Fiscal policy: by bT2ekd


									      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.

             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
When government revenue exceeds government spending it is known as a Budget
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
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

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

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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