Fiscal Policy - Taxation and Public Expenditure- A Level Economics

8/13/2019 Fiscal Policy - Taxation and Public Expenditure- A Level Economics

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Fiscal Policy - Taxation and Public ExpenditureThis chapter seeks to build on your study offiscal policyat AS level.

Government Spending

Government spending can be broken down into three main categories:

o General government expenditure- capital and current spending of central governmentincluding debt interest payments to holders of government debt.

o General government final consumption- spending on current goods and servicesexcluding transfer payments the main item of spending is on pay for public sector workers.

o Transfer payments from taxpayers to benefit claimants through the social security system.

Government Spending Objectives

The Treasury has outlined the main goals of fiscal policy to be the following:

o Equity concerns: To ensure that government spending and taxation impact fairly within andacross generations fiscal policy should be equitable to current and future generations.

o Funding government spending: To meet the governments spending and tax prioritieswithout a damaging rise in the burden of government debt.

o The benefit-pay-princip le: This principle seeks to ensure that those who benefit from publicservices such as state education and the NHS also meet the costs of the services theyconsume.

o Macroeconomic stability: Fiscal policy in the UK is designed to support monetary policy incontributing to an environment of sustainable growth and stable inflation.

The level of spending by the UK government has soared in recent years and has been criticised bythose who claim that public sector spending is open to a high level of waste and lack of productiveefficiency. Successive governments have striven to improve the efficiency with which public servicesare provided. This has included the use of contracting-outand competitive tenderingwhereprivate sector businesses compete with the public sector for the contracts to provide services such asNHS catering, laundry and cleaning together with maintenance of the road network and aspects ofthe prison service. The government has also introduced value for money auditsfor each majorgovernment spending department together with a huge and growing number of performancetargets.

As we see below, the share of national income taken up by government spending has risen from41% when Labour came into office in 1997 to over 50% now. Ultimately a state that spends such a

high percentage of GDP needs to raise an equivalent amount in tax revenues to pay for the spending otherwise public sector borrowing and the national debt rises to unsustainable levels.
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Measured as a percentage of national income (2010-11 is a forecast from the OECD)

UK Government Spending and Taxation

Source: OECD World Economic Outlook

90 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07 08 09 10 11

35.0

37.5

40.0

42.5

45.0

47.5

50.0

52.5

55.0

PercentofGDP

35.0

37.5

40.0

42.5

45.0

47.5

50.0

52.5

55.0

Total Tax Revenue

Total Government Spending

When government spending > total tax revenues as a share of GDP then there is a budgetdeficit

When government spending < total tax revenues then there is a budget surplus.

The OECD is forecasting that in 2010 the budget deficit will be in excess of 12% of national income,one of the biggest fiscal deficits that the British economy has ever seen.

Taxation

The current government's objectives for the British tax system are broadly as follows:

1. The burden of tax: To keep the tax burden as low as possible (measured as the % of GDP)

2. To improve incentives

3. Equitable taxes: To ensure taxes are applied equallyand fairlyto everyone. Equality is notalways the same as fairness see the notes below on the canons of taxation

4. Correct for market failure: Using taxes to make markets work better including externalities.

Principles of a Good Tax System

Adam Smith developed one set of principles known as the canons of taxationin his famous work onthe Wealth of Nations published in the late 18thcentury.

Efficiency- an efficient tax system raises sufficient revenue to pay for government spending,without reducing work-incentives for individuals and investment incentives for companies.

Equity taxes should be fair and based on people's ability to pay.

The benefit princ iple of taxation this principle is that taxes paid by people have a linkwith the benefit that the person paying the tax actually receives from government spending.The benefit principle is mainly concerned with allocative efficiencyrather than equity.


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Transparency and certainty- taxpayers should understand how the system works andshould be able to plan their tax affairs with a reasonably degree of certainty. Taxes shouldalso be difficult to evade and should not be too difficult or expensive to collect.

