Lecture 14 1
Macroeconomic Analysis 2003
Fiscal Policy 1: Tax and Spending MultipliersRefer: Public Finance excel file from the
hm-treasury.co.uk
Lecture 14 2
Objectives and Instruments of the Fiscal Policy
• Objectives– Stabilisation
– Redistribution
– Growth
– Public services • Pure public goods
• Semi-public goods
• Instruments– Tax: How high should
it be?
– Spending: how should it be allocated
– Debt: how can it be stabilised
Lecture 14 3
Fiscal Policy with the IS-LM Model: Keynesian Model
Y1 Y2
i1
i2
IS1 IS2
LM
TcGrIcc
Y 1011
1
rkYP
M
o
Keynes assumes that Investment is not that sensitive to the interest rate. LM is flat because high liquidity preference.
Lecture 14 4
AD1
Yr YN
Pr
Pf
ADf AS:
Finetuning
LASFiscal Policy to Bring Economy from Recession to Recovery
Fiscal InstrumentsTax cutsMore spendingHigher public borrowing
o
Under employment to Full Employment
A
B
cOverheating
syyaPP et
rkYP
M
TcGrIcc
Y 1011
1
TcGkY
P
MIc
cY 10
1
1
1
1
LM:
IS:
Ph
Lecture 14 5
32.5
33
33.5
34
34.5
35
35.5
36
36.5
37
37.5
38
38.5
39
39.5
1980-81 1982-83 1984-85 1986-87 1988-89 1990-91 1992-93 1994-95 1996-97 1998-99 2000-01 2002-03 2004-05 2006-07
%
C2: Tax-GDP ratioForecast
Lecture 14 6
VAT16% Corporation tax
8%
Excise duties9%
National insurance16%
Income tax29%
Council tax4%
Other13%
Business rates5%
C3: GOVERNMENT RECEIPTS
Lecture 14 7
How much should be the tax rate be to maximise the government revenue ?
Revenue
Tax rates Tax rates
2250 tttR
t1 t2
2250 tttR
R-maxR1
R-max
Higher tax causesTax avoidanceTax evasionSmuggling
Optimal tax Rate
Lecture 14 8
A Simple Laffer Curve Model:A Numerical Example
2250 tttR
Where R is revenue in billion of pounds, t is the tax rate. The tax rate that maximises the revenue is given by
0450
tttR t = 12.5
There are two tax rates that can raise the same revenue. 2250200 tt
0100252 tt ;2
)100(42)25()25(2
,1
tt =
20,52
15252
,1
tt
Lecture 14 9
LS0
LS1
L0L1
w
w(1+t)
0
Higher Labour Income Tax Reduces Labour Supply
Lecture 14 10
r
r(1+tr)
K1 K0
Higher Tax rate on Capital Income (interest) Reduces Capital Accumulation
0
Higher tax rate discourages private Investment
Lecture 14 11
How much should a government tax and spend and how should tax revenue and government expenditure behave
over the cycle?
G
T=T(Y)
T-G=0
T-G<0
T-G>0Surplus
Y
T
Benefit Cost
Tax, Spending
Costs
Benefits
Lecture 14 12
B3: Total managed expenditure
37
39
41
43
45
47
49
1980-81 1982-83 1984-85 1986-87 1988-89 1990-91 1992-93 1994-95 1996-97 1998-99 2000-01 2002-03
% o
f G
DP
Forecast
Lecture 14 13
Social security27% Other health and personal social
services4%
NHS15%
Transport3%
Education13%Defence
6%
Law & order6%
Other expenditure12%
Debt interest5%
Industry, agriculture & employment4%
Housing & environment5%
B4: GOVERNMENT SPENDING BY FUNCTION
Lecture 14 14
£million
1996-97 1997-98 1998-99 1999-00 2000-01
England 193280 196336 202288 213044 226446
Scotland 24680 25029 25830 26970 28428
Wales 13678 13838 14410 14877 15622
Northern Ireland 9081 9261 9627 10033 10906
Total identifiable expenditure 240719 244464 252155 264924 281402
Non-identifiable expenditure 34986 34144 38202 38203 40436
Total expenditure on services 275705 278608 290357 303127 321838
£ per head
England 3937 3984 4087 4282 4529
Scotland 4813 4886 5045 5268 5558
Wales 4683 4728 4913 5065 5302
Northern Ireland 5441 5512 5701 5930 6424
Total identifiable expenditure 4093 4142 4257 4452 4709
Non-identifiable expenditure 595 579 645 642 677
Total expenditure on services 4688 4721 4902 5094 5386
Source: Public Expenditure Statistical Analyses 2002-2003, table 8.1
How much are People Getting from the Government on Average?
