Unit 4-4.3, 4.4 & 4.5 Fiscal Policy PDF

Unit 4- 4.3,4.4 &4.5 4.3-Fiscal Policy. ​ Budget: A financial statement showing the forecasted government revenue and expenditure in the coming fiscal year. Types of budgets: (a) Balanced Budget: If the government revenue is just equal to the government Expenditure, then it is known as balanced b...

Unit 4- 4.3,4.4 &4.5 4.3-Fiscal Policy. ​ Budget: A financial statement showing the forecasted government revenue and expenditure in the coming fiscal year. Types of budgets: (a) Balanced Budget: If the government revenue is just equal to the government Expenditure, then it is known as balanced budget. (b) Surplus Budget: If the revenue received by the general government is more in comparison to expenditure, it is known as surplus budget. (c) Deficit Budget: If the expenditure made by the general government is more than the revenue received, then it is known as deficit budget. The Public Sector That part of business activity that is organised and controlled by the government or its agencies on behalf of the nation as a whole The public sector comprises: Central Government; Parliament State government Local government public corporation Public expenditure It refers to the amount of money spends by central government, state government and local government for the development of economy. Private expenditure It refers to the amount of money spend by private people to meet their needs and wants. 1 Public expenditure divided in to: Current expenditure- It refers to day to day spending of government. Examples: wages and salaries, social security benefits paid to unemployed people, spending on office stationary etc. Capital expenditure- it refers to that amount of money spend by government to make investment in roads, bridges, parks etc. Real expenditure- the amount of money spend by public sector to purchase goods and services that contribute to the productivity of public sector and the economy. Transfer payments-The money is given by government to people in the form of cash benefits such as old age pensions, unemployment insurance and other social security payments. Reasons for governments spending To supply goods and services that the private sector will not do, such as public goods, including defence, roads and streetlights; merit goods, such as hospitals and schools; and welfare payments and benefits, including unemployment and child benefits, old age pension etc. To improve productivity in the economy, government spend on education and training, tax concessions. To reduce the negative externalities, such as pollution and to increase positive externalities. To reduce inequalities between rich and poor by providing free homes , free health care and unemployed benefits to poor people. To invest in economic infrastructure such as roads, railways, public buildings, waterways etc. To support agriculture and industry by providing subsidies, by investing in new machinery and in new plants etc Effects of government spending 2  ► Increased government spending will lead to more income, higher demand in the economy and leads to economic growth, ► Increased government spending on public goods and merit goods, especially in infrastructure, can lead to increased productivity and growth in the long run. ► Increased government spending on welfare schemes and benefits will increase living standards, and help to reduce inequality between rich and poor. ► However too much government spending can also cause reduction in private sector investments, if it is financed by increased taxes and borrowing. Also Increased government spending may result in inflation. Sources of government finance. Taxes on income, taxes on wealth [direct taxes], Taxes on expenditure or spending [indirect taxation]. Borrowing money from the people, internal and international institutions Interest payments on loans, Rent from publically owned buildings. Revenue from government agencies and public corporations Income from sale of government owned industries, land and buildings. Taxation A compulsory payment by people to the government or local authority examples. sales tax, income tax. The proportion of tax taken from national income in a country measures the total tax burden. Why government imposes taxes?( Aims or Objectives of 3  Taxation) It is a source of government revenue: if the government has to spend on public goods and services it needs money that is funded from the tax. They need money to provide public goods and merit goods ,infrastructure roads, railways, airport etc. To redistribute income: governments imposes taxes to those people who earn higher incomes and have a lot of wealth. This is then used to help poor people.. To reduce consumption and production of demerit goods: a much higher tax is imposed on demerit goods like alcohol and tobacco than other goods , so its prices will go up and discourage its consumption and production. Such tax is called excise duty. To protect home industries and maintain favourable BOP: taxes are also levied on foreign goods entering the domestic market. This makes foreign goods relatively more expensive in the domestic market, and then people prefer to buy domestic goods.then BOP will become favourable. To protect environment: government imposes tax, for example by imposing tax on petrol. Qualities of a good tax system (the canons of taxation): canon of Equity( equality : the tax rate should be based on the ability of the taxpayer. Rich people should pay more than poor people. Certainty: information about the amount of tax to be paid, when to