2. Fiscal Policy Economics – Some Key Terms
Bond Yield The rate of interest paid on government debt
Budget (Fiscal) Deficit
The budget deficit is the difference between what the
government receives in revenue and what it spends
Cyclical Fiscal Deficit
The size of the deficit is influenced by the state of the
economy: in a boom, tax receipts are relatively high and
spending on unemployment benefit is low
Direct Taxation
Taxes on income, profits and wealth, paid directly by the
bearer to the tax authorities.
Fiscal Policy
Taxation and spending measures that allow the
government to guide the economy.
Indirect Taxation
Taxes on expenditure (e.g. VAT). They are paid to the tax
authorities, not by the consumer, but indirectly by the
suppliers of the goods or services.
National Debt
Debt is the total amount owed by the government which
has accumulated over the years.
Structural Fiscal Deficit
The structural deficit is that part of the deficit which is
not related to the state of the economy. This part of the
deficit will not disappear when the economy recovers.
3. What is Fiscal Policy?
• Fiscal policy involves the use of government spending, direct
and indirect taxation and government borrowing to affect
the level and growth of aggregate demand, output and jobs
• Fiscal policy is also used to change the pattern of spending
on goods and services e.g. spending on health care and
scarce resources allocated to renewable energy
• Fiscal policy is also a means by which a redistribution of
income & wealth can be achieved for example by changing
tax rates on different levels of income or wealth
• It is an instrument of micro-economic government
intervention to correct for market failures such as pollution
or the sub-optimal provision of public and merit goods
• It is important to be aware that changes in fiscal policy affect
both aggregate demand (AD) and aggregate supply (AS)
4. Total UK Government Spending and Tax Revenue
Source: International Monetary Fund, data from 2015 onwards is a forecast
500
550
600
650
700
750
800
850
2010 2011 2012 2013 2014 2015* 2016* 2017* 2018* 2019* 2020*
Revenue/Spendinginbillionpounds
Revenue Spending
5. The Public and the Private Sector of the Economy
Public sector businesses are owned and operated by the
government, whilst the private sector is privately owned
• The public sector is not profit-driven, while this is usually (but not always)
the case with the private sector.
• In September 2013, there were 5.7 million people working in the UK
public sector (18.8% of people in employment). The National Health
Service (NHS) employs over 1.5 million people
• Public sector businesses / corporations include the following:
• Met Office and Ordnance Survey
• Channel 4, National Nuclear Laboratories
• Eurostar, NATS (National Air-Traffic Control Services)
• Network Rail
• Royal Mail was part privatised in 2013 (Govt retains 30% stake)
6. Some Key Roles for Fiscal Policy
Financing
government
spending
Changing final
income and
wealth
Providing a
welfare state
safety-net
Managing the
economic cycle
Improving long
run
competitiveness
Tackle important
market failures
Fiscal policy decisions have an impact on millions of consumers and
businesses – in both the short and the long term
7. Breakdown of UK Government Spending in 2015-16
Welfare protection is the largest single element of government spending,
with the NHS and Education the biggest single departmental items.
8. Government Spending
Welfare Spending
Transfer Payments
Public Services
Recurring spending
State Investment
Investment Projects
Total UK government spending is forecast to be £745 billion in 2015
This is 43.1% of GDP. £50 billion or 7% will be on capital spending
Spending on public services such as education & health is 22% of GDP
Government spending is spending by the public sector on goods
and services such as education, health care and defence
9. Government Current and Capital Spending
Current spending – on
providing public services
Capital spending – new public
infrastructure
Salaries of NHS
employees
Drugs used in
health care
Road
maintenance
Army logistics
supplies
Construction of
new motorways
New equipment
in the NHS
Flood defence
schemes
Extra defence
equipment
10. Economic Importance of Government Spending
Is a Key
Component
of Aggregate
Demand
Has a big
Regional
Economic
Impact
Providing
Public &
Merit Goods
Achieving
greater
Equity in
Society
11. Economic Importance of Education & Health Spending
Education and health are regarded by economists as merit goods.