Lecture 14 15
Education Culture,Health and Social Central Total
media and
personal
security Admin
sportservice
s
North East 746 109 1196 2126 61 5148
North West 747 76 1190 1960 46 4888
Yorkshire and Humberside 742 145 1139 1764 39 4669
East Midlands 700 72 1024 1648 44 4280
West Midlands 744 93 1077 1755 41 4491
South West 674 84 1081 1658 42 4312
Eastern 696 76 1014 1518 47 4142
London 767 102 1384 1636 65 5067
South East 668 72 1031 1450 44 4000
Total of all England 719 90 1132 1692 47 4529
Source: Public Expenditure Statistical Analyses 2002-2003, table 8.12b
Predominance of Social Security and Health Expenses in Public Spending
Lecture 14 16
-8
-6
-4
-2
0
2
4
6
8
10
1980-81 1982-83 1984-85 1986-87 1988-89 1990-91 1992-93 1994-95 1996-97 1998-99 2000-01 2002-03 2004-05 2006-07
% o
f G
DP
Public sector net borrow ing Surplus on current budget
ForecastA4: BUDGET BALANCES
Lecture 14 17
-8
-6
-4
-2
0
2
4
6
8
10
1980-81 1982-83 1984-85 1986-87 1988-89 1990-91 1992-93 1994-95 1996-97 1998-99 2000-01 2002-03 2004-05 2006-07
% o
f G
DP
Public sector net borrow ing Surplus on current budget
ForecastA5: CYCLICALLY ADJUSTED BUDGET
BALANCES
Lecture 14 18
Equilibrium national income:
TcGIcc
Y 1011
1
Government expenditure multiplier:
11
1
cG
Y
Adverse tax multiplier:
1
1
1 c
c
T
Y
Balanced budget multiplier:
111
1
1
1
1
c
c
cT
Y
G
Y
National income changes by the amount of tax. Equal change in G and T is not macro economically neutral.
Balance budget multiplier: Spirit for Public Speding
Lecture 14 19
National Income: GICY
Consumption function: DYccC 10
Disposable income TYYD
Proportional tax function: YttT 10
Assume I and G as constants. Equilibrium Income:
]tc-[c*)tcc-(1
1010
111
GIY
Automatic Stabiliser: 1111 1
1
)tcc-(1
1
cG
Y
Automatic Stabiliser: Cyclical Fine Tuning of the Economy
Lecture 14 20
Comparison Between the Lump-Sum Transfer and Automatic Stabiliser
• The economy now responds less to changes in autonomous spending, Some increase in income is taxed away.
• Multiplier in automatic Stabiliser case is less than in the lump-sum tax case.
• Output varies less than in the Lump-sum tax case. Therefore the fiscal policy is called an automatic stabiliser.
1111 1
1
)tcc-(1
1
cG
Y
Lecture 14 21
20
25
30
35
40
45
50
55
60
65
70
1970-71 1973-74 1976-77 1979-80 1982-83 1985-86 1988-89 1991-92 1994-95 1997-98 2000-01 2003-04 2006-07
% o
f G
DP
Forecast
A11: PUBLIC SECTOR NET DEBT
Lecture 14 22
Balanced Budget: 0 TG Change in debt = Primary deficit plus debt servicing
Primary Budget Deficit: rBTGB
0 TG rB
B
0B rBGT A primary surplus is required to pay the interest if debt is to remain constant Bet Borrowing Requirement as a Proportion to GDP:
Y
rB
Y
TG
Y
B
Budget Deficit and Debt
Lecture 14 23
Y
B
Y
Y
Y
B
Y
B
(1)
Y
Bg
Y
B
Y
B
Y
Bg
Y
B
Y
B
(2)
From the Previous page:
Y
rB
Y
TG
Y
B
(3)
Y
rB
Y
TG
Y
Bg
Y
B
Y
B
(4)
Y
Bgr
Y
TG
Y
B
(5)
0
Y
B
Y
Bgr
Y
GT
(6)
Sustainable Debt: Condition on growth rate of Output and Interest rates
Lecture 14 24
Inflation Tax: Seigniorage
Inflation rate
RevenueFrom theInflation tax
*
R*
Lecture 14 25
Exercises• How high should be the tax revenue?
• Balance budget multiplier
• Automatic stabiliser
• Sustainable debt
• Major sources of tax revenue
• Major headings for public spending
• Impact of taxes on labour supply, capital accumulation and growth