pay it, and how to pay it should all be informed to the taxpayer. Economy: the cost of collecting taxes must be kept to a minimum and shouldn’t exceed the tax revenue itself. Convenience: the tax must be levied at a convenient time, for example, after a person receives his salary. Elasticity: the tax imposition and collection system must be flexible so that tax rates can be easily changed as the person’s income changes 4  Simplicity: the tax system must be simple so that both the collectors and payers understand it well Classification of Taxes Taxes can be classifies into direct or indirect and progressive, regressive or proportional. Direct Taxes Direct Taxes are taxes on incomes. The burden of tax payment falls directly on the person or individual responsible for paying it. Types of direct taxes Income tax: paid from an individual’s income. When income tax rise, there is little disposable income to spend on goods and services, so firms will face lower demand and sales, and will cut production, increasing unemployment. Lower income taxes will encourage more spending and thus higher production. Corporate Tax: tax paid on a company’s profits. When the corporate tax rate is increased, businesses will have lower profits left over to put back into the business and will thus find it hard to increase investment and produce more. This will discourage people from investing in businesses and economic growth could slow down. Reducing corporate tax will encourage more production and investment. Capital gains tax: taxes on any profits or gains that arise from the sale of assets held for more than a year. Inheritance tax: tax levied on inherited wealth. Property tax: tax levied on property/land. Advantages of direct taxes High revenue: as all people above a certain income level have to pay income taxes, the revenue from this tax is very high. 5  Can reduce inequalities in income and wealth: as they are progressive in nature – heavier taxes on the rich than the poor- they help in reducing income inequality. Economical - Direct taxes are economical in the sense that the cost of collecting these taxes is relatively low compared to revenue. Certainty - Direct taxes satisfy the canon of certainty. The taxpayers know how much they have to pay and on what basis they have to pay. Promotes elasticity Taxes are the earnings of the government, and when they fluctuate, the earnings also change. They can go higher or lower. Disadvantages of direct taxes Reduces work incentives: people may rather stay unemployed rather than be employed if it means they would have to pay a high amount of tax. Reduces enterprise incentives: corporate taxes may demotivate entrepreneurs to set up new firms, as a good part of the profits they make will have to be given as tax. Tax evasion: a lot of people find legal loopholes and escape having to pay any tax. Thus tax revenue falls and the govt. has to use more resources to catch those who evade taxes. Indirect Taxes An indirect tax is imposed on the expenditure of a person or it is imposed on goods and services.it is initially paid by producer ), but the burden of tax is passed over to some other individual (consumer ). Types of indirect taxes GST/VAT: these are included in the price of goods and services. Increasing these indirect taxes will increase the prices of goods and services and reduce demand and in turn profits. Reducing these taxes will increase demand. Customs duty: includes import and export tariffs on goods and services flowing between countries. Increasing tariffs will reduce demand for the products. 6  Excise Duty: tax on demerit goods like alcohol and tobacco, to reduce its demand. sales tax-it is a tax imposed on sale of goods and services.example VAT Advantages of indirect taxes Cost-effective: the cost of collecting indirect taxes is low compared to collecting direct taxes. Wider tax-base: Indirect taxes are paid by all people (young, old, unemployed etc.) who consume goods and services, so there is a larger tax base and good amount of revenue. Can reduce consumption of demerit goods: for example, excise duty can discourage the consumption of harmful goods such as alcohol, cigarette etc. Flexible: indirect tax rates are easier and quicker to alter/change than direct tax rates. Thus their effects are immediate in an economy. Disadvantages of indirect taxes Inflationary: The prices of products will increase when indirect taxes are added to it, causing inflation. Regressive: since all people pay the same amount of money, irrespective of their income levels, the tax will fall heavily on the poor than the rich as it takes more proportion of their income. Tax evasion: high tariffs on imported goods or excise duty on demerit goods can encourage illegal smuggling of the good. This may leads to black market Types of tax system Progressive Taxation Progressive taxes are those taxes ,the rate of taxation increases as incomes increase. which burdens the rich more than the poor. An income tax is the perfect example of progressive taxation. 