Annual tax revenues, measured at current Prices, billion

Income Tax, VAT & Corporation Tax

Source: HM Treasury Public Finance Databank

90 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07 08 09

billions

0

25

50

75

100

125

150

175

(billions)

0

25

50

75

100

125

150

175

VAT

Corporation tax

Income tax

Progressive Taxation

INCOME TAX PAYABLE BY INCOMENUMBER OF TAXPAYERS

(THOUSANDS)AVERAGE RATE OF TAX

(PERCENTAGES)

6,0357,499 1,440 1.9

10,00014,999 6,390 8.4

15,00019,999 4,930 11.7

20,00029,999 6,910 14.0

50,00099,999 2,010 23.3

100,000199,999 470 30.1

1,000,000 and over 11 35.9

All incomes 31,000 17.9

In a progressive tax systemthe average rate of tax rises with income for example, income tax isprogressive in its effects on disposable income. The table above gives a flavour of how the taxburden rises with taxable income. For someone with an annual taxable income of 13,000, the taxrate is just under 12% whereas for some earning well over 100,000 the percentage taken in taxrises above 30%. In the 2009 Budget, Chancellor Alastair Darling raised the rate of income tax on

those earning over 150,000 to 50% from April 2010. In addition the government has announced thephasing out of tax-free personal allowances for those earning six figure sums. There will be nopersonal allowance at all, once someones income reaches about 113,000


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The Tax Base

The tax base refers to the number of tax-paying agents in the economy and the amount of income,wealth and spending on which taxes are applied. When an economy is expanding, so does the taxbase. There are more people in work, businesses are growing and making more profits. And bothprices and incomes tend to rise, all of which leads to a rise in tax revenues flowing into the Treasury.

The reverse happens during a recession. Indeed one of the features of the 2009 recession has beenthe slump in tax income for the UK government a feature of the downturn that has contributedhugely to the rising budget deficit.

Fiscal Drag

Fiscal drag occurs when tax allowances do not rise in line with prices and incomes. The result is thatpeople and businesses end up paying a larger percentage of their incomes in tax.

Tax competition

Tax competition describes a process where a national government decides to use reforms to the taxsystem as a deliberate supply-side strategy aimed at attracting new capital investment and jobs intotheir economy. The issue has become important in the European Union because some countriesincluding France and Germany complain that poorer countries are using tax competition as anincentive to attract inward investment, yet they are also net recipients of EU structural funds. If thesecountries can afford to lower business taxes, can they also afford not to do with the extra EU fundingthat helps to finance, for example, infrastructural spending required sustaining fast rates of economicgrowth?

Flat Rate Taxes

A flat tax means that everyone is taxed at just one rate. I.e. everyone pays the same percentage tax

on any income earned above the tax threshold. Examples of countries that have moved towards flatrate tax systems include Estonia, Latvia, Poland, Lithuania,Russia,Slovakia and Hungary. Supply-side economists are often fans of flat rate taxes because they think that they will

1. Help reduce red tape and reduce the resources wasted on tax forms,chasing up non-payersand enforcing tax laws. This would reduce the money spent on administering the tax system.

2. Boost incentives for people to work, to save (e.g. for retirement) and for companies to useprofits to invest - both of which could increase the countrys potential growth rate.

3. Generate increased tax revenue based on the idea of the Laffer Curve

4. A flat tax may make an economy more attractive to foreign investment.

Arguments against

1. Flat rate taxes are no longer progressive and so the distribution of income and wealth will bemore unequal certainly in the short and medium term.

2. Flat taxes can form part of a race to the bottom with governments competing with each otherto offer the lowest rates of tax to entice inward investment and skilled workers.

3. If tax rates are cut, some people may choose to work less because they can earn the sameincome from working fewer hours.

4. There is no guarantee that businesses will engage in more investment and R&D if company

taxes are lower they may simply offer more in the way of dividends to their shareholders!
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Microeconomic effects of tax changes

1. Taxation and work incentives:

Can changes in income taxes affect the incentive to work? Consider the impact of an increase in thebasic rate of income tax. This has the effect of reducing the post-tax income of those in workbecause for each hour of work taken the total net income is now lower. This might encourage the

individual to work more hours to maintain his/her target income. Conversely, the effect might be toencourage less work since the return from each hour worked is less.

Changes to the tax and benefit system also seek to reduce the risk of the poverty trap wherehouseholds on low incomes see little financial benefit from supplying extra hours of their labour. If taxand benefit reforms can improve incentives and lead to an increase in the labour supply, this will helpto reduce the natural rate of unemployment and increase the economys non-inflationary growth rate.

