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CH13: fiscal policies, Impact of taxation: the person, company or…
CH13: fiscal policies
fiscal policy is the discretionary management
- government spending and / or
- taxation
designed to influence the level of AD and hence economic activity
public finance rfers to the ways in which the govt colleges revenue for its expenditure, the ways in which the govt allocates the revenue collected among different items of govt expenditure
Tax
- main source of revenue for most economies
- change in tax can cause change in spending, saving, investment and growth in long run
Purpose of taxation
economic purpose
- fiscal tool for stabilization or for economic growth
- change pattern of demand through indeirect tax and hence resources allocation
- protect domestic industries through the imposition of tariff - influence BOP
- direct trade away from one source and guide it into desired channels through preferential tariffs
social purpose
- reduce inequality in income and wealth distribution e.g. progressive income taxes — which is the used to subsidy education, healthcare etc. — benefit poor more than rich
- to check on the consumption of commodities regarded as socially undesirable e.g. cigarette and alcohol
revenue purpose
- finance the provision fo goods and services which are not efficiently provided by the market e.g. healthcare, education, roads and defence
types of taxation
Direct tax
- taxed on income and wealth (does not pass on to others)
e.g. income tax, property tax, inheritance tax
Merits
- equitable (e.g. progressive tax)
- economical (easily traced, payments are more direct, cost of collection is low)
- stabilization tool (e.g. income raise due to inflation, tax also increase so purchasing power decrease)
demerits
- unpopular (burden lead to discontent)
- difficult of assessment and possibility of evasion (arises when accounting system is inefficient)
- disincentive to word or invest (if higher income will also lead to higher tax, workers may prefer leisure compare to work )
indiect tax
- taxes on expenditure o production of goods and services (can be transfer to consumer who eventually bears part of the burden of the tax)
e.g. general expenditure tax (VAT - value-added tax, GST - goods and services tax )
merits
- convenience (collecting )
- difficult to evade (is included as part of the process f community and thus the consumer will find it almost impossible to avoid or evade )
- adjustable to specific govt policies (indirect tax can be used to reduce the consumption of demerit goods )
- broaden tax bases (reduce reliance on direct tax )
demerits
- inequitable (both the rich and the poor pay the same )
- difficult to determine the real tax burden
- depends on the elasticity of demand (only effective when the demand is inelastic )
- inflationary tendency (increase price of products hence inflation)
Economic effect of tax
(a) production
(i) labor supply
- high income tax will encourage absenteeism and discharge overtime work - reduce supply of labor
- income effect: raising tax reduce disposable income, ppl will hence work more to earn more to maintain their consumption level
- substitution effect: raising tax, one hour work buys less goods and services than before, but it still involved the sacrifice of an hour of leisure. — the raising tax reduce the opportunity cost of leisure - discrouage ppl to work
low-income: income effect
High-income: substitution effect
enterprise
- profit is considered as reward of taking risks
- higher tax - taking away the reward, does not compensate the producer for any possible losses incurred
- incentive to production
(b) resource allocation
- influence supply of various products
- change people’s occupation choice by progressive income tax
- change choice of goods and services by imposing various taxes on various goods and services hence influence the supply and price, hence allocation of resources
(c) saving
- heavy progressive tax, reduce the willingness and abilit to save
(d) investment
- corporate tax cut is likely to increase post-tax profitability and enclave investment
- however, tax cut lead to govt deficit, result in government borrowing, cause i/r to increase (crowing-to effect) and hence discourage investment
(e) inflation
- increase general price of goods and services
- cost of living increase
- trade union demnd wage increase
- inflation (wage-push)
- on the other hand, tax reduce disposable income and hence spending decrease, AD decrease, price level decrease
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Effect of budget surplus / deficit
- surplus occurs when government expenditure is less than government revenue
- deficit occu when government expenditure is less than the government revenue
internal goals
(a) effect on economic growth
- tax increase, fall in disposable income, hence C decreases
- together with fall in government expenditure (G), AD decreases
- fall in national income by multiplier effect
(b) effect on unemployment
- national income falls, firms will demand less factor of production and hence cyclical unemployment
(c) effect on inflation
- fall in AD, fall in general price level
- reduce demand-pull inflation
- also, increase competitiveness of the exports due to lower price, incraese exports demand and hence revenue, increase X. This may be able to mitigate the fall in G and C.