An increase in funding of both can affect the macro-economy
Education spending
• May increase the skills and
productivity of workers
• Improvement in human capital will
lower structural unemployment
• More innovation / competitiveness
Health care spending
• Improved health outcomes will boost
active labour supply
• Will also increase productivity
• Lessens risks of relative poverty
Evaluation Arguments
1. Effectiveness of
education spending has
been questioned
2. Money might be better
spent targeting certain
groups or ages
Evaluation Arguments
1. Better health results can
be achieved without
increase in health
funding
2. Will lower income
families get the improved
access
12. Median Age of the UK Population
34.9 35.1 35.5 35 34.2 33.9 34.4 35.3 35.8 36.5
37.6
38.7
39.8 40.5
0
5
10
15
20
25
30
35
40
45
1950 1955 1960 1965 1970 1975 1980 1985 1990 1995 2000 2005 2010 2015*
Medianageinyears
The median age of the UK population is rising. This is likely to have both
demand and supply-side effects on the UK economy in the years ahead.
Source: Office for National Statistics
13. How Government Spending can affect Incomes
Welfare state transfers
• Universal child benefits / unemployment benefit
• Public (state) pensions
• Conditional welfare transfers e.g. Conditional on
attending unemployment programmes
• Targeted welfare payments- linked to income
State-provided services (in-kind benefits)
• Education - reduces inequality of market incomes
• Health care – state provided health services
• Social housing e.g. Provided by local authorities
• Employment training
14. Welfare Spending by the UK Government
£ billion per year 2014-15 2015-16 2016-17
Welfare capped spending
Department of Work and Pensions (DWP) social security 74.4 76.0 74.8
of which:
Housing benefit (not on JSA) 21.4 22.1 21.9
Disability living allowance and personal independence
payments
15.3 15.6 15.1
Incapacity benefits 14.1 14.8 14.7
Winter fuel payments 2.1 2.1 2.1
Personal tax credits 29.7 29.5 25.3
Child benefit 11.6 11.5 11.4
Tax free childcare 0.0 0.0 0.1
Total welfare cap 119.1 120.6 115.2
Welfare spending outside the welfare cap
DWP social security spending 92.0 94.0 96.1
of which:
State pension 86.5 89.7 92.1
Jobseeker's allowance 3.1 2.2 2.3
Housing benefit (on JSA) 2.4 1.6 1.7
Total welfare outside the welfare cap 95.1 96.4 98.6
Total welfare 214.3 216.9 213.8
15. Sources of UK Government Tax Revenues in 2015-16
Income tax and VAT are the two biggest sources of government revenues
16. Direct and Indirect Taxation
• Direct taxation is levied on income, wealth and profit
• Direct taxes include income tax, inheritance tax,
national insurance contributions, capital gains tax,
and corporation tax (a tax on company profits)
• The burden of a direct tax cannot be passed on
• Indirect taxes are taxes on spending
• Examples of indirect taxes include excise duties on
fuel, cigarettes and alcohol and Value Added Tax
(VAT) on many different goods and services
• Producers may be able to pass on an indirect tax –
depending on price elasticity of demand and supply
17. UK Government Tax Revenues by Size
2013/14 2014/15
Income tax 163.7 170.2
National insurance contributions 110.3 114.8
Value added tax 111.3 115.9
Corporation tax 42.9 43.1
Petroleum revenue tax 0.1 0.0
Fuel duties 27.2 27.1
Business rates 27.3 28.0
Council tax 27.9 28.4
VAT refunds 13.7 13.6
Capital gains tax 5.6 6.4
Inheritance tax 3.8 4.2
Stamp duty land tax 10.9 11.5
Stamp taxes on shares 2.9 3.2
Tobacco duties 9.3 9.1
Spirits duties 3.0 3.2
Wine duties 3.8 4.0
Beer and cider duties 3.6 3.5
Air passenger duty 3.2 3.1
Income Tax, National Insurance and VAT are far and away the biggest
sources of tax revenue for the UK government.