2. Taxation and the Pattern of Demand

Changes to indirect taxes in particular can have an effect on the pattern of demand for goods andservices. For example, the rising value of duty on cigarettes and alcohol is designed to cause asubstitution effect among consumers and thereby reduce the demand for what are perceived as de-merit goods . The use of indirect taxation and subsidies is often justified on the grounds ofinstances of market failure. But there might also be a justification based on achieving a moreequitable allocation of resources e.g. providing basic state health care free at the point of use.

3. Taxation and labour productivity

Some economists argue that taxes can have a significant effect on the intensity with which peoplework andproductivity.But there is little empirical evidence to support this view. Many factorscontribute to improving productivity tax changes can play a role - but isolating the impact of tax cutson productivity is extremely difficult.

The Laffer Curve

Created by the US supply-side economist Arthur Laffer, thiscurve tries to shows the relationship between tax rates and taxrevenue collected by governments. It argues that as tax ratesrise, total tax revenues rise at first but perhaps at a diminishingrate. There may be an overall tax burden (e.g. expressed as apercentage of GDP or as a percentage of income) which yieldsthe highest tax revenues and that beyond this, further hikes intaxation serve only to reduce the money flowing in.

The Laffer curve has been used as a justification for cuttingtaxes on income and wealth - the argument being that improved incentives to work and create wealth

will broaden the base of tax-paying businesses and individuals and also reduce the incentive to avoidand evade paying tax. Lower taxes might increase tax revenues. For this to be the case the laboursupply must respond elastically to the change in post-tax wages or salaries and/or we needinformation on the lengths to which the rich will go to avoid paying taxes.

AKeynesianinterpretation might be that lower direct taxes could stimulate higher spending within thecircular flow which itself boosts demand, output, profits and employment, all of which can drive taxrevenues higher.

The Laffer Curve came back into the news in Spring 2009 when the Labour government announceda rise in the top rate of income tax designed to raise more than 5bn per year and help plug some ofthe holes in the government's finances. Will a rise in higher income tax rates yield the extra revenue -Laffer curve supporters argue that it might fail to do this, perhaps even cause revenues to fall.

The richest 1% of UK taxpayers paid 23% of all income tax collected in 2008-09. And the richest 5%pay 42% of the tax. In 1999-00 these ratios were 21.3% and 39.6% respectively. The independentInstitute for Fiscal Studies (IFS) has calculated that the peak yielding tax rate for UK income tax is
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about 42.5% and that, on this model, the 55% tax due to start in 2010 would actually lose 800m tothe Exchequer.

Case Study: Does the UK tax system need reform?

George Osborne on Emergency Budget Day in 2010

The current state of the public finances in Britain with a predicted fiscal deficit of over 12% of GDP for2009-10 has led many to wonder how this deficit will be halved, as the present government havepledged, in the four years from 2011. The governments commitment will mean some difficultdecisions on public expenditure and taxation particularly as half of the reported deficit is structural,meaning that it will not disappear when the economy recovers and tax revenues start to rise again.

The cyclical part of the deficit is of less concern, but the structural deficit needs tackling either by cutsin government expenditure and/or tax increases. Deficits of the size run by the UK becomeincreasingly difficult to finance through the sale of government debt (gilt-edged securities).

On the tax issue the government has a problem because tax revenues are barely over 35% of GDP

as a result of the erosion of the tax base due to the recession. Simply putting up taxes may not bethe answer as the new 50% higher tax rate might demonstrate. In addition, personal and corporatetax regulations in the UK have become hugely complex in recent years. The abolition of the 10%income tax rate has arguably affected incentives to work and the planned 50% rate may do the sameat the other end of the income scale. There is a view that in order to boost economic growth andpromote an enterprise culture the government need to switch the burden of tax away from income,wealth and savings and towards expenditure and the environment.

Taxes on environmental degradation will raise revenue, reduce external costs and internalisenegative externalities. Direct taxes on income and wealth are prone to avoidance and evasion andcan affect incentives whereas indirect taxes on spending are much harder to evade. Hence maybethe UK government needs to think radically and by reforming the tax system try to achieve a

remarkable double of increasing tax revenue and stimulating enterprise- thereby boosting the supply-side of the economy.

The government could radically reform the tax system by using a 20% rate as the basis of all majortaxes similar in principle to the flat tax system used by some economies in Eastern Europe. If VATwere raised to 20% and its scope extended to all goods and services (including food) revenue wouldmost probably rise significantly although it would be regressive and lead to a bout of inflation.