External goals
(a) effect on balance of payment
- budget surplus will go into an economy’s reserves
- can be used to manage external volatility
- can be invested to gain sustainable return
- the surplus that is invested overseas (capital outflow) is recorded as a credit on the capital and financial account
(b) effect on exchange rate
- with capital outflow, there is an increaes in supply of a domestic economy currency in the foreign exchange market
- lead to depeciation
- export hence being cheaper and more competitive, increase the demand for X and hence the revenue from X. Price of M become more expensive and demand of M decrease and expenditure decrease assuming its demand is price elastic.
- (X-M) increase, BOT improves and hence BOP
Non-discretionary fiscal tools / automatic stabilizer
- their difference with discretionary fiscal policies:
- can only moderate the fluctuations but will not eliminate fluctuation entirely and therefore cannot be completely relied on.
- while discretionary fiscal policy is able to deal with deep recession and mass unemployment
- in these circumstances, the automatic stabilizers will act as a drag to the fiscal policies instead
(i) progressive taxation
- as an economy expands, tax payments increase faster than the increase in income, as tax payers are pushed into higher bracket when their income increases.
- the extra withdrawal exerts a contractionary impact on the economy, economic expansion therefore slow downs and reducing the pressure on general prices
- in times of recession, tax receipts fall sharply, as income falls, tax payments fall faster than the fall in national income, fall in consumption slow down and AD is checked
(ii) unemployment compensation
- as unemployment rises, there will automatically be more unemployment benefits paid out, this will offset the loss of eared income and therefore the fall in AD slows down
(Disposable income is maintained, AD won’t fall too much)
- also, when unemployment rate is low, less compensation will be paid to and the rate of inflation is slowed down
(iii) Family assistance program
- tied to income level and therefore automatically stabilize the demand.
- provision help to slow down fall in C and hence AD and hence output
Fiscal policies
Expansionary
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reducing taxation
- reduce taxation
- eliminate certain taxation
- reduce personal income tax, increase in disposable income. C increase
- stimulate investment as the profitability increase as taxation decreases
- AD increase due to C and I increase
- worsening the budget deficit
- depends on whether the country has reserves accumulated form previous years
- crowding out effect if the gov starts to borrow
Contractionary
- can be
- debt reduction with surplus: part of the tax revenue is r transfer back to the domestic money market, rate of interest fall and C and I are stimulated
- impounding: to let the surplus idle, it is not re-rejected into the economy (more contractionary )
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increasing taxation
- effectively discourage investment as tax increases
- decrease I hence AD
- Singapore open to trade and open, so it has to maintain a competitive tax regime to attract foreign investment
Limitations
Problem of magnitude
(a) crowding out effect
- gov want to increase expenditure or reduce tax, hence finance this by borrowing from individuals or firms, competing with private sectors hence will cause i/r to increase
- discouraging firms form investing, limiting the intended effect of the increase in gov expenditure
(b) size of multiplier
- if high leakage, the multiplier effect on national income will be relatively smaller
(c) forecast error
- it may be difficult to predict
- whether private investment will be crowded out
- whether C will fall as G increases
- how much ppl will actually cut down C when tax rise (depends on if they think the tax rise is temporary or is permanent)
- the size of k (MPC may change due to household expectation about future pice and income changes)
- the extent so which induced investment will increase depends on the extent which a fiscal stimulus may restore business confidence
- the extent to which real national income wil be affect in real world. Complexity of multiple interactions - very difficult to estimate.
problem of timing
(a) time lags
- e.g. when expansionary policies are used to solve the problem of recession, but it may only be implemented when recession already recovered and is experiencing a boom, thereby worsening the problem of overheating
- recognition lag - time lag before the problem is recognized and diagnosed
- admistrative lag - time between recognition of the need for ducal policy ad the taking of action (planning, designing, signing of contract, implementation …)
- operational lag - time between action and impact of an action on national output, employment and general price level. E.g. change in tax will only affect tax payment at the end of financial year. multiplier takes time.
(b) inflexibility
- once projects, especially major infrastructure project, are underway, it’s hard to stop without wasting resources
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In case of Singapore
- use in time of recession
- high import leakage and high savings rate - low multiplier effect, the increaes of national income is limited.
- small and open. Lack of natural resources, foreign investment and manpower-dependent. This limits its abilit to raise tax
hence: prudent fiscal policy
- under normal economic circumstances, sg will build up the government reserves
- hence avoid debt, ensure the gov has adequate reserves to ride out any economic crisis.
- Impact of taxation: the person, company or transaction on which tax is levied
- incidence of taxation: the eventual distribution of the burden of the tax
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