DemandSidePolicies- FiscalPolicyGCEA-LEVEL& IBECONOMICS

WhatisFiscalPolicy?

Fiscalpolicyiswhenthegovernmentchangestheamounttheyspend ortheamountthey taxtoaffectthelevelofaggregatedemand(AD) intheeconomy.ThiswillhenceaffectinflationandrealGDP.

Therefore,likemonetarypolicy,fiscalpolicyisalsoatypeof“Demand-sidepolicy”.

FiscalPolicyandGov.Spending

EquationofAggregateDemand(AD)=C+I+G +(X- M)

Ifthegovernmentincreasesgovernmentspending(G),itwilltriggeraninjection intothecircularflowofincome.ThiswillincreaseADandshifttheADcurvetowardstheright.Itmayalsoleadtoapositivemultipliereffect fortheeconomy,enlargingtheinitialgovernmentspending;viceversa.

e.g.viaconstructionprojects,healthcare/educationspending

FiscalPolicyandTaxes

Ifthegovernmentincreasestaxation (T),itwilltriggerawithdrawalfromthecircularflowofincome.ThiswilldecreaseADandshifttheADcurvetowardstheleft.Itmayalsoleadtoanegative multipliereffect fortheeconomy,enlargingtheinitialgovernmenttaxation;viceversa.

e.g.viaVAT,income/corporationtax

ExpansionaryFiscalPolicy

Anexpansionary fiscalpolicyhappenswhenthegovernmentaimsforanincreaseinAD andGDP.Thisisdonewhenthegovernmentincreasesgovernmentspending(G)ordecreasestaxes(T).Thegovernmentmayadoptthispolicyinarecession tocompensateforthelossinEconomicactivityduetothebusiness/economiccycle,inordertoachievestableeconomicgrowth.

Price Level

Real GDP

AD

AD1

P1

AS

P

Y Y1

ContractionaryFiscalPolicy

Ancontractionary fiscalpolicyhappenswhenthegovernmentaimsforadecreaseinADandGDP.Thisisdonewhenthegovernmentdecreasesgovernmentspending(G)orincreasestaxes(T).Thegovernmentmayadoptthispolicyinaboomtodecreaseabovetargetinflation/economicactivityduetothebusiness/economiccycle,inordertoachievestablelevelofinflation.

Price Level

Real GDP

AD1

AD

P

AS

P1

Y1 Y

FiscalPolicyandGov.Budget

Thegovernmentrunsabudgetdeficitwhengovernmentspending/expenditureishigherthantaxrevenue/income(G>T).Thiswouldmeanthatoverall,thegovernmentisinjectingmoneyintotheeconomy,andcanbedescribedasoperatinganexpansionaryfiscalpolicy.

Thistendstobethecaseinarecession whenbusinessprofitsandhouseholdincomesarelow,leadingtolowertaxrevenue.Atthesametime,welfarepaymentswillbehigher,increasinggovernmentspending.

Theoppositehappenswhenthegovernmentrunsabudgetsurplus (G<T).

FiscalPolicyandGov.Budget

Hence,acyclicalfiscaldeficitisabudgetdeficitcausedbythebusiness/economiccycle,particularlywhentheeconomyisinrecession.Itisexpectedtobebalancedoutbytheadditionaltaxincomereceivedinaboom.E.g.Unemployment/welfarebenefits,Covid-19governmentaidHowever,astructuralfiscaldeficitisabudgetdeficitunrelatedtothebusiness/economiccycle.Itisexpectedtocontinuetoexistdespitetheeconomyrecovers.Thistendstoindicateamorefundamentalproblemintheeconomywhichrequiredgovernmentfunding.E.g.UKPensioncrisis

ImplementingFiscalPolicy(Spending)Thegovernmentcanincrease/decreasemajorcomponentsofgovernmentspendingtoimplementfiscalpolicy.

E.g.buildingmorehospitals,schools;orreducetheiravailablefunding.

Evenanincreaseindefensespendingduringwartimewouldqualify.

Source:TheGuardian2013/14

SpendingandSupply-SidePolicy

Interventionistsupply-sidepoliciesareundertakenbythegovernmenttoincreaseproductivepotentialintheeconomybyimprovingfactorsofproduction(e.g.labour)

Governmentspendingprojectsoninfrastructure,healthcareandeducationalsotendtohaveasupply-sideelementforittomaximizewelfarebenefittosociety.

Examples:HS2,Crossrail(Elizabethline),5GNetwork

Hence,theseprojectswouldbeanoverlapofbothfiscalandinterventionistsupply-sidepolicy,duetothegovernmentspendingelementandtheimprovementinproductivepotential,shiftingADandAStotheright.

ImplementingFiscalPolicy(Taxation)Therearetwotypesofgovernmenttaxation:DirectTax– taxesleviedonincome/profitsE.g.Incometax,Corporationtax,Dividendstax,InheritancetaxIndirectTax– taxesleviedthroughproduction/consumptionofgoodsandservicesE.g.VAT,alcoholandtobaccotax,sugartax,petrol/fuelduties

Directtaxestendtobeprogressive(e.g.UKIncometax)whichmeansthosewithhigherincomeswillpayalargeproportionoftax.Thehighertaxratesinhigherincomebracketsmeanmoretaxpereachdollar/poundearned.Indirecttaxestendtoberegressive(e.g.VAT)asthosewithhigherincomespaylessVATasaproportiontotheirtotalincome.

