4.5 Role of the State in the Macroeconomy
Transfer payments- a redistribution of income and wealth made without goods or services being received in return
Automatic stabilisers- effects which help influence the path of economic growth due to cyclical changes in tax
revenue and welfare costs, without direct intervention by gov
Current expenditure- government spending on the day to day running of the country e.g. wages. An increase will see
a shift in the SRAS curve to the right
Capital expenditure- government spending on physical assets will help to develop infrastructure, allowing businesses
to operate effectively and efficiently. This will help shift the LRAS curve to the right and PPF outwards
Balanced budget- this occurs when government expenditure is equal to gov revenue through taxations
Budget deficit- where government expenditure exceeds tax rev
Budget surplus – where taxation exceeds government expenditure
Crowding in - when an increase in government spending investment leads to an expansion of economic activity (real
GDP) which incentivises private sector firms to raise the own levels of capital investment and employment.
Crowding out- rapid growth of government spending leads to a transfer of scarce productive resources from the
private sector to the public sector where productivity might be lower. Can also lead to higher taxes and i/r which
squeezes profits, investment employment in the private sector
Public sector debt- owed by central and local government and by public corporations
Quantitative easing- a central bank uses QE to inc the base supply of money in the banking system and encourage
banks to lend at cheaper I/R i.e. to small and medium sized businesses
Direct tax- A tax on income and wealth e.g. income tax or corporation tax where the burden of the tax cannot be
passed on to someone else
Indirect tax- imposed on producers (suppliers) by the government
Laffer curve- relationship between economic activity and the rate of taxation which suggests there’s an optimum tax
rate which maximises total revenue
Progressive tax- the marginal rate of income tax rises as incomes rises
Proportional tax- when the marginal rate of income tax is constant leading to a constant average rate of tax
Regressive tax- the rate of tax paid falls as incomes rise
Tax burden- measures total tax revenue as a % of GDP
Discretionary fiscal policy- deliberate attempts to affect the level and growth of AD using changes in gov spending,
direct and indirect taxation
Fiscal deficit- when government expenditure is higher than the revenue from taxes in a given year
National debt- a governments total outstanding debt- effectively what the government still owed from the budget
deficits accumulated over time
,National savings- total public and private sectors saving measured as a share of GDP. Saving is the difference
between income and consumption
Public sector- made up of central government, local government and public corporation
AAA credit rating – the best credit rating that can be given by credit rating agencies to corporate or governemtn
bonds, effectively indicating that the risk of debt default is negligible
External shocks – an unexpected event beyond the control of the country’s -large negative impact on its economy
LRPC- the long run Philips curve is assumed to be a vertical line at the natural rate of u/e where the rate of inflation
has no effect on the rate of u/e
Sovereign debt wealth- a broad term for the widespread problem of high government fiscal deficits and rising national
debts In many developed countries especially in the vulnerable countries inside European currency zone
Transfer pricing- method of pricing goods and services transferred within a multinational or trans-national company in
order to reduce tax burdens and maximise profits.
Cyclical budget deficit- temporary budget position, related to business cycle. Deficit may occur during a recession, tax
rev fall and expenditure of u/e benefits increases- gov increase sending to stimulate the economy
§ Size of the deficits is influenced by the state of the economy: in a boom, tax receipts are relatively high and
spending on unemployment benefit is low.
Structural budget deficit- a budget which is either in a deficit or surplus due to an imbalance in the revenue and
expenditure of the government, it exists at every point in the business cycle. Doesn’t matter if a county is in a boom or
recession, country would still run a deficit (planned spending)
§ The structural deficit is that part of the deficit which is not related to the state of the economy. This part of the
fiscal deficit will not disappear when the economy recovers.
