The History of Fiscal Policy • ‘Sound finance’ approach • A balanced budget and low tax & spend1850s-1950s • Use of fiscal policy in demand management • Keynesian belief that government should actively manage aggregate demand1950s-1970s running a deficit if necessary • Return to principles of ‘sound finance’ and balanced budgets • Fiscal policy used to promote aggregate supply, not demand1980s-2008? • Cutting taxes not to boost demand but to create incentives to work and invest Note the links with the changing role of monetary policy which has replaced fiscal policy in the modern era as the demand management tool.
2008-present• In the latter years of the Labour government increased public spending took precedent over fiscal discipline• Following the financial crisis and subsequent recession the Labour Government briefly reverted to Keynesian demand management, reducing VAT and dramatically increasing spending• The Code for Fiscal Stability was suspended• ‘Loose’ fiscal discipline before the crisis and policy after the crisis left the UK with large deficit• The election of the coalition government resulted in the introduction of ‘austerity’ to reduce the budget deficit (‘sound finance’)• Monetary policy alone had to deal with falling demand, firstly by lowering interest rates to almost zero, then through a programme of quantitative easing
http://www.guardian.co.uk/news/datablog/2012/mar/21/budget-2012-spending-tax-visualised#How far have we strayed from a balanced budget?
Keynesian Fiscal Policy• The free market creates volatile business cycles• Insufficient AD leads to persistent unemployment• Running a deficit can inject money into the economy when needed• Fiscal policy can be used to stabilise the economy once back to full employment• Assumption that the multiplier effect is large “If economists could manage to get themselves thought of as humble, competent people on a level with dentists, that would be splendid.” John Maynard Keynes
Supply-side Fiscal Policy• Rejection of use of fiscal policy to manage demand as this is inflationary in the short term and in the long term the deficit must be paid off• With increasing imports the multiplier effect didn’t work and merely created inflation• Public spending and tax to be reduced to allow private sector to flourish• Fiscal policy used as a micro-economic tool to target incentives for workers and firms Most of the energy of political work is devoted to correcting the effects of mismanagement of government. Milton Friedman
Examples of fiscal supply side policy• Incentives to work Giving incentives to people to work• Minimum wage• Welfare to work Ensuring industry have• Education spending skilled labour available• Reducing corporation tax Incentives to invest• Enterprise zones Tackling regional decline and structural unemployment
The middle wayThe choice does not have to be between fiscal demand management or a balanced budget. There are automatic stabilisers that even out the economic cycles. Reduced exports Higher Weak pound Excess demand in = lower AD unemployment improves X-M economy Higher benefit Welfare payments Wage levels rise to Budget deficit payments and fall and tax draw workers into lower tax income revenues increase labour force Reduces impact Surplus budget of contractionary takes heat out of multiplier economy Dampening deflationary effects Dampening inflationary effects
Automatic stabilisers soften boom and bust This leads to the conclusion that it is important to balance the budget not over an annual cycle but over the period of the economic cycle. There is a difference between the cyclical budget deficit (caused by the automatic stabiliser) and the Government deficit rises in a structural budget deficit (an recession... imbalance in the economy which leads to a deficit even when the And falls during a boom. economy is growing at the trend rate)Context – The Government are attempting to reduce the deficit during a period of lowor negative growth. Is it reasonable to expect to ‘balance the books’ when theeconomy is not booming?
Let us not forget though that fiscal policy is not just about...Economic managementi.e. As a tool to achieve macro objectives It is also about...Managing the allocation of resourcese.g. Affecting consumption of merit/demerit goods, limiting externalities, controlling monopolistic excesses, creating incentives to work, save or investAltering the distribution of income and wealthi.e. The use of progressive taxation and redistributive public spending
Trade-off between equity and efficiency Greater equality can be achieved by; • Free state services • Welfare support • Progressive taxation • Pre-1979 approachBut the resultant dependency culture requires;• Lower taxes and benefits to get people off benefits• Allowing rich to keep more of their money to invest and create growth and jobs = greater inequality but less absolute poverty
And the related debate... How big should government be?Big governments can crowd out the private sector in two ways;Resource crowding out whereby resources aren’t available for the private sector as they are employed by the public sectorFinancial crowding out whereby• Higher taxes to pay for spending reduce consumption on private goods• Government borrowing (e.g. Bond issues) are attractive investments which divert funds from private investment
However...Taxing the rich and giving to the poor CAN increase consumption as people on lowerincomes have a higher propensity to consume.During periods where spare capacity exists the public spending can usefully employresources without crowding out the private sector. Furthermore, if the spending is oncapital projects (e.g. road building) the private sector may experience higher demand asgovernment commissions projects. The above two points lead to calls during a recession for redistribution of income and government infrastructure projects - like the huge road building effort in the US during the Great Depression.
One more problem with big government... The Laffer curve If 100% of income is taxed then there would be no incentive to do anything! No economic activity would therefore result in no tax income. If 0% of income is taxed then thereThis model is named after the supply-side is also no tax income.economics Arthur Laffer. What is not clear is Government income from taxat what level of taxation government increases as the rate of taxrevenues go into reverse? Some economistsargue that in the Keynesian era of big increases, and falls after agovernment the ‘tax burden’ was excessive certain tax rate is reached asand lower revenues were the result. It is the disincentives sendinteresting to consider that this logic leads to economic activity into reverse.the conclusion that to increase tax income afall in taxation is necessary.
