CH9: Fiscal Tools

It is the discretionary management of govt. spending and/or taxation designed to influence level of AD and hence economic activity

TAXATION

Purpose

Types

Revenue

Economic

Social

To finance the provision of goods and services which are not efficiently provided by the market. E.g education, healthcare

Reduce inflation / for economic growth

Protect domestic industries through tariffs

Change pattern of dd through indirect tax and therefore rss allocation (curbing ext. for optimal rss allocation

Reduce income inequality through progressive income taxes (tax brackets) where the rich pay a greater proportion of their incomes in taxes than the poor

To check on consumption of commodities regarded socially undesirable e.g cigarettes and alcohol

Direct

Indirect

Taxes on income and wealth

Taxes on expenditure or production of goods and services

Economic effects

Labour supply

Enterprise

Rss allocation

Savings

Investments

Inflation

Income effect

Substitution effect

Raising tax reduce disposable income, people have to work more in order to maintain their consumption of goods and services. They reduce their leisure time and work longer hrs. Encouraging people to work more

Raising tax reduce disposable income, thus an hour taken in leisure from work now involves a smaller sacrifice in consumption. This causes people to substitute leisure for work. Encouraging people to work less

Disincentives firms to invest due to higher taxes as the profits obtained from taking the same risks are reduced

High progressive income tax may deter entry to lucrative professions. May affect other FOPs, or supply of final goods and services

Heavy progressive direct taxes may reduce willingness and ability to save. This can reduce funds available for investments

A corporate tax cut may lead to firms incentivised to invest as after-tax profitability increased and expected ROR increase.
Tax cuts may lead to govt. deficit, which could leda to govt borrowing from banks to finance other expenditures, leading to a higher interest rate and in turn reduce investment (crowding-out effect)

Tax increment can lead to a decrease in inflation as disposable income decreases, C decreases, AD decreases. OR I decrease, AD decrease. Firms need not bid up prices of FOP in light of excess capacity. GPL falls when AD falls

Govt. Expenditure

Types

Economic effects

Effects of a budget surplus / deficit

Current / Operating Expenditure

Development Expenditure

Incurred on a daily basis E.g wage cost of civil servants and expenses on social services (education, health and social welfare)

Purpose of economic and social dev. E.g. Expenditure on building of expressways, schools, flood alleviation schemes

Rss allocation

Potential economic growth

Economic stability

Income and wealth distribution

Through grants and subsidies to affect pattern of production

Expenditure on health, educational services, social welfare and old age pensions. Works tgt with progressive tax system. Reduces income inequality

Expenditure on infrastructure, such as buildings and skills training of workers improve productive capacity and increases the LRAS. Leads to potential economic growth.

govt. expenditure increases G, thus increasing AD and thus increases level of employment, output via multiplier effect.


During inflation G is decreased to decrease AD to lead to a decrease in GPL to lessen effect of inflation

Internal Goals

Budget surplus occurs when the
govt. spending < govt. revenue


Budget deficit occurs when
govt. spending > govt revenue


govt. rev refers to tax revenue

External goals

Effects on ec. growth

Effects on UNNT

Effects on inflation

Effects on BOT

Effects on Exchange rate

When tax increase, e.g income tax, C decreases. Together with a fall in G, AD decreases and leads to a more than proportionate decrease in RNY due to reverse multiplier effect

AD falls, RNY falls UNNT increases

AD falls GPL falls. Reduces demand-pull inflation. This increases the qty dd of X, assuming PEDx >1, TRx increases which can mitigate fall in G and C, cp

Given a budget surplus, this will go into the economy's reserves which can be used to manage external volatility and deal with unexpected economic recession.

With capital outflow, there is an increase in supply of domestic country's currency in FOREX and leads to a depreciation of exchange rate. Leads to X being cheaper in foreign currency, thus qty dd for exports increase. M is more expensive and thus qty dd for imports decrease. (X-M) increases assuming Marshall-Lerner condition holds |PEDx+PEDm|>1

Non-discretionary fiscal tools (aka Automatic stabilisers)

Stimulate AD when recession &
Reduces AD when there is inflation

UNNT compensation

Family Assistance Programme

Progressive Tax system

As economy expands, tax payments increase faster than increase in income. This extra withdrawal exerts a contractionary impact on the economy and thus economic growth slows down to reduce pressure on GPL.


Conversely, in depression, tax receipts fall sharply, as income falls, tax payments fall faster than the fall in RNY. Fall in consumption slows down and fall in AD is not as extensive.

Offset the loss in income and thus fall in AD due to fall in C slows

More provision to families arising from hard times to reduce fall in C and thus a fall in AD.