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Fiscal policy: Taxation, government spending and borrowing. Fiscal policy is the use of government spending and taxation and borrowing to influence the level and composition of aggregate demand The role of fiscal policy: 1. Automatic stabiliser Fiscal policy can act to automatically stabilise the economic cycle. When national income is increasing the amount of tax that people pay automatically increases, in addition government spending on unemployment benefit decreases, which should dampen the rise in national income. If the economy is heading towards a recession, tax revenues will fall and government spending on benefits will increase, thereby reducing the effect of the recession. 2. Discretionary fiscal policy Occurs when the Government decide to alter the level of government spending or taxation to influence the level or composition of aggregate demand. E.g. the government may decide to increase spending to prevent a recession or to increase taxation to reduce inflationary pressure. The budget Each year in the budget the chancellor sets out the governments fiscal policy plans for the forthcoming year. In the budget the chancellor explains how much revenue the government expect to receive from taxation and how this revenue will be spent. Taxation: In 2000 – 2001 the UK government raised about £377bn from taxation. The breakdown of this revenue is shown below. Income tax £96 bn National insurance £59 bn Excise duty £37 bn Corporation tax £34 bn Business rates £16 bn Council tax £55 bn Government spending: In the same year the UK government spent around £370bn as shown below. Social security £106 bn NHS £54 bn Education £46 bn Defence £23 bn Transport £9 bn Debt interest £28 bn Law and order £20 bn Housing £14 bn Industry £15 bn Other £59 bn We can see from these figures that the government spent less than it gained from tax revenue. When government revenue exceeds government spending it is known as a Budget surplus. When spending exceeds revenue it is known as a Budget deficit. The public sector net cash requirement. (PSNCR). The PSNCR (formerly known as the PSBR) is the amount of money the governments needs to borrow each year. It is defined as “borrowing by central government, local government and public corporations”. If the government have a budget surplus, the figure for the PSNCR will be negative. The national debt: When the government have a budget surplus this allows them to pay of part of its accumulated debt. This debt known as the “national debt” is the total amount of borrowing undertaken in previous years (and by previous governments), which have not yet been paid back. The reason the national debt is so large is that governments find it politically easy to borrow to finance expenditure during a recession, but much more difficult to increase taxation to repay the borrowing when the economy is booming. The conservative government borrowed heavily in the early 1990’s and ended up with a very large national debt. In recent years the Labour government have been able to run large budget surpluses. This has allowed them to pay back some of the national debt and therefore reduce the cost of servicing this debt (interest payments). Since September 11th the UK economy has grown much slower than was predicted by the treasury. This has led to a reduction in tax revenues (receipts from corporation tax have decreased as company profits have fallen and income tax receipts have fallen as incomes and employment have fallen). At the same time the total government spending has increased, (as the government have pumped money into the health service and social security payments have increased with the increase in unemployment). This combination of lower tax receipts and higher spending has led to a budget deficit of between £15bn - £17bn. The chart below shows how much tax revenue the government expects to collect in 2002-2003. The treasury predicted that in 2002-2003 the UK would raise £408bn from the various taxes listed above. At the same time they expected to spend £418 the breakdown of which is shown below. When these figures were calculated the treasury was predicting a budget deficit of £10bn, however the deficit has turned out to be much larger sine the economy has not grown as quickly as the chancellor had predicted. Funding a budget deficit If the government do not receive enough tax revenue to finance their spending plans then they must borrow. The government can borrow money from two sources (assuming they do not wish to borrow from foreigners). 1. Borrowing from the non-bank sector. If the government wish to borrow from the non-bank sector, i.e. the general public, they will issue bonds and treasury bills for sale. In order to encourage people to purchase these gilts and bills, the government will have to offer a higher rate of interest. However this will force up market interest rates and will lead to “crowding out”. Crowding out occurs when government spending leads to higher interest rates which reduce private sector investment. Therefore financing government spending in this way might lead to little or no real increase in aggregate demand. 2. Borrowing from the banking sector. The second option is to sell debt to the banking sector. However if the government sells debt to the banking sector it is essentially printing money. If the government sells £100 worth of bill to the banking sector and spends that money on civil service wages. The £100 will find its way back into the banking system, since the wages will be paid into the banks. Therefore the government will have virtually printed an extra £100. When the debt was financed by the non-bank sector, individuals had to take money from their banks to buy the government bills. Therefore when the government spending found it way back into the banks the “new deposits” only replaced or cancelled out the original withdrawals. Therefore no extra money was created. Financing government spending by borrowing from the banking sector increases the money supply and can therefore cause inflation. Alternative sources of government finance: Taxation and borrowing are not the only methods governments can use to raise money. The government can also raise money in various other ways: 1. The sale of public assets. The conservative government raised huge sums of money through the privatisation of a range of public enterprises (BT, British gas, British Rail etc). 2. The sale of goods and services. The labour government raised billions of pounds through selling licences to mobile phone companies to use 3G phones. 3. Fines Many government departments raise finance through the imposition of fines, e.g. the police and the competition commission. What are the limitations of using fiscal policy to manage the economy? 1. Predicting the effect on AD It is difficult to predict the effect of a change in taxation or government spending on AD, e.g. decreasing income tax will increase disposable income, but some of this money may be saved which will therefore reduce the impact on AD. 2.Time lags Fiscal policy takes a long time to implement (normally occurs once a year) and a long time to take effect after it is implemented, e.g. the NHS was unable to spend all of the extra funding it received in 2001. 3.Side effects Fiscal policy has many side effects. E.g. Increasing taxation to reduce AD will reduce the incentive to work. Increasing corporation tax will reduce foreign investment. Increasing VAT will increase inflation.
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