A Corporation Tax rate of 20% for all companies (its 21% for small firms and 28% for large firms atpresent) would be popular and may attract foreign inward investment. It may even boost tax revenueas Ireland found a few years ago when it reduced its company tax rate to 12.5%. It has been reportedrecently that there are a few large firms considering moving their tax domicile from the UK due to thehigh corporate tax rate here and the over complex tax regulations. The rate for Capital Gains Tax is

at present is 18% - why not raise it to 20%? Similarly Inheritance Tax, a very unpopular tax, has a40% rate. If it could be reduced to 20% would revenue from it fall or would it rise as avoidance falls?Income Tax could continue to use 20% as the present basic rate with the 40% rate being maintainedto keep it progressive. However, a return of the 10% tax rate could reduce incidence of the poverty


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and unemployment traps among the low paid. The forthcoming planned 50% tax rate could becancelled, as it is unlikely to raise much revenue and have a negative effect on incentives.

Clearly reform of this kind could be seen as far too risky when the public finances are so weak andthere would always be doubt as to whether revenue would increase or not. Revenue effects woulddepend on where the levels of tax free allowances were set for the income and capital taxes.However, the UK tax system is a cumbersome mess at the moment and now may be the time to beradical revenue needs to rise while enterprise and incentives. Sadly no politician would have thecourage to be so bold.

Source: Ruth Tarrant, EconoMax, Spring 2010

Fiscal Policy and the Economic Cycle

The credit crunch and recession has brought the use of fiscal policy as a demand-side instrumentfirmly into prominence. Many countries have chosen to introduce afiscal stimulusin a bid to boostconfidence and demand and prevent a deflationary slump. But how effective is fiscal policy in the

aftermath of a huge global demand shock? What are some of the medium term consequences of abig rise in government borrowing?

Fiscal policy is the Governments main demand-management tool. Government spending, direct andindirect taxation and the budget balance can be used counter-cyclically to help smooth out someof the volatility of real national output particularly when the economy has experienced an externalshock.

1. Discretionary fiscal changesare deliberate changesin taxation and govt spending forexample a decision by the government to increase total capital spending on road building.

2. Automatic fiscal changes(also known as automatic stabilisers) are changes in taxrevenues and state spending arising automatically as the economy moves through the trade

cycle.

Automat ic stabilisers and the business cycle

Automat ic stabilizers refer to how fiscal policy instruments will influence the rate of GDP growthand help counter swings in the business cycle.

During phases of high GDP growth, automatic stabilizers will help to reduce the growthrate and avoid the risks of an unsustainable boom and accelerating inflation. Withhigher growth, the government will receive more tax revenues and there will be a fall inunemployment so the government will spend less on unemployment and other welfarebenefits.

Conversely in a recession, GDP growth becomes negative but because of lowerincomes, people pay less tax, and government spending on unemployment benefitswill increase. The result is an automatic increase in government borrowing with thestate sector injecting extra demand into the circular flow.

Recent evidence from the OECD suggests that a government allowing the fiscal automatic stabilizersto work might help to reduce the volatility of the economic cycle by up to 20 per cent. The strength ofthe automatic stabilizers is linked to the size of the government sector (e.g. government spending asa % of GDP), the progressivity of the tax system and how many welfare benefits are income-related.In short automatic stabilizers help to provide a cushion of demand in an economy and support outputduring a recession.

Measuring the fiscal stance

1) A neutral fiscal stancemight be shown if the government runs with a balanced budget.

2) A reflationary fiscal stancehappens when the government is running a budget deficit.
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3) A deflationary fiscal stancehappens when the government runs a budget surplus (i.e.G


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need to borrow to fund a rise in production (perhaps for export) and also investment in fixedcapital and extra stocks.

Openness of the economy: The more open an economy is (i.e. the higher is the ratio ofimports and exports to GDP) the greater the extent to which higher government spending ortax cuts will feed their way into rising demand for imported goods and services, lowering theimpact on domestic GDP.

Fiscal and monetary policy decisions in other count ries:Modern economics are deeplyinter-connected with each other. The UK government has decided to run a huge budget deficit- so what happens to government borrowing and interest rates in the EU, the USA and inmany emerging market countries will have an important bearing on prospects for a broadlybased recovery in global trade and output which then affects the UK economy.