ImplementingFiscalPolicy(Taxation)Examplesofhowchangingtaxesachieveanincrease/decreaseinAD:

1.Decreaseincorporationtax->Increasesprofitsretainedbybusinesses,whichcanbeusedtofundnewbusinessprojects

->Increasesinvestment(I)e.g.buyingmorecapital/equipmenttoexpandbusiness

->AsAD=C+I+G+(X– M)andIincreases,ADincreases

2.Anincreaseinpersonalincome/indirecttax->Reducesdisposablehouseholdincomeandtheirpurchasingpower

->Thisdecreasesconsumption(C)aslessgoodsandservicescanbeafforded

->AsAD=C+I+G+(X– M)andCdecreases,ADdecreases

TaxationandSupply-SidePolicy

Market-basedsupply-sidepoliciesreducegovernmentinvolvement inthefreemarkettoincreasemarketefficiency.Thisispossiblydonebyprovidingincentives orencouragingmarketcompetition.

Thisincludesreducingincometaxtoincentivizemoreworkerstojointheworkforce,orreducingcorporationtaxtoincentivizebusinessinvestment/inwardFDI.

Asaresult,theseexpansionaryfiscalpoliciesalsohaveasupply-sideelement,leadingtoashiftinADandAStotheright.

FiscalPolicyEvaluationHowcanfiscalpolicyhelptoachievekeymacroeconomicobjectives?

1.EconomicGrowth->ExpansionaryfiscalpolicycanshiftADtotherightasgovernmentspendingincreasesdemandforgoodsandservices,henceincreasingGDPiftheeconomyisunderfullemploymentinarecession

->Non-targetedfiscalpolicy(e.g.income/corporationtaxcuts)thatarenotsupply-sidepoliciesdoesnotgeneratelongtermeconomicgrowthasitisnoteffectiveinincreasingproductivecapacity

FiscalPolicyEvaluationHowcanfiscalpolicyhelptoachievekeymacroeconomicobjectives?

2.Unemployment->AnincreaseinaggregatedemandandGDPmeansahigheroutputofgoods&services.Thiswouldcausehigherderiveddemandforlaborandhencedecreaseunemploymentintheeconomy.

->Ifthefiscalpolicyisfocusedonlabortrainingortohelpwithfrictionalunemployment(e.g.unemploymentbenefits),thiscanbeevenmoreeffectiveasitwillhelpreduceoccupationalimmobilityandstructuralunemployment.

FiscalPolicyEvaluationHoweffectivecanfiscalpolicyhelptoachievekeymacroeconomicobjectives?

3.Inflation->InflationcanbetackledbycontractionaryfiscalpolicyandareductioninAD.Thisisbecauselowerdemandintheeconomycausesproducerstochargelessforgoodsandservices,thusreducingthegeneralpricelevel.

->However,thismaynotbeveryeffectiveifthecauseoftheinflationisduetorisingcostofproduction(cost-pushinflation),andmayalsoreduceemploymentandGDP.

->Viceversa,expansionaryfiscalpolicyincreasesinflationarypressuredespiteraisingAD/GDP.

FiscalPolicyEvaluationHoweffectivecanfiscalpolicyhelptoachievekeymacroeconomicobjectives?

4.BalanceofPayments->Contractionaryfiscalpoliciessuchastaxhikescanhelptoreduceimportsbyloweringhouseholds’disposableincome.Thisisbecauseconsumerimportstendtobeincomeelasticnormalgoods.Loweringtotalexpenditureonimportswillhelpdecreaseacurrentaccountdeficit.

->However,thismaynotbeveryeffectiveifalargeproportionofthecountry'simportsareonrawmaterials/commoditiesthatarenecessitiesandareincomeinelastic(meaningachangeinincomewillonlyaffectquantitiespurchasedminutely).

->Fundamentally,theeffectivenessdependsonthemarginalpropensityofimportofcitizens.Furthermore,thegovernmentcanuseexpansionaryfiscalpolicyontargeteddomesticindustriestoproduceneededgoods/serviceslocallyandreplaceimports.

FiscalPolicyEvaluationWhataresomegeneralconsiderationswhenconsideringtousefiscalpolicy?

->Canquicklymaintainingdemand/stimulatingtheeconomybyincreasingADandGDPinarecession

->Noteffectiveifeconomyisalreadyworkingafullcapacity/employment(e.g.ataboom)

->Mayleadto“crowdingout”wheregovernmentspendingreplacestheneedforprivateinvestment.Thismayoccurifgovernmentborrowsmoneyforthefiscalspending,leadingtohigherinterestratesandcostsforprivatecompaniestoinvest

FiscalPolicyEvaluationWhataresomegeneralconsiderationswhenconsideringtousefiscalpolicy?

->Dependsonthemarginalpropensitytosave/consumeofthoseaffectedwhichchangesthesizeofthemultipliereffect

->Impactismoreshort-termandmaynotnecessarilyberecurring/long-lasting

->Canbetargetedatspecificregions/industriesbutmayleadtogeographicalimbalances