect taxation
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Effects of an indirect tax using supply
demand analysis
An ad valorem tax when demand is inelastic
A specific tax when demand is elastic
S Tax
Price
Price
S Tax
S1
S1
P2
P2
P1
D1
P1
D1
Q2
Quantity
Q1
Quantity
Q2
Q1
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Progressive and regressive taxation

• Progressive taxes
• With a progressive tax, the marginal rate of tax
  rises as income rises. I.e. as people earn more
  income, the rate of tax on each extra pound
  earned goes up
• This causes a rise in the average rate of tax
  (the percentage of income paid in tax)
• Proportional taxes
• With a proportional tax, the marginal rate of tax
  is constant. For example, we might have an income
  tax system that applied a standard rate of tax of
  25 across all income levels
• Regressive taxes
• With a regressive tax, the rate of tax falls as
  incomes rise I.e. the average rate of tax is
  lower for people of higher incomes
• In the UK, most examples of regressive taxes come
  from excise duties of items of spending such as
  cigarettes and alcohol.

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Evaluation Direct versus Indirect taxation
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Trends in the government tax burden
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The benefit principle of taxation

• The benefit principle of taxation is that taxes
  paid have a link with the benefit that the person
  paying the tax receives from government spending
• There are some problems with too much emphasis on
  the benefit principle
• It ignores the redistributive aims of taxation.
  The benefit principle is mainly concerned with
  allocative efficiency rather than equity.
• The benefit principle assumes correct revelation
  of preferences by consumers whereas in reality
  many consumers do not have to pay for the public
  goods and services provided for them
  (free-riders)