18. Tax Revenues from UK Air Passenger Duty
Text goes here
948
806 816 791
864 905 971
1,994
1,862 1,856
2,155
2,607
2,791
3,013
0
500
1000
1500
2000
2500
3000
3500
00/01 01/02 02/03 03/04 04/05 05/06 06/07 07/08 08/09 09/10 10/11 11/12 12/13 13/14
Airpassengerdutyreceipts£million
Air Passenger Duty is charged for all travel in aircraft. It has two rates
(standard and higher) and is also based on distance flown
19. Progressive, Proportional and Regressive Taxes
• With a progressive tax, the marginal rate of tax rises
as income rises. I.e. as people earn more income, the
rate of tax on each extra pound goes up. This causes
a rise in the average rate of tax
• Examples: Income tax (basic and higher rates)
• With a proportional tax, the marginal rate of tax is
constant leading to a constant average rate of tax
• Examples: National insurance contributions
• With a regressive tax, the rate of tax falls as incomes
rise – I.e. the average rate of tax is lower for people
of higher incomes
• Examples: Excise duties on tobacco and alcohol
20. Progressive, Regression and Proportional Taxation
Percentage of gross income taken up by different taxes in the UK in 2013-14
Lowest 20%
of Income
2nd
Quintile 3rd
Quintile 4th
Quintile
Highest 20%
of Income
All
households
Income Tax 2.5 4.4 8.2 11.2 16.9 11.8
VAT 11.0 7.9 7.7 7.0 5.5 6.8
Duty on
alcohol
1.5 1.0 1.0 0.9 0.7 0.9
Duty on
tobacco
2.8 1.7 1.3 0.6 0.3 0.8
All indirect
taxes
28.1 19.1 17.8 15.3 11.3 15.3
Source: Office for National Statistics
Income tax is progressive – notice how the average burden of income tax
rises across income groups. Duties on tobacco and alcohol are regressive.
21. Original and Final Income – Redistribution in the UK
The UK tax and welfare system is mildly progressive because it leads to a
smaller gap between households when final income is measured.
0
200
400
600
800
1000
1200
1400
1600
1800
1 2 3 4 5 All households
£ per week
Disposable income quintile
The effects of direct and indirect taxes and welfare benefits on
household income by quintile groups, 2013/14
Original income Final income
Source: Office for National Statistics
22. The Effects of Taxes and Benefits on Rich and Poor
Benefits in kind include the estimated value to households of consuming
services such as state education and the national health service.
-700
-600
-500
-400
-300
-200
-100
0
100
200
300
400
1 2 3 (median) 4 5 All households
£ per week
Disposable income quintile
Summary of the effects of taxes and benefits on all households, 2013/14
Indirect taxes Direct taxes Benefits in kind Cash benefits Net position
Taxes and benefits lead to net increase in income Net decrease in income
Source: Office for National Statistics
23. Taxation and Aggregate Demand
Changes in tax rates and tax allowances can have direct and
indirect effects on the level of aggregate demand (AD)
Income tax and
disposable income
Corporation taxes and
business investment
Taxation of imports
affects trade
National insurance
and labour demand
VAT and levels of
consumer spending
Taxation and business
R&D spending
24. Lower Taxes and Components of Demand
Cut in personal
income tax rates
Boost to disposable
income
Adds to consumer
demand
Cut in indirect
taxes e.g. VAT
Lower prices –
leads to higher
real incomes
Adds to consumer
demand
Adds to business
capital spending
Cut in corporation
tax
Higher “post tax”
profits for
businesses
Cut in tax on
interest from
saving
Boost to disposable
income of people with
net savings
Adds to consumer
demand
Expansionary
Fiscal Policy
25. Effect of a Lower Corporation Tax on Businesses
Government cuts the
rate of corporation
tax
Businesses get to
keep a larger
percentage of their
profits
Increase in post-tax
profitability may lead
to a rise in planned
investment
Investment can be by
both domestic and
overseas businesses
Increased capital
spending is an
injection into the
circular flow model
Creates a multiplier
effect on demand,
output and
employment
Evaluation points
1. Effect depends on the
scale of the tax cut
2. Many factors affect
capital investment
e.g. the pace of
technological change
and strength of
market competition
3. There will be time
lags between change
in corporation tax
and increased flow of
actual investment
4. Some extra
investment may lead
to a loss of jobs
through capital-
labour substitution
effects.
26. Impact of a rise in indirect taxes on the UK Economy
All other things being equal, an increase in indirect taxes by the
government is most likely to …..