Problems with Fiscal Policy as an Instrument o f Demand Management

In theory a positive or negativeoutput gapcan be overcome by the fine-tuning of fiscal policy.

However, in reality the situation is complex.Different types of lag

o Recognition lags: Inevitably, it takes time to for policy-makers to recognise a need for someactive discretionary changes in spending or taxation.

o Imperfect information: The data that comes out on the economy is often delayed andsubject to revisions.

o Response lags: It then takes time to implement an appropriate policy response. Tax cuts canfeed through quite quickly but new capital expenditure is difficult to start; roads have to beplanned, hospitals and schools designed

o Impact on consumer and business behaviour: It then takes time for the change in fiscalpolicy to work, as the multiplier process is not instantaneous.

Fiscal Crowding-Out

The crowding-out hypothesis is an idea that became popular in the 1970s and 1980s when freemarket economists argued against the rising share of national income being taken by the publicsector.

The crowding out view is that a rapid growth of government spending leads to a transfer of scarceproductive resources from the private sector to the public sector. For example, if the governmentchooses to run a bigger budget deficit, the government will have to sell debtto the private sector and

getting individuals and institutions to purchase the debt may require higher interest rates. A rise ininterest rates may crowd out private investment and consumption, offsetting thefiscal stimulus.
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per cent

Interest Rates on 10-year UK Government Bonds

Source: Reuters EcoWin

Jan

08

Mar May Jul Sep Nov Jan

09

Mar May Jul Sep Nov Jan

10

Mar May Jul Sep

0.00

1.00

2.00

3.00

4.00

5.00

6.00

Percent

0.00

1.00

2.00

3.00

4.00

5.00

6.00

Quantitative easing programme started here

Despite the growing budget deficit, UK bond yields on longer-dated government debt have remainedlow mainly due to the financial markets appetite for relatively low-risk Treasury Bonds of differentduration.

The Keynesian responseto the crowding-out hypothesis is that the probability of 100% crowding-out is remote, especially if the economy is operating well below its capacity and if there is a plentifulsupply of savingsavailable that the government can tap into when it needs to borrow money. Thereis no automatic relationship between the level of government borrowing and the level of short termand long term interest rates. One interesting aspect of the UK economy is that UK government debtis long-term with an average maturity of 14 years this means that Britain is less exposed toproblems of having to find money to repay lots of short term public sector debt.

Crowding-In

Some Keynesian economists argue that in an economic depression, fiscal deficits crowd-inratherthan crowd-out private sector investment. In the aftermath of an economic shock, many countriesoperate with spare capacity that puts big downward pressure on business profits and jobs. Well-targeted timely and temporary increases in government spending can absorb the under-utilisedcapacity and provide a strong multiplier effectwhich then generates extra tax revenue.

In 2009 we saw a spectacular fall in private sector borrowing government deficits provide acounter-weight to this. And the fact that real in terest rates on ten-year government bondsremainat historically low levels suggests that there isnt an immediate funding crisis for westernGovernments who have chosen to use a fiscal stimulus as a counter-cyclical policy. Much of thefunding for the borrowing at least in the short term will come from the rising savings of the privatesector of rich advanced nations.

The Rational Expectations View

According to a school of economic thought that believes in rational expectations, when thegovernment sells debt to fund a tax cut or an increase in expenditure, a rational individual will realisethat at some future date he will face higher tax liabilities to pay for the interest repayments. Thus, he


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should increase his savings as there has been no increase in his permanent income. Theimplications are clear. Any change in fiscal policy will have no impact on the economy if all individualsare rational. Fiscal policy in these circumstances may become ineffective.

Government borrowing

Budget Deficits and Budget Surpluses in 2010

% of GDP

Country Deficit Country Surplus

USA -9.5 Norway 10

Germany -5.5 Saudi Arabia 7.3

Italy -5.5 South Korea 0.3

France -9 Singapore 0.4

Spain -10.3 UAE 13.3

UK -11.1

Japan -9

Budget balance and gross government debt as a % of GDP, 2011 is a forecast

UK Government Borrowing and Debt

Source: OECD World Economic Outlook

90 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07 08 09 10 11

-12.5

-10.0

-7.5

-5.0

-2.5

0.0

2.5

5.0

%o

fGDP

-12.5

-10.0

-7.5

-5.0

-2.5

0.0

2.5

5.0Annual government budget balance

Budget deficit

Budget surplus

30

4050

60

70

80

90

%o

fGDP

30

4050

60

70

80

90

Gross Government Debt (% of GDP)

When the government is running a budget deficit, the state has to borrow through the issue of debtsuch as Treasury Bills and long-term Bonds. The issue of debt is done by thecentral bankandinvolves selling debt to the bond and bill markets.

