How does Fiscal Policy influence economic activity?

Hello readers, welcome back to my blog.

You may remember me discussing in one of my posts a few weeks ago, a number of fiscal facts as well as analysing a few of the policies introduced in the recent budget. In today’s post, I thought I would take fiscal policy further and explore how it actually influences economic activity. This post will be quite technical in terms of the economics jargon used; however, it should still be interesting and especially relevant if you are studying A-level Economics.

Fiscal policy is one of the instruments that governments have as part of their economic toolbox to ‘fix’ or manipulate the economy and create the optimal conditions that allow the ultimate macroeconomic objective of improved economic welfare to be achieved. It involves the use of government spending and tax policies (direct or indirect) to influence the level of economic activity. It is often described as being ‘all encompassing’ in the sense that it targets a number of different avenues of the economy; from boosting aggregate demand and economic growth, altering employment and inflation to redistributing income or providing merit goods, which otherwise if left to free market forces alone, would be consumed below the social optimum, thus having negative spillover effects. How such policies are used and implemented is completely dependent on the state of the economy and the objectives that the government is prioritizing. In times of a recession when consumer confidence, consumption, animal spirits and net investment are low then an expansionary policy may be used to stimulate aggregate demand which will result in an increase in GDP in the short run. If governments are looking for non-inflationary or even dis-inflationary growth then they may implement long run supply side fiscal policies, which increase the productive potential of the economy, resulting in an outward shift of the PPF curve or the LRAS curve, thus targeting the supply side of the economy as opposed to the demand side. On the flipside, contractionary fiscal policy may be employed when the economy is ‘overheating’ and needs to be ‘reigned in’. This would involve raising taxation such as income tax and/or reducing government spending perhaps by employing an austerity package.

Fiscal policy is the sister strategy to monetary policy through which a central bank alters a nation’s money supply with the primary aim of promoting price stability. Although there is no ‘one size fits all policy’ in economics the type of policy implemented often depends on the current state of the economic climate and it is vital that governments ensure that the two work in line with each other as this could prevent them meeting their objectives, or worse, lead to government failure. For example, in 2010 the coalition government enforced austerity at a time when expansionary monetary policy was being pursued, thus contradicting the efforts and aims of monetary policy. Perhaps Keynes’ idea that ‘governments should spend their way out of a recession’, would have been a better approach. Furthermore, fiscal policy may be useful when central banks ‘run out of road’; in other words when interest rates are at the ‘zero lower bound’ and no longer work to influence the economy in terms of aggregate demand. Moreover, due to the dynamic and volatile nature of the economy and external influences/shocks such as Brexit and the financial crash of 2008/09, the effectiveness of fiscal policy in altering the level of economic activity in the UK may be reduced. It is also important for governments not to be myopic, in the sense that they should strike a balance between the amount they borrow and the level of debt they are creating for future generations. This is because financing the national debt carries an opportunity cost; of around £50bn (larger than the UK’s defense budget) meaning that other areas of the economy such as the NHS or education budgets are likely to suffer. It also means that at some point in the future, tax rates will have to increase to repay the debt. On the contrary they should consider the long-term prosperity that can arise from investing in a healthcare system for all as well as education free at the point of consumption, allowing the poorest to benefit most from such policies and ultimately increasing economic growth. Since debt is measured against the size of the economy, if economic growth were to substantially increase, the size of the debt would essentially be ‘eroded’ as it is expressed as ratio of debt to GDP.

Over the past decade in the UK, there have been different approaches, largely determined by the political power in party. Although these have been carried out with varying degrees of success, it is clear that governments should set realistic dates for when the budget deficit, currently around £48bn (2.5% of GDP) will be “balanced” and national debt which stands at £1.9 trillion (86% of GDP) can start to be repaid. From Osborne who said we would be running a surplus by the end of 2015 to Mrs May who is to committed to wipe out the UK deficit by the middle of the next decade, supposedly allowing for greater borrowing levels to support the economy in the run-up to Brexit; it is hard to see how the economy will pan out, especially if the UK’s borrowing is predicted to spike over the next two years as the UK attempts to exist the EU. It is also faced with a hefty exit bill and concerns of whether Mrs May will stay in power for much longer are dampening confidence within the UK economy in terms of the already low exchange rate against major currencies.

It is hard to disagree with the fact that the great recession offset and disturbed the economy so violently, that it has led to a rapid rise in levels of government borrowing to finance the deficit which hit £160bn at its peak. The effect of the recession is therefore still felt today indirectly; nevertheless the recession cannot be reversed and governments must look to use fiscal policy effectively in current times.