Macroeconomic Objective Comment on the Effect
Inflation Higher in short run as business pass on tax
Economic growth Slower as real incomes and demand falls
Unemployment Higher if aggregate demand weakens
Balance of trade in goods & services
Improved – falling incomes may cause
demand for imports to contract
Spare capacity in the economy Rising spare capacity from weaker demand
Business investment
Decline if businesses are hit by lower profits
and weaker consumer spending
Government fiscal balance
Short run improvement from higher taxes
but risk of falling revenues in medium term
27. Taxation and Aggregate Supply
Changes in tax rates and tax allowances can have a direct and
indirect effect on both short-run and long-run aggregate supply
Work incentives /
active labour supply
Inward migration of
key workers
Capital investment
e.g. FDI projects
Enterprise /
Entrepreneurship
Taxation and
incentives to study
Tariffs affect import
costs
28. How Could Tax Cuts Stimulate Economic Recovery?
Low confidence – tax
cuts likely to be saved
rather than spent
Businesses might
choose to invest
overseas instead
Skills shortages might
limit new job creation
Consumer spending
• Cuts in VAT or income tax to boost
demand for goods and services
Business investment
• Lower corporation tax to increase
investment and tax incentives for R&D
Lower employment taxes
• Reduced national insurance so that
businesses create more jobs
Lower fuel / carbon taxes
• Lower costs for businesses, less
inflation and higher profits
Possible conflicts with
environmental policies
29. Tax Competition between Countries
Changes in business taxation in particular are now regarded as an
important form of supply-side policy.
• Tax competition happens when
a national government uses
reforms to the tax system as a
supply-side strategy to attract
investment and jobs into their
economy.
• A number of countries have
introduced a flat tax system,
examples include Russia,
Estonia and Poland
• Is tax competition between
countries a fair way of bidding
for investment? What might be
some of the economic and
social effects?
Income Tax Lowest and Highest
Rate the same (%)
Russia 13%
Ukraine 17%
Mongolia 10%
Costa Rica 15%
Business Profits Tax
(Corporation Tax)
Standard rate (%)
Macedonia 15%
Hong Kong 17.5%
Bahrain 0%
Macao 12%
30. Evaluating the Arguments for a Low Tax Economy
Lower
Taxes
Stimulates work incentives and
productivity
Helps to create more jobs because
businesses have less tax to pay
Encourages an inflow of FDI from
businesses looking for low tax country
Incentivizes enterprise and start-ups – a
source of long term wealth and jobs
Lower tax rates might end up increasing
total tax revenues (Laffer Curve concept)
31. Evaluating the Arguments for a Low Tax Economy
Higher
Taxes
Taxation is a key instrument for changing the final
distribution of income and wealth. It is equitable
for those with the greatest resources to pay more
Tax cuts don’t necessarily lead to an increase in
total tax revenues for the government
Consider the relative success of countries such as
Denmark, Norway and Sweden who have higher
tax burdens
Taxes are needed to fund high quality public
services
32. Actual & Forecast Government Budget Balance
Source: Office for Budgetary Responsibility, July 2015
The budget deficit is the difference between what the government receives in
revenue and what it spends. The last year of budget surplus was in 2000.
The UK budget deficit
peaked at over 10% of
GDP in 2009-10
Forecast
The annual average UK budget
deficit has been 3.5% of
national income since 1970
33. The UK Budget Balance and National Debt
Source: OBR, July 2015
Public Sector
Borrowing
% of GDP
Public Sector Net Debt
% of GDP
2007–08 2.7 36.7
2008–09 6.7 49.0
2009–10 10.2 62.0
2010–11 8.6 68.7
2011–12 7.0 72.3
2012–13 7.2 76.7
2013–14 5.7 79.1
2014–15 4.9 80.5
2015–16 4.0 80.2
What is government
borrowing?
Public sector borrowing
is the amount the
government must
borrow each year to
finance spending
What is national debt?
Public sector net debt is
a measure of the
accumulated national
debt owed by the
government sector
34. Government Borrowing and Bond Interest Rates
When a government borrows it issues debt in the form of bonds. The
yield on a bond is the interest rate paid on state borrowing
Purchasers of
government
bonds include
pension funds,
insurance
companies,
households and
overseas
investors. The %
yield on debt
has been very
low in recent
years.