Does a budget defic it matter?

A persistently large budget deficit can be a problem. Three of the reasons for this are as follows:
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1. Financing a deficit: A budget deficit has to be financed through the issue of debt. In a worldwhere financial capital flows freely between countries, it can be fairly easy to finance a deficit.But if the budget deficit rises to a high level, in the medium term the government may have tooffer higher interest rates to attract sufficient buyers of debt. This raises the possibility of thegovernment falling into a debt trapwhere it must borrow more simply to repay the interest onaccumulated borrowing.

2. A government debt mountain? By the summer of 2009 UK government debt was surgingabove 800bn and is set to rise much higher in the next couple of years. There is anopportunity costinvolved here because interest payments on bonds might be used in moreproductive ways, for example on health services or extra investment in education. 100 basispoints equates to 1 per cent. Every 5 basis points (0.05%) saved on 220bn of new debt paysone years salary for 46,000 teachers. Higher public sector debt also represents a transfer ofincome from people and businesses that pay taxes to those who hold government debt andcause a redistribution of income and wealth in the economy.

3. Crowding-out - the need for higher interest rates and higher taxes. If a larger budgetdeficit leads to higher interest rates and taxation in the medium term and thereby has anegative effect on growth in consumption and investment spending, then a process of fiscalcrowding-outis said to be occurring. There must be a limit to which taxpayers are preparedto pay for government spending. The Institute of Fiscal Studies has estimated that that toreduce the UK budget deficit over the next five years will require every person in the UK topay over 1250 of extra taxes each year.

4. Risk of capital flight: Some economists believe that very high levels of state borrowing anddebt risk causing a run on the pound. This is because the government may find it difficult tofind sufficient buyers of its debt and the credit-rating agencies may decide to reduce the ratingon UK sovereign debt. If the risks of holding UK government debt go up, some foreigninvestors may choose to take their money out of the UK driving sterling lower in the currencymarkets.

Potential benefits of a budget deficit

1. Government borrowing can benefit growth:A budget deficit can have positivemacroeconomic effects if it is used to finance capital spending that leads to an increase in thestock of national assets. For example, spending on transport infrastructure improves thesupply-side capacity of the economy. And increased investment in health and educationcan boost productivity and employment.

2. The budget deficit as a tool of demand management: Keynesian economists support theuse of changing the level of government borrowing as a legitimate instrument of managingaggregate demand.An increase in borrowing can be a useful stimulus to demandwhenother sectors of the economy are suffering from weak or falling spending. If crowding out is

not a major problem - fiscal policy can play an important counter-cyclical role leaning againstthe wind of the economic cycle

Case Study: Fiscal Retrenchment for the UK Economy

Fiscal retrenchment means that a government has to introduce deflationary fiscal measures designedto reduce the amount of borrowing and debt that has been run up during the downturn andeconomic/financial crisis. Ultimately fiscal retrenchment can be achieved in one of two ways

*1 Raising indirect and direct taxation

*2 Making cuts in the real level of government spending

Both are painful - tax hikes might choke off a tentative recovery in 2010 and 2011 and reducinggovernment spending must hit the availability of public services.

The automatic versus discretionary fiscal policy choice
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Much of the debate during the recent general election campaign focused on an important economicdecision namely whether to follow an automatic or discretionary fiscal policy.

Simply put, automatic fiscal policy is concerned with the changes in tax revenue and governmentspending that occur naturally over the course of the economic cycle; discretionary policy, however,concerns active manipulation of policy to change the amount earned in revenue and the amountspent.

The former Chancellor Alastair Darling has emphasised the importance of allowing the economy togrow since this would automatically reduce the size of his budget deficit. In other words, he displayedgreater confidence than the new Treasury team in the coalition government in the ability of automaticstabilisers to help restore a budget balance.