Let us first analyse the taxation aspect of fiscal policy in altering economic activity in the UK. The primary objective of taxation is to collect revenue to and redistribute income from richer members in society to more vulnerable individuals as well as to provide public goods and other infrastructure. In terms of direct taxes, we could look at the Laffer curve argument, which states that a fall in the higher rate of tax may actually increase tax revenue by increasing work incentives and reducing the black economy. Tax avoidance is a topical issue with the recent exposure of the paradise papers, but has been an underlying problem for years with Apple’s ‘Sweetheart deal’ to companies such as Vodafone, Google and Amazon battling various disputes. Despite the fact that it is legal, it is frowned upon by many people and presents more of a moral issue rather than an economic one.

Different approaches to direct taxes have been tried for example Osborne reduced the higher rate of tax from 50% to 45% with the aim of giving people more disposable income. Corporation tax is also a direct tax and works in a similar way. Hammond recently announced that corporation tax in the UK is set to fall to 17% by the turn of the decade, with the aim of firms using the saving in tax to finance investment projects, which should help to boost the UK’s ‘sluggish’ productivity. Cuts may also be made on the other end of the spectrum to aid poorer households who generally have a higher marginal propensity to consumer meaning any extra income will be spent on consumption. In the recent budget it was announced that the tax-free allowance which primarily benefits low-income earner, will be increased from £11,500-£11,850 although this is only just in line with inflation.

Screen Shot 2017-12-11 at 13.21.29

The diagram shows that the optimal tax rate is at T*, whereby tax revenues are at their greatest. That said, it is difficult to know exactly where this point may be and in reality governments will not know if they are below or above their optimal rate.

As well as altering the economy as a whole, fiscal policy can also influence people’s behaviors i.e. though indirect taxes/Pigouvian taxes. Although a microeconomics issue, this can have ramifications for the economy as a whole. For example ‘sin taxes’ on sugar, alcohol and cigarettes can deter people from using such goods, whilst raising revenue, which can be ring-fenced to spend on the issues, created by such activities. That said, the demand for such goods is inelastic and thus it may not lead to a socially optimal solution. VAT is another indirect tax that can be manipulated. One example was the VAT holiday implemented after the great recession. The intention was to restore consumer confidence and bring about stronger growth by altering the consumption part of AD (around 65% of AD). It was the first cut in VAT for 34 years; however, it was ‘slow to get going’. It was not until it was announced that the change would be reversed did consumers start to purchase big-ticket items and white goods. Furthermore such VAT changes may not have been passed onto consumers and it largely depends on the Price Elasticity of Demand. Such a change is likely to be a part of a number of expansionary policies deigned to kickstart the economy and would not work in isolation. It is important to consider that ‘Freemarketeers’ would not support such changes and they would argue that the allowing markets to operate freely with limited government intervention would enable the price mechanism to allocate scarce resources amongst competing users.

Changing taxation also has an asymmetric effect; that is, firms/consumers will experience different impacts. It also depends on the type of tax being changed and the behaviour of firms. Reducing corporation tax may just lead to increased profits for companies and no change in the level of their investment. Alternatively in Ireland (a “tax haven”) it may lead to the influx of FDI from companies such as Apple and the creation of ‘Enterprise Zones’, which may boost employment as firms look to expand and produce higher levels of output, thus enhancing growth leading to regional multiplier and accelerator effects.

We must also assess some of the issues with taxation. Firstly as stated in Adam Smith’s canon’s of taxation if taxes are complicated it can increase administrative costs thus impinging on the revenue earned by the tax itself. Secondly ‘too high’ levels of tax could lead to a ‘brain drain’ whereby professionals e.g. doctors move to other countries such as Australia or Canada where tax rates at the upper end are lower. Thirdly, asymmetric information may lead to the government forecasting wrong, and ultimately implementing the wrong policy. In addition, certain taxes e.g. ‘sin taxes’ may be termed regressive, whereby poorer households are hardest hit. Fiscal drag may also occur whereby during times of inflation, when wages are increasing, the income tax allowances may not increase in line with the growth in average earnings. As a result people are ‘dragged’ into a higher tax bracket and the government receives more revenue-thus a boon for the government but a negative impact for consumers. Furthermore the tax system used, can play a role in determining the pattern of economic activity. Currently the UK has a progressive tax system; although, others argue a flat rate tax employed in countries such as Romania or Jamaica are more ‘equitable’ and less money would be ‘wasted’ on clamping down on tax avoidance.

Government spending is the other main branch of fiscal policy and involves boosting the ‘G’ part of AD: C+I+G+(X-M). The theory suggests here, that an increase in spending e.g. on social protection or subsidies helps stimulate consumption, and is an injection into the circular flow of income thus benefiting the economy in the short run. Although fiscal policy is often thought of as being largely a demand management tool whereby it affects aggregate demand, it can also be used to alter the supply side of the economy via schemes such as the new ‘National Productivity Investment Fund’ and increasing school’s budgets for Maths and Science etc. Moreover, tax cuts may boost labour supply thus expanding the economy in the long run.

