Fiscal Policy

Key Terms
Fiscal policy: The manipulation of public spending, taxation and borrowing to achieve the government’s macroeconomic objectives.

The budget: The government’s annual announcement of changes to its planned levels of spending and taxation.

Hypothecation: When taxes are earmarked for a specific purpose.

Public Sector Net Cash Requirement (PSNCR): The amount the government needs to borrow each year.
Theory

Background on Fiscal Policy



Aims of government spending and taxation


1) Redistribution of income.

2) Allocation of resources (public and merit goods such as hospitals).

3) Macro-economic management.


Adam Smith's Four Canons of Taxation


Adam Smith suggested that a good tax is one that is:

  • Equitable - A tax system should be fair

  • Economical - Cheap to collect

  • Convenient - The means and timing of the payment should be suitable for the payer

  • Certain - Amount should be clear to the payer


    • Modern economists also add two more "Canons":

  • Efficient - Tax should achieve it's desired objective with minimal unintended consequences

  • Flexible - Easily changed to meet new circumstances


    • Types Of Fiscal Policy

    1) Automatic fiscal stabilisers

    There is no deliberate change to policy, the amount of money the government spends and receives will fluctuates automatically with the economic cycle e.g. in a recession a budget deficit will occur automatically.

    Higher unemployment stimulates benefit expenditure and tax revenues fall due to low consumer spending.


    2) Discretionary fiscal policy

    This refers to the deliberate manipulation of government expenditure and tax.E.g. in a recession the government may choose to spend more money or cut tax to stimulate the economy. Discretionary policy can be broken down into expansionary and contractionary fiscal policy.


    Expansionary (or loose) Fiscal Policy

    Increase in government spending (G) and / or cut in tax (T). Cuts in tax, increases consumer spending as people have more disposable income. This provides net injections into the circular flow.


    Contractionary (tight) Fiscal Policy

    Government will cut spending or increase tax resulting in a leakage from the circular flow as consumers have less disposable to spend.


    Crowding Out

    Crowding out, a term used mostly by fiscal conservatives, suggests that fiscal policy is ineffective in stimulating aggregate demand, as it reduces the size of the private sector.

    There are two type of crowding out:


    1) Resource crowding out

    It is impossible to allocate resources simultaneously in the public and private sector. Therefore resources employed in the public sector due to government spending, reduces the resources available to the private sector.


    2) Financial crowding out

    If the government increase spending, the resulting budget deficit of the spending will be financed with the sale of new gilt-edged securities (gilts). To encourage big financial institution such as insurance companies to buy the government debt, the annual interest rate of the gilt must increase.

    The rise in interest rates reduces private sector investment, as it becomes increasingly expensive for firms to borrow and to raise capital.


    Crowding In

    The basic idea of crowding in is that, when there is spare capacity in the economy, an increase in public spending does not neccesarily reduce the size of the private sector, in some cases it may increase the size of the private sector.

    For example if there is a sizable amount of unemployment in the economy, an increase in government spending to reate jobs does not reduce resources available to the private sector.

    If the government decides to spend on building a new motorway the private sector may be 'crowded in' as private construction firms are contracted to do the work.
    Advantages Of Fiscal Policy
    1) Impact on AD

    Public spending can have a considerable impact on the level of AD. It can even compensate for fallings in other components of AD such as household spending.


    2) Flexibility

    Public spending and taxation can be targeted over a wide range of areas. This is known as hypothecation, where taxation can be earmarked for a specific purpose. E.g. If the government want to increase employment among the student population they could increase tax free allowed for a specific age range.


    3) Supply-side Effects

    Fiscal policy can have supply-side effect, government action of this kind is known as supply-side fiscal policy. For example lower income tax can attract more worker to the market thus increasing the labour supply and therefore potential growth.
    Disadvantages Of Fiscal Policy
    1) Time lags

    Government plans to increase spending can take a long time to filter into the economy. It takes time to recognise that AD is growing too quickly or slowly. The budget is also set only once a year.

    It then takes time for the policy to work e.g. It takes time for households to realise that they can take advantage of government spending schemes


    2) Crowding Out

    Public sector spending arguably crowds-out the private sector, resulting in a limit to growth and less efficient use of resources. This point can be contested by the crowding-in argument but the answer ultimately depends on how much spare capacity exists in the economy.


    3) Fiscal Policy limited by E.U.

    A major constraint to government spending across the EU is a country's membership of the Stability and Growth Pact. This pact limits government borrowing to no more than 3% of national income in any one year.


    4) Inadequate Information (Government Failure)

    Economic data is regularly revised months or years after its initial release. The government therefore lacks perfect information about the size of the output gap and the size of the multiplier effect. If the government believes there is going to be a recession they will increase AD.

    However if the forecast is wrong or the multiplier effect was greater than expected and the economy grew too fast, government action would cause inflation.
    Fiscal Policy Committee

    What is a Fiscal Policy Committee?


    A Fiscal Policy Committee is a body independent of the government responsible for the control of fiscal policy. In the U.k fiscal policy is currently controlled by the government, however, many economists are now calling for a fiscal policy committee much like the monetary policy committee.


    Advantages of a Fiscal Policy Committee

    1) Decreases the role of politics in fiscal policy decisions Under the current fiscal policy the government (in the run up to an election) often undertakes expansionary fiscal measures to boost electoral support.

    E.g. Existing government may lower the rate of VAT in the run up to election. This gains short-term votes.

    The effect of political short-termism depends on where the economy is in the economic cycle, If there is a positive output gap, additional expansionary fiscal policy may cause pure inflation.

    However just because government undertake expansionary fiscal policy does not mean negative consequences will neccesarily occur. Consumers may pre-empt a future rise in tax after an election and therefore not take the bait.


    2) Increased Confidence

    If FPC’s role is effective this will improve confidence both in business and for consumers. Much like the reassurance brought by the MPC in the early 2000’s. By detaching the economic cycle from the political cycle there is less fluctuation.

    This will allow business to more effectively plan production and costs. Confidence in the future stability in the economy will allow firms to under take investment.


    Disadvantages of a Fiscal Policy Committee

    1) Members are not elected

    Members of FPC (assuming it takes the same structure as the MPC) would not be accountable to the public. Therefore decision may not be representative of the various groups in society.

    However the FPC may be seen as more representative as there will be various people deciding fiscal policy not just the chancellor.


    2) Conflict of Economic ideologies

    Conflict either internally within the FPC or externally with the government may arise in an independent body. If stalemate is so severe the FPC may be immobilised.

    However in recent years the view of many economists have changed. Away from the Cold War era of highly conflicting ideologies where views were entrenched and each side were blind to the others way of thinking, towards an empirical era where theories and policies are decided through analysis of data.


    Evaluation

    The effectiveness of setting up a FPC depends on how much power it is given. Influence could range from advisory body to operational independence.

    One example of an FPC is the OBR (Office for Budget Responsibility).

    The OBR in an independent body that produces statistics for the budget report. The OBR scrutinise fiscal policy and even disagree with the government on occasions E.g OBR forecast growth rate to fall in 2018 from 2.7% to 2.5%.









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