Government & Fiscal Policy

Government vs Fiscal Policy

• A government is a pre-defined structure
• Fiscal policy involves how a government achieves its financial objectives

The Government in the Economy

• Central governments oversee defense and foreign affairs, and their main offices reside at the Head Office
• Regional/provincial governments are responsible for health, education, and housing
• Local governments handle the local roads and streetlights
• Public corporations like Eskom and Transnet report to the Department of Public Enterprises (DPE)
• General government = A + B + C, where
  • A is the central government
  • B is the regional/provincial government
  • C is the local government
• Public sector = A + B + C + D where D is the public corporations

Government's Role

• Governments spend, tax, borrow, and regulate
• Governments provides public goods and services such as health, education, and housing
• Governments issue pension funds, subsidies, and uses taxes to finance public goods and services

Market Intervention

• Private corporations are generally more efficient than governments
• Government provides the legal frameworks in which market forces operate
• Government correct the market failure (inefficient production) using subsidies
• Government ensures equitable distribution of income and wealth via social grants

Cases of market failure

• Market failure occurs when there is an allocation inefficiency in the market
• Monopoly and imperfect competition
• Public goods
• Externalities
• Asymmetric information
• Common property resources

Monopoly and Imperfect Competition

• Market structures are not allocative efficient
• Responses to monopoly include:
  • No intervention, relying on profits attracting competitors
  • Imposing price controls
  • Taxing excess profits
  • Regulating via competition policy

Public Goods

• Public goods or non-private goods are not provided by the free market
• Arises from the market's failure to provide sufficient quantities

Externalities

• Externalities involve third-party benefits or costs, external costs of production are a type of externality

Asymmetric Information

• Relates to information imbalance in a market

Common Property Resources

• Common property resources are non-excludable but rivalrious

Further Reasons for Government Intervention

• Income distribution
• Macroeconomic growth and stability
• Merit goods, which are subsidized or freely provided, like education

Fiscal Policy and the Budget

• Fiscal policy is how governments adjust spending and tax rates to influence a nation's economy
• This involves decisions about government spending, taxation, and borrowing
• Budget instruments include:
  • Reflection of political decisions
  • Managing budget deficits or surpluses

Demand Management

• Uses fiscal and monetary policies
• Monetary policy: Central banks manage liquidity for economic growth
• Expansionary (stimulatory) policy
• Contractionary (restrictive) policy

Government Spending

• Government can finance spending using income from property, taxes, or borrowing
• Borrowing helps finance budget deficits through domestic and international capital markets or central banks
• Borrowing increases public debt and related interest costs

Taxation Factors

• Attributes of a good tax:
  • Neutrality: Minimal impact on taxpayers' transaction decisions
  • Equity: Fair both horizontally (equals taxed equally) and vertically (unequals treated appropriately)
  • Administrative simplicity: Easy to understand, comply with, and cost-efficient

Taxation Distinctions

• Tax avoidance vs. tax evasion
• Direct vs. indirect taxes (VAT)
• Taxes on income/wealth vs. taxes on products/production
• General (VAT) vs. selective taxes (excise duties)
• Progressive, proportional, and regressive taxes

Main Tax Types

• Personal income tax
  • Taxable income base
  • Marginal tax rate
  • Average/effective tax rate
  • May be progressive and include capital gains taxes
• Company tax
  • Paid on company profits
  • Proportional tax
• Value-added tax (VAT)
  • Indirect and regressive tax

Keynesian Model Impact

• Impact of government spending (G) and taxes (T) on:
  • Aggregate spending (A)
  • Multiplier (α)
  • Equilibrium income (Y) This relates to Fiscal policy changes in G and T

Government Spending (G) Impacts

• Is primarily a political issue, not systematically related to Y
• Considered exogenous/autonomous
• Introduction of G increase aggregate spending (A) and the equilibrium level of income (Yo)
• Introduction of G leaves the multiplier (α) unchanged

Taxes (T)

• Taxes (T) lead to leakage from circular flow and reduce disposable income
  • Yd = Y – T
• Impacts
  • Taxes are related to income
  • They indirectly decrease consumption(C)

Taxes in the Keynesian Model

• Introduction of T: -No direct impact on aggregate spending (A) -Reduces multiplier (α) and equilibrium income (Yo)

Taxes and Multiplier

• Taxes are leakage or withdrawal
• 1/1–c(1–t) formula instead of 1/(1–c)
• Taxes must be paid before spending

Equilibrium Levels

• Key formulas in the model include:
  • Y = A (equilibrium)
  • A = C + I + G (aggregate spending)
  • C = C + cYd, where Yd = Y–T (consumption spending)
  • T = tY (taxes)
• Y0 = 1/ 1–c(1–t) (C+Ī+Ḡ) (= multiplier α x autonomous spending Ā)

Fiscal Policy Tools

• Fiscal policy utilizes government spending and taxes to affect economic output(Y).
• Expansionary (stimulatory) policy:
  • Increase G
  • Decrease t (taxes)
• Contractionary/restrictive policy:
  • Decrease G
  • Increase t (taxes)

Impact of Government Spending

• If income Y must increase by ΔY
• Increase G by less than ΔY because of the multiplier α
• Increase in G will be multiplied

Numerical Example for Fiscal Policy

• If ΔY = 300 and α = 3
• ΔG required = 300 / 3 = 100