7  For example, a person earning above $100,000 a month will have to pay a tax rate of 20%, while a person earning above $200,000 a month will have to pay a tax rate of 25%. Regressive Taxation Regressive Taxes are those taxes the rate of taxation falls as incomes increase, which burden the poor more than the rich,. An indirect tax like GST is an example of a regressive tax because everyone has to pay the same tax when they are paying for the product, rich or poor. For example, suppose the GST on a kilo of rice is $1; for a person who earns $500 dollars a month, this tax will amount to 0.2% of his income, while for a richer person who earns $50,000 a month, this tax will amount of just 0.002% of his income. The burden on the poor is higher than on the rich, making its regressive. Proportional Taxation Proportional Taxes are those taxes, the rate of taxation remains equal as incomes rise or fall. An example is corporate tax. All companies have to pay the same proportion of their profits in tax. For example, if the corporate tax is 30%, then whatever the profits of two companies, they both will have to pay 30% of their profits in corporate tax. Impacts of taxation Taxes can have various direct impacts on consumers, producers, government and thus, the entire economy. 8  The main purpose of tax is to raise income for the government which can lead to higher spending on health care and education. The impact depends on what the government spends the money on. For example, whether it is used to fund infrastructure projects or to fund the government’s debt repayment. Consumers will have less disposable income to spend after income tax has been deducted. This is likely to lead to lower levels of spending and saving. However, if the government spends the tax revenue in effective ways to boost demand, it shouldn’t affect the economy. Higher income tax reduces disposable income and can reduce the incentive to work. Workers may be less willing to work overtime or might leave the labour market altogether. However, there are two conflicting effects of higher tax: Substitution effect: higher tax leads to lower disposable income, and work becomes relatively less attractive than leisure – workers will prefer to work less. Income effect: if higher tax leads to lower disposable income, then a worker may feel the need to work longer hours to maintain his desired level of income – workers feel the need to work longer to earn more. The impact of tax then depends on which effect is greater. If the substitution effect is greater, then people will work less, but if income effect is greater, people will work more. Producers will have less incentive to produce if the corporate taxes are too high. Private firm aim on making profits, and if a major chunk of their profits are eaten away by taxes, they might not bother producing more and might decide to close shop. Conflicting effect of taxation On producers Producers will have less incentive to produce if the corporation taxes are too high, they might not bother producing more and might decide to close shop. On economy 9  When government imposes higher taxes ,People will spend less, demand will fall, producers will not get enough profit, this lead to less investment in the economy. This will create unemployment and low economic growth. Fiscal Policy Fiscal policy is a government policy which adjusts government spending and taxation to influence the economy. It is the budgetary policy, because it manages the government expenditure and revenue. When there is a budget surplus, the government employs an expansionary fiscal policy where govt. spending is increased and tax rates are cut. When there is a budget deficit, the government employs contractionary fiscal policy, where govt. spending is cut and tax rates are increased. Fiscal policy helps the government achieve its aim of economic growth, by being able to influence the demand and spending in the economy. It also indirectly helps maintain price stability, via the effects of tax and spending. Types of fiscal policy Expansionary Fiscal Policy During the period of deflation or recession government follow expansionary fiscal policy such as increases in government spending and decrease in taxes to increase AD there by increase economic growth and employment. Contractionary fiscal policy During the period of inflation government follow contractionary fiscal policies such as decrease government spending and increase taxes to achieve low inflation. ************************* 4.4-Monetary policy. 10  The money supply is the total value of money available in an economy at a point of time. The government can control money supply through a variety of tools including interest rate. Monetary Policy Monetary policy is a government policy to control money supply in an economy in order to attain growth and stability. these measures taken by central bank in the from interest rates, money supply and the exchange rate.It is usually used to maintain price stability, low unemployment and economic growth. Monetary policy measures (instruments) There are three main monetary policy measures, as described below. » Changes in interest rates — the main monetary policy measure is the use of interest rates to influence the level of economic activity. » Changes in money supply — the government can control the money supply in order to influence the level of economic activity. » Changes in foreign exchange rates — the foreign exchange market has a direct impact on the domestic money supply. The buying and selling of foreign currencies will therefore affect the money supply in an economy. Expansionary monetary policy(loose monetary policy) During the period of recession central bank follows Expansionary monetary policy by cutting interest rates. Low interest rates will encourage borrow and spend rather than saving, and businesses will invest more as they will have to pay lower interest on their borrowings. Thus, the higher money supply will mean more money being circulated increasing economic activity. Economic growth and an improvement in the balance of payments will