Fiscal and Supply-side Policy

The History of Fiscal Policy

1850s-

1950s

• ‘Sound finance’ approach• A balanced budget and low tax & spend

1950s-

1970s

• Use of fiscal policy in demand management• Keynesian belief that government should actively manage aggregate demand

running a deficit if necessary

1980s-

2008?

• Return to principles of ‘sound finance’ and balanced budgets• Fiscal policy used to promote aggregate supply, not demand• 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

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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• Minimum wage• Welfare to work• Education spending• Reducing corporation tax• Enterprise zones

Giving incentives to people to work

Ensuring industry have skilled labour available

Incentives to invest

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 = lower AD

Higher unemployment

Higher benefit payments and

lower tax incomeBudget deficit

Reduces impact of contractionary

multiplier

Dampening deflationary effects

Weak pound improves X-M

Excess demand in economy

Wage levels rise to draw workers into

labour force

Welfare payments fall and tax

revenues increase

Surplus budget takes heat out of

economy

Dampening inflationary effects

Automatic stabilisers soften boom and bust

Government deficit rises in a recession...

And falls during a boom.

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 structural budget deficit (an imbalance in the economy which leads to a deficit even when the economy is growing at the trend rate)

Context – The Government are attempting to reduce the deficit during a period of low or negative growth. Is it reasonable to expect to ‘balance the books’ when the economy 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 invest

Altering the distribution of income and wealthi.e. The use of progressive taxation and redistributive public spending

Trade-off between equity and efficiency

But 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 equality can be achieved by;

• Free state services• Welfare support• Progressive taxation• Pre-1979 approach

= 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 sector

Financial 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 lower incomes have a higher propensity to consume.

During periods where spare capacity exists the public spending can usefully employ resources without crowding out the private sector. Furthermore, if the spending is on capital projects (e.g. road building) the private sector may experience higher demand as government 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 curveIf 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 there is also no tax income.

Government income from tax increases as the rate of tax increases, and falls after a certain tax rate is reached as the disincentives send economic activity into reverse.

This model is named after the supply-side economics Arthur Laffer. What is not clear is at what level of taxation government revenues go into reverse? Some economists argue that in the Keynesian era of big government the ‘tax burden’ was excessive and lower revenues were the result. It is interesting to consider that this logic leads to the conclusion that to increase tax income a fall in taxation is necessary.

Big or small?

Other factors which affect the decision on how big 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

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What makes a good tax?

Having considered how much we tax, let us now consider what constitutes a ‘good’ tax.

Adam Smith’s

Cannons of Taxation

Equitable

Economical

Convenient

Certain

And we may add efficiency 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 change in relation to income. To some extent people can choose whether to pay VAT as they choose whether to purchase goods. Some goods are exempt from VAT (e.g. children’s clothes) in an attempt to 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 significant cost. It is generally a good tax, although not progressive.

Monetary and Fiscal harmonyIm

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Control of inflation

Macro-economic stability

Long-run growth

Interest Rates being used for demand management, although redundant in promoting increased demand at present and not as yet rising to curb cost-push inflationary pressures. Other policies are needed.

Drive to achieve a balanced budget through austerity and pay down national debt. Quantitative easing employed to attempt to maintain credit availability to promote aggregate demand and supply.

Intention to reduce size of the state and create competitive and efficient markets which will drive the recovery.

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 work or will a ‘lost decade’ result as the economy cannot lift itself out of a prolonged slump?

Limitations of fiscal policy

•Not possible to accurately assess costs and benefits

•Difficult to predict effects of policy•May make industries less internationally competitive

•Political resistance

•Brain drain•Disincentives to work•Political pressures

•Long time to have an effect (e.g. education)•Social effects (e.g. cutting benefits)•Difficult to predict effects

• Increased PSNCR may require increased money supply therefore inflation and no benefit to output

•Borrowing must be paid back, with interest•Blunt tool•Risk when large debts build up

As a demand management

tool

As a supply-side tool

To correct market failure

To redistribute

wealth

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

Single currency means loss of monetary control at a

national level

Possible move toward a

common fiscal framework or

tax harmonisation?

Controls over budget deficits

(3% of GDP)

Greater integration with Europe means the transfer of national economic powers to European institutions (e.g. the ECB). Those countries which have adopted the Euro can no longer use interest rates as a demand management tool. This causes problems if their economic cycle is out of sync with the rest of Europe. The use of fiscal policy for counter-cyclical management is also limited by rules over deficits.

The benefits however include currency 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 in line and remove national competitive advantages which distort the patterns of trade. The argument against is that this would further remove powers from national government to respond ‘locally’ to economic shocks and pressures.

Greece has a massive deficit and poorly structured economy. They are under pressure to pay down their debts but the massive ‘austerity’ cuts required will be devastating to an already depressed economy. If they had their own currency its value would be falling rapidly boosting exports and reducing imports, bringing demand into the economy. They would also have monetary tools at their disposal to promote consumption and investment. As part of the Euro they are instead suffering from a strong German economy pulling up the value of the Euro. They have, however, benefitted from European bail-outs.