Fiscal Policy: Smoothing The Cycle

Fiscal Policy is government spending and taxation to do what it needs to do. Redistributing income aswell as correcting market failures. Since John Maynard Keynes added to economics, it is now used to smooth out the economic cycle.

A great example has been the recent recession, which saw £billions injected into getting people to buy cars and bailing out Northern Rock.

Taxes and Types

Direct Tax comes straight from the reward from supplying factors of production. Profit, Incomes, Rent and Capital Gains

Indirect Tax is a tax on the buying of consumer and capital goods. Includes VAT, Excise Duties and Tariffs.

Hypothecated Tax is an indirect tax which attempts to change consumer behaviors for it’s policies, usually green, with the revenues directed to following that policy e.g public transport.

Hypothecation aims to cut emissions following the Kyoto Protocol

Adam Smith’s Principles of A Good Tax

The first economist to be denoted on a UK banknote suggested that the best way to implement a tax is if it’s.

  1. Economical: Not costly to administer, little paperwork.
  2. Equitable: Vertical and horizontal equity. Burdens equally on social groups and levels of income.
  3. Convenient: Easy to follow and pay.
  4. Certain: Consistent and difficult to evade.

How Can It Smooth Out the Cycle??

It does this by smoothing out the level of aggregate demand, namely the amount of consumption and investment in the economy. When we have a downturn, expansionary fiscal policy means more spending then tax. When we have a boom, contractionary fiscal policy keeps taxation above spending. Simplified model of budget and growth is below.

Automatic Stabilisers

These are tax and spending measures which smooth out aggregate demand without the government having to change anything.

A progressive taxation and benefit system is the best thought. A boom will be kept in check by more people earning higher incomes having to pay a higher % tax, and benefit payments being removed from the economy. A recession would see a vice versa scenario.

Discretionary Stabilisers

This is where the government has to step in by changing some of it’s spending/tax plans in an attempt to smooth out demand.

Examples in the 2008-10 recession, the US and UK governments used a variety of measures. Including bailing out Freddie Mac and Fannie Mae, UK reducing VAT from 17.5% to 15%, subsidising the car industry ‘cash for clunkers’ programme. Nationalising private enterprises.

Crowding Out: ‘Problems of Big Government’

Free market economists criticise too much intervention by the government in markets, such as nationalised firms. One of their main arguments is heavy production in the public sector crowds out private enterprise.

Think of it as suffocation of free markets, for a variety of reasons…

Rescource Crowding Out

If the government is to build more schools or nationalise industries, then they employ factors of production in doing so. In an economy with opportunity cost of output, this leaves less factors for the private sector in all cases maybe except enterprise.

Scarcer labour and capital increases costs of production, creating lower potential profit for private enterprise. The private sector is suffocated as it now has less land, labour and capital to employ.

Financial Crowding Out

The are a few ways this can happen. An expanding government in markets depresses enterprise by….

Rate of Interest If the government has a large, sunk investment it may need to borrow to finance it, mainly by issuing bonds. To get people to buy bonds, their yield rates of interest rise, which means that the government seems more attractive than banks to save.

To compete, banks may rise their rates of interest, depressing consumption and investment for the private sector.

Less Favourable Fiscal Policy may result. If the government incurs costs by entering markets than, if it does not borrow, it must either sacrifice government spending or put a greater tax strain on the private sector.

Government Budget

Obviously there are limits to the amount of spending the government can do in a recession, and it nearly reached that limit recently. Just as with a household, spending more than it recieves means it had to borrow.

Public Sector Net Cash Requirement: The amount the government has to borrow annually.

 We can see over time that the government was recently only in surplus 2000-01. Mostly, it had a budget deficit and accumulated debt.

The Reasons for A Budget Deficit

Structural Budget Deficit..

This is where spending is greater than revenues for reasons other than automatic and discretionary stabilisers. Stays the same irrespective of how the economy is growing, even if the economy is doing well, this may pull down the finances.

Reasons: Government subsidies and supply side policies may cause an excess of spending. For instance providing public and merit goods, or funding competition authorities.

Cyclical Budget Deficit…

‘Deficits due to the governments aim to smooth out the cycle’

In this part, the excess of spending over revenues is solely due to economic growth. In a recession, the deficit gets larger and in a boom gets smaller, the difference being the component of this deficit. If the deficit totally erodes in good times, it was a wholly cyclical deficit.

Reasons: Automatic and discretionary stabilisers means a deficit will be enlarged during a downturn and eroded, even incurring a surplus during a boom. In a downturn, less tax revenues due to lower activity and nationalisation/benefit rises means the government may have to borrow.

Budget Deficit: The annual borrowing needed to finance spending over revenues

Government Debt: The sum of all past unpaid deficits.

Notable Fiscal Policies of Recent

Prior to the recent recession, the UK and EU followed some ‘rules’ as to the nature of the budget which the government pledged to follow.

The Sustainable Investment Rule was a UK policy 1997-2007 which the total UK government debt shall not exceed 40% of GDP ‘a stable and prudent level’

The Golden Rule was that any public sector borrowing shall be for the purpose of long term supply side policies to benefit generations to come, rather than current consumption e.g funding regulatory bodies.

The Stability and Growth Pact was an EU agreement that it’s members shall not run a budget deficit of more than 3% of GDP.

Notice the ‘was’ in all of these 😉

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One Response to Fiscal Policy: Smoothing The Cycle

  1. Pingback: Thinktank « Zahablog's Economic Page

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