35. Economic Justifications for Budget Deficits
Since 1970, the government has had a surplus in only six years – it is
normal for government to have to borrow money
1. A rise in borrowing to fund extra government spending can have
powerful effects on AD, output and employment when an
economy is operating below full capacity output
2. There is an automatic rise in the budget deficit to cushion the fall
in AD caused by an external economic shock. A higher fiscal deficit
is needed to lift AD back towards pre-recession levels
3. If a fiscal stimulus works the budget deficit will improve as a result
of higher tax revenues and reductions in welfare spending. A
growing economy helps to shrink debt as a percentage of GDP
4. It makes sense for a government to borrow money if interest rates
are low and if the deficit is being used for investment
36. Countries with Highest Government Debt in 2015
246.14%
172.73%
133.76%
132.82%
131.82%
129.24%
126.35%
121.08%
115.89%
107.75%
107.11%
106.91%
106.57%
105.67%
105.06%
0.0% 50.0% 100.0% 150.0% 200.0% 250.0% 300.0%
Japan
Greece
Italy
Jamaica
Lebanon
Enritrea
Portugal
Cape Verde
Bhutan
Ireland
Grenada
Antigua and Barbuda
Belgium
Cyprus
United States
Public (government) debt as a percentage of GDP
37. Countries with the Lowest National Debt in 2015
1.82%
3.28%
6.37%
8.32%
8.56%
8.87%
9.46%
10.13%
11.48%
11.88%
12.73%
13.62%
13.64%
14.75%
16.25%
0.0% 2.0% 4.0% 6.0% 8.0% 10.0% 12.0% 14.0% 16.0% 18.0%
Saudi Arabia
Brunei Darussalam
Hong Kong SAR
Uzbekistan
Oman
Kiribati
Kuwait
Estonia
Nigeria
Iran
Botswana
Solomon Islands
Algeria
United Arab Emirates
Chile
National (government) debt measured as a percentage of GDP, Source: IMF
38. Is a High Level of Public Debt Bad for the Economy?
Public debt is the total stock of debt issued by a government that has
yet to be re-paid – it is also known as the National Debt
• High deficits cause rising debt interest payments which
in 2015-16 are are forecast to be £47 billion or £700
per head of population
• This interest burden has an opportunity cost for less
interest on debt could free up extra spending on health
and education. Borrowing of £70 billion is equivalent to
£1,100 per head of the UK population
• An increase in the national debt is likely to cause higher
taxes in the future. This will cut the disposable incomes
of tax payers and reduce growth in the private sector
• It might be unfair if the rising tax burden falls more
heavily on future generations of tax payers rather than
people who benefit from government spending now.
UK Debt Data
UK government
debt is forecast
to reach 94% of
GDP in 2013. This
is lower than the
average of
advanced
economies.
Japan’s gross
debt is 245% of
GDP in 2013,
while Greece’s is
179% of GDP.
39. Government Debt for a selection of EU Countries
2006 2008 2010 2012 2015
France
% of
GDP
81.9 87.7 103.5 113.4 127.5
Germany
% of
GDP
64.1 61.2 67.4 65.1 60.0
Greece
% of
GDP
103.4 109.4 145.7 156.8 186.0
Ireland
% of
GDP
44.1 84.4 280.3 334.0 316.0
Italy
% of
GDP
116.2 114.5 126.0 138.1 144.9
Spain
% of
GDP
45.7 47.1 66.7 91.0 118.6
United Kingdom
% of
GDP
42.5 51.8 76.4 85.8 90.0
Source: IMF
40. • The UK government has a fiscal deficit-reduction policy with the emphasis on
cutting government spending in some areas in real terms and a series of direct
and indirect tax increases:
• Key policies for deficit reduction:
1. Rise in standard rate of VAT to 20%
2. Rise in employee national insurance contributions (11%)
3. Deep cuts in real government spending e.g. for local authorities
4. Welfare caps including £26k pa cap on welfare for each family
Some taxes have been cut
1. A series of cuts to corporation tax (main rate is now 20%)
2. Freezing of fuel duties (meaning a cut in real terms)
3. Increases in the real value of the income tax free allowance
4. Cuts in employer national insurance for long term unemployed
5. Freezing of council tax (so that council tax falls in real terms)
The UK Government has also been helped by lower interest rates on newly issued
debt as a result of quantitative easing
UK Government’s Fiscal Austerity Policies
41. In the July 2015 Budget, the
Chancellor George Osborne
announced a new fiscal rule.
The government’s fiscal rules now
include a target for a budget
surplus by 2019/20 and for all
subsequent years when in
‘normal times’.
The economy will be viewed as
being in ‘normal times’ if real
annual growth is above 1%
Balanced budget
when G= T
Normal times – a full
economic recovery
UK Government’s New Fiscal Rule (2015)