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Both diagrams show how the long run capacity of the economy increase from Y-Y1 putting downward pressure on the general price level.

Despite this, it is important to consider and disaggregate where this money is being spent and which sectors of the economy will receive the money or if it will it make a productive difference. Government spending can be categorized as ‘current’-consumption related, which is unproductive; or ‘productive’, where it is used for investment and boosts the long run trend rate of growth. Gordon Brown’s Golden Rule was to ‘Only borrow to invest’. Further, fiscal policy may be used alongside supply side polices rather than as an alternative. This may ensure fiscal polices can react to economic shocks. We should also consider the role of Automatic fiscal stabilisers – If the economy is growing, people will automatically pay more taxes (VAT and Income tax) and the Government will spend less on unemployment benefits. The increased T and lower G will act as a check on AD. Conversely, in a recession, the opposite will occur with tax revenue falling but increased government spending on benefits-this will help increase AD.

Another point about spending that we should factor in is the government may have poor information about the state of the economy and struggle to understand the best what the economy needs. There may also be time lags-it could take several months for a government decision to filter through into the economy and actually affect AD and by then it may be too late. Another argument is crowding out. Some economists argue that expansionary fiscal policy will not increase AD because the higher government spending will crowd out the private sector. This is because the government will borrow from the private sector who will then have lower funds for private investment. Free market economists would also argue that Government spending is inefficient and that higher government spending will tend to be wasted on inefficient spending projects. It can then be difficult to reduce spending in the future because interest groups put political pressure on maintaining stimulus spending as permanent. There may even be higher borrowing costs-under certain conditions; expansionary fiscal policy can lead to higher bond yields, increasing the cost of debt repayments. Finally, the real business cycle argues that macroeconomic fluctuations are due to changes in technological progress and supply-side shocks. Therefore, using demand-side policy to influence economic growth fails to address the issue and just makes the situation worse.

Other peripheral points around this issue are: Reduced government spending (G) to decrease inflationary pressure could adversely affect public services such as public transport and education causing market failure and social inefficiency. If the government uses fiscal policy, its effectiveness will also depend upon the other components of AD, for example, if consumer confidence is very low, reducing taxes may not lead to an increase in consumer spending. It can depend on the Multiplier effect as any change in injections may be increased by the multiplier effect. Also, fiscal policy is most effective in a deep recession where there is a liquidity trap as higher government spending will not cause crowding out because the private sector saving has increased substantially.

The diagram below shows the effect of expansionary fiscal policy and contractionary fiscal policy on AD in theoretical terms i.e. without the exceptions discussed above. Although the economic theory often deviates from reality, it is important to use it as a base line to compare what would happen to the economy ‘ceteris paribus’. The Monetarist argument is that the LRAS is inelastic therefore an increase in AD will only cause inflation to increase and thus they are generally skeptical of fiscal policy as a tool to boost economic growth.

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In conclusion, a rise in government expenditure, or a fall in taxation, in theory should increase aggregate demand and boost employment, likewise contractionary polices should do the opposite However, the size of the resulting final change in equilibrium national income is determined by the multiplier effect as well as confidence and the current state of the economy. Fiscal policy can be used to influence the level and pattern of economic activity in many ways. Firstly through an increase in government spending on services such as the NHS will create more jobs and thus increase consumption as consumers now have more disposable income. A change in direct taxation such as a change in level of corporate tax on firms may cause firms to increase investment spending due to spare money that hasn’t been removed by the burden of tax. That said, large budget deficits do require financing and in the long run, this requires a higher burden of taxation meaning it is important for governments to strike a balance. When the government sells debt to fund a tax cut or an increase in expenditure then a rational individual will realise that at some future date he will face higher tax liabilities to pay for the interest repayments. Thus, he should increase his savings, as there has been no increase in his permanent income. This gives rise to the Keynesian idea of the Paradox of thrift, whereby increased savings lead to a reduction in aggregate demand and lead to individual being worse off. Overall we have to consider both long run and short run effects of fiscal policy. The effect that fiscal policy has in the long run on the supply side of the economy is particularly important and over time we have seen a switch away from the use of fiscal policy as government tool for demand management and a turn towards its use as a supply side incentive. We also have to consider the drawbacks of fiscal policy such as time lags. Fiscal policy may cause an increase in AD but it takes time to recognise that AD is growing either too quickly or too slowly. It then takes time to implement an appropriate policy and then for the policy to work, as the multiplier process is not instantaneous. Although fiscal policy has been relatively successful in the UK it will be interesting to see how factors such as a growing and ageing population will change things as the pressure increases on the NHS and state pensions.


Sources used:

AQA Economics A-Level Textbook 2, Powell and Powell

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