Big or small?Other factors which affect the decision on howbig government should be are;1. Efficiency – does government or the private sector deliver goods more efficiently?2. Equity – to what extent do we sacrifice efficiency for equity? For example, private dentistry may be more efficient but would it exclude certain people from treatment?
Government size over timeThe size of the state is usually driven by public sector spending., which in turn is influenced by war, political ideology and economic orthodoxy. Public spending is often measured by the ratio between public expenditure and national income. The Big Picture • Public spending steadily increased throughout the 20th century • From around 10% to over 40% of GDP The Peaks • Spending increased sharply in the two World wars • Peak in 1982/3 at 46.75% • By 2005/6 it was again above 42%, rising to over 50% after the recession in 2008/9 Does public spending = share of output? • Some public spending is on ‘transfers’ i.e. using tax revenues to redistribute money via welfare benefits. This spending is not taking resources away from the private sector and is not generating an output. • The governments actual contribution to output is more like 20-30% of the total GDP
http://www.guardian.co.uk/news/datablog/2012/mar/21/budget-2012-spending-tax-visualised#Look again at what we are spending this money on.
What makes a good tax?Having considered how much we tax, let us now consider whatconstitutes a ‘good’ tax. And we may add efficiency Equitable and flexibility to this list. VAT is levied at a flat rate (currently 20%). It is therefore a proportionate tax as the rate does not Adam change in relation to income. To some extent people can choose whether to pay VAT as they choose Certain Smith’s Economical whether to purchase goods. Some goods are exempt Cannons from VAT (e.g. children’s clothes) in an attempt to of Taxation avoid discouraging purchase. VAT is relatively easy to collect as firms must levy the tax and pay on behalf of the consumer, and therefore convenient to those being taxed. However, it is open to avoidance when ‘cash in hand’ purchases are made. VAT can be changed quickly and raises around £100 billion a year without Convenient significant cost. It is generally a good tax, although not progressive.
Monetary and Fiscal harmony The Big Picture – The need to reduce the deficit has taken precedent over all other objectives. A ‘sound finance’ approach to fiscal policy dominates, with the refusal to follow the Keynesian approach of increasing demand in a downturn through deficit spending. Interest Rates, potentially a demand-boosting alternative, have no room for falling further and should if anything increase to curb inflation. Quantitative easing has propped up a flailing economy. Falling real incomes and high unemployment are the painful medicine to a period of excessive consumption and debt. The question is whether the medicine will workImproving economic welfare or will a ‘lost decade’ result as the economy cannot lift itself out of a prolonged slump? Interest Rates being used for demand Control of management, although redundant in promoting increased demand at present and not as yet rising to inflation curb cost-push inflationary pressures. Other policies are needed. Macro-economic Drive to achieve a balanced budget through austerity and pay down national debt. Quantitative easing stability employed to attempt to maintain credit availability to promote aggregate demand and supply. Intention to reduce size of the state and create Long-run growth competitive and efficient markets which will drive the recovery.
Limitations of fiscal policy•Increased PSNCR may require increased money •Long time to have an effect (e.g. education) supply therefore inflation and no benefit to •Social effects (e.g. cutting benefits) output •Difficult to predict effects•Borrowing must be paid back, with interest•Blunt tool•Risk when large debts build up As a demand As a supply- management side tool tool To To correct redistribute market wealth failure•Brain drain •Not possible to accurately assess costs•Disincentives to work and benefits•Political pressures •Difficult to predict effects of policy •May make industries less internationally competitive •Political resistance
Other supply-side policies• Privatisation / Deregulation• Liberalising financial markets• Open economy – reduce barriers to trade• Well functioning labour markets (where wage levels are allowed to fall, firms can hire and fire, and the natural rate of unemployment is minimised)
EU Perspective Greater integration with Europe means the transfer of national economic powers to Controls over budget deficits European institutions (e.g. the ECB). Those (3% of GDP) countries which have adopted the Euro can no longer use interest rates as a demand management tool. This causes problems if Possible move their economic cycle is out of sync with the toward a common fiscal rest of Europe. The use of fiscal policy for framework or tax counter-cyclical management is also limited harmonisation? by rules over deficits. Single currency means loss of monetary control at a The benefits however include currency national level stability, free trade and movement of resources, and access to fiscal support and large ‘bail-out funds’. The argument for greater fiscal integration is that this would bring economic cycles inGreece has a massive deficit and poorly structured economy. Theyare under pressure to pay down their debts but the massive ‘austerity’ line and remove national competitivecuts required will be devastating to an already depressed economy. If advantages which distort the patterns ofthey had their own currency its value would be falling rapidly boosting trade. The argument against is that thisexports and reducing imports, bringing demand into the economy. would further remove powers from nationalThey would also have monetary tools at their disposal to promote government to respond ‘locally’ toconsumption and investment. As part of the Euro they are instead economic shocks and pressures.suffering from a strong German economy pulling up the value of theEuro. They have, however, benefitted from European bail-outs.