be experienced and employment will rise. Contractionary monetary policy (tight monetary policy) During the period of inflation central bank follows contractionary monetary policy by increasing interest rates. Higher interest rates will reduce borrowing and 11 increase saving rather than spending, and businesses will reduce invest as they will have to pay high interest on their borrowings. Thus, the lower money supply among the government, producers and consumers, reducing economic activity. This helps slow down economic growth and reduce inflation. but at the cost of possible unemployment resulting from the fall in output The effects of monetary policy measures on macroeconomic aims Monetary policy measures can enable the government to achieve its macroeconomic aims » Economic growth — the monetary policy measure of lower interest rates can be used to achieve economic growth. This will tend to reduce the cost of borrowing for households and firms, thus boosting their consumption and investment respectively. Savers will receive a lower rate of return, discouraging savings and encouraging more spending. The combination of lower savings, more consumption and more investment will lead to economic growth. » Full employment/low unemployment — lower interest rates, will tend to cause economic growth. More spending and investment in the economy will tend to create more jobs. » Stable prices/low inflation —higher interest rates are used to limit consumption and investment in order to control the rate of inflation. » Balance of payments stability — a lower exchange rate, through government intervention in the foreign exchange market will tend to improve the international competitiveness of the country. Hence, this should help to improve the balance of payments. 4.5-Supply side policies- Supply-side policies are long-term strategies aimed at increasing the productive capacity of the economy by improving the quality and/or quantity of factors of production.. This can be shown by an outward shift of the country’s production possibility curve from PPC1 to PPC2 in Figure. 12  Reduction in taxation - such as cutting taxes on income and profits(income tax and cooperation tax) can increase firms investment in new plants.so firm can do research and development of new products and production process. It helps to achieve high economic growth and employment. Government can provide subsidies-.a subsidy is a financial assistance paid to businesses by government to improve their productivity. it encourages business people to start new business, encourage firms to make more investment in technology and machines and there by increase in productivity. Also Subsidy can be used to expand output and reduce market price.it helps to achieve high economic growth and employment Improving education and training -well educated trained workers can raise labour productivity and able to adapt to new methods of production.A government can assist firms by helping them design and finance training programs. If this does occur,workers’ skills and productivity may increase as well as their flexibility and mobility. it helps to achieve high economic growth and employment. Government can make some Labour market reforms Such as laws and regulation to reduce the power of trade unions and there by protect the right of workers and employers. More over in some countries have minimum wage laws to encourage more people in work. Deregulation: removing or easing the laws and regulations required to start and run businesses so they can operate and produce more output with reduced costs and hassle, encouraging investments. Privatization - transferring some public corporations to private ownership will increase efficiency and increase output, as the private sector has a profit-motive absent in public sector. 13  Public sector investments: investments in infrastructure such as transport and communication can greatly help the economy by making the flow of resources quick and easy, and facilitate faster growth. The effects of supply-side policy measures on macroeconomic aims Supply-side policy measures can enable the government to achieve its five macroeconomic aims » Economic growth — supply-side policy measures can be used to achieve sustainable economic growth by increasing the productive capacity of the economy. For example, investment in education and cuts in corporate taxes can help to boost economic growth in the long run. » Full employment/low unemployment — an increase in the economy’s productive capacity will tend to increase national output, thereby creating jobs in the economy in the long term. Also, supply-side policies such as investment in training can help to reduce both frictional and structural unemployment » Stable prices/low inflation — as supply-side policies increase the productive potential of the economy, they help to prevent the general price level from rising beyond control. Supply-side-policy measures increase the productive capacity of the conomy, resulting in economic growth, without higher prices. » Balance of payments stability — since supply-side policies can improve productivity and national output without putting upward pressure on the general price level, the international competitiveness of the country should improve. This helps to boost the economy’s export earnings. »Redistribution of income — supply-side policies such as greater investmentin education and training, along with greater incentives to work, tend to benefit low income earners more than high income earners. ****************************** 14