When the economy grows, national income rises both because people already in work receive higherwages and because some previously unemployed people find work. This means that the governmentearns more in revenue from income tax and also in VAT receipts as people spend their higherincome. Profits will tend to rise and so more is earned from corporation tax. At the same time, thegovernment needs to spend less on unemployment benefits. So, tax revenue rises and governmentspending falls, automatically. With a few tweaks here and there, Alistair Darling reckoned that this

would essentially be enough to reduce the size of the budget deficit.

The new Business Secretary Vince Cable of the Liberal Democrats advocated during the election forsignificant cuts in government spending; essentially, a more discretionary approach. His range ofoptions included severe limitations on public sector pay rises, scrapping defence projects such as thenuclear Trident submarines and banishing expensive projects such as the ID cards scheme. At thesame time, he would reduce tax payments by lower income earners and substantially increase taxeson high earners. Overall, tax revenue would likely rise. This combination of lower governmentspending and higher tax revenue would, argued Cable, cut the budget deficit much more quickly thanLabours suggested approach.

Both approaches should allow the budget deficit to be reduced; it is likely that the more discretionary

approach will reduce the deficit more quickly. Whether this is important or not depends on the abilityof the UK government to raise funds to finance that deficit whilst it continues. Or the AAA-rating of UKdebt is downgraded as a result of the poor state of the UKs finances. The automatic approach isentirely dependent on the UK achieving economic growth, whereas the discretionary approach ismore likely to reduce the UKs growth potential, at least in the shorter-term. In practice, a combinationof the two would probably be preferable.

Source: EconoMax, Ruth Tarrant, spring 2010

Blanchflower critical of the governments fiscal plans

Economist David Blanchflower has criticised George Osbornes contractionary fiscal policy at a timewhen economic growth in the UK is still anaemic, emphasising the collapse of multiplier effects from

government spending, but also the negative impact on employment, both in the public and privatesector, at a time when the private sector is still recovering slowly from the recession.

Whilst cutting spending and raising taxation in a recession is clearly against the Keynesian ethos,Blanchflower accuses the Conservatives of also only following ideology rather than common sense,at a time when the government is one of the few entities to still able to spend right now. He says this,and while there are reasons why the fiscal outlook for the UK is different to Greeces. Althoughgovernment debt is high (both in total and as a share of GDP), the yield on government bonds hasbeen falling (making it cheaper to borrow money) and there is little sign that the financial marketshave reached a tolerance threshold in terms of how much new government debt they are prepared tobuy.

Source: Tutor2u economics blog, July 2010


15/15

The Emergency Budget in the UK - July 2010

The new coalition government introduced an emergency budget in July 2010 designed to achieve aquicker than forecast reduction in the size of the UK's budget deficit. The Chancellors rule of thumbis that deficit reduction will need to be achieved based on the 80:20 rule, with 80 percent achievedthrough state spending cuts and 20 percent from tax rises.

The main elements of the budget were as follows:

1/ VATup from 17.5% to 20% from Jan 2011 - from which the Chancellor hopes to raise about 12billion annually.

2/ Capital Gains Taxto rise from 18% to 28% from 23 June 2010 - this was not as great an increaseas was anticipated by many speculators before the Budget. The rate for smaller businesses is less.

3/ Corporation tax-The UKs tax competitiveness for companies will improve with the phasedreduction in the main rate of corporation tax from 28 percent to 24 percent by one percent for each ofthe next four years. Small companies will also benefit from a reduction in their rate to 20 percent fromnext April.

4/ Tax credits- the Chancellor announced a number of reductions to tax credits and welfarebenefits. From April 2011, tax credit eligibility will be reduced for families with household incomeabove 40,000. The Government will make further changes in 2012-2013 with the aim of focusing taxcredits on lower income families. In addition, child benefit will be frozen for three years from April2011.

The new Chancellor George Osborne believes he will be able to eliminate the structural budgetdeficit (i.e. that part of the deficit unrelated to the stage of the economic cycle) by 2014/15, as heaimed for a fiscal consolidation of some 91 billion in coming years.

Fitch, one of the leading ratings agencies, seemed to welcome the Emergency Budget, stating that itshould materially strengthen confidence in the countrys public finances and its triple-A rating if the

government can deliver its planned measures. In a press release, the rating agency said the budgetsends a strong statement of intent by the new government that it will speed up deficit reduction andreduce the U.Ks debt burden.

Source: Tutor2u economics blog, author Mo Tanweer

Documents

Fiscal Policy - Taxation and Public Expenditure- A Level Economics