,4.5.1 Public Expenditure
The government spends money for a number of reasons; macroeconomic management objectives. They aim for
equity and equality by providing services to individuals or groups who’d otherwise not receive them. Gov spending
can correct market failure by providing public goods and fixing externalities
Types of expenditure:
§ Capital government expenditure- l/t gov spending- spending on investment goods such as new roads, schools,
hospitals will be consumed in over a year
§ Current government expenditure- s/t. – general government final consumption plus transfer payments plus
interest payments
§ General final consumption is spending on goods and services that’ll be consumed within the next year, such as
public sector salaries
§ Transfer payments- gov payments for which there is no corresponding output, money is taken from one group
and given to another e.g. benefits and pensions. Not included in GDP
§ Gov spend money on interest payments for national debt
Major areas of expenditure:
§ defence (6%), protection (4%), education (12%), pensions (20%), welfare (15%), transport (2%) and health care
(18%).
§ 2014 Government spending was 38% of GDP. Finland – progressive taxation. Gini coefficient- 0.26
Composition and size of public expenditure:
§ In most mixed and free economies, the lower the average income of the country, lower is likely to be the
percentage of GDP spent by the Gov- poorer countries tend to have a lower tax revenue , due to avoidance,
inefficiency at collecting and a smaller amount of wealth to tax. Citizens in higher income countries demand
more services from their governments ; gov provided goods are income elastic=, access to improving
technologies more is demanded from NHS compared to demands of state healthcare in poorer countries.
§ However, amongst developed countries- significant differences in size of gov spending. For example USA has
much lower state spending - due to attitudes in that country.
§ Global Financial Crisis - huge increases in government spending as governments had to increase welfare
payments and some governments used taxpayer money to bail out of banks. 2010 pursued austerity to reduce
debt. Because of austerity- did not complement expansionary monetary policy
§ Europe and Japan will see pressure on government spending due to aging populations meaning larger pension
bills and higher levels of care needed.
Impacts:
Productivity and growth:
§ Free market economists- gov spending is wasteful and cause inefficiency. FM= profit motive whereas Gov has
a social welfare. However, the government is able to enjoy EOS when it provides goods= improves productivity.
§ Gov provide the, roads, necessary for the economy to run efficiently.
§ Education creates human capital necessary for growth whilst healthcare system reduces number of days
workers lose from serious illness. Spending on research and development may not be done by the private
sector and the government will undertake it to give businesses a long term competitive edge.
§ Keynesians- for gov intervention- multiplier effect. Higher growth and lower unemployment
,Impacts on living standards:
§ Government spending can cause large improvements in living standards- GOV corrects market failure -provides
public goods =improves social welfare.
§ They reduce absolute poverty - providing benefits and basic goods - education and healthcare. In developing
countries, GOV do not have the resources = leads to malnutrition, poor water etc.
§ There is some debate about how much the government can contribute to improved living standards. It is argued
gov will be inefficient at providing goods and services and will have a negative disincentive impact on workers,
meaning that output overall is reduced and so living standards fall.
§ Government suffers from the principal agent problem since they make decisions on behalf of the people and
individuals may have spent that money differently= there is a loss in welfare =fall in living standards. However,
the political system means that society decides the government and so therefore decides to an extent where it
would like money to be spent.
Crowding out (classical economist theory) – good evaluation point gov spending
Definition- when increased public sector spending leads to less private sector spending
If the government borrows from the private sector, there are fewer funds available for the private sector, which could
lead to crowding out- excessive gov borrowing increases the demand for loanable funds in the market - pushing up
equilibrium I/R making it more £££ for firms finance investment projects and reach their hurdle= reduce investment in the
economy harming both s/r and l/r econ growth
§ For Gov to spend money above their tax rev- gov has to borrow from individuals and businesses. However the
amount of money in the economy available to borrow doesn’t increase. Gov will thus be competing with private
sector for finance= higher I/R= discourage firms from investing and individuals from buying on credit. This therefore
will reduce both short run econ growth and Long run- reducing AD, LRAS, Productive potential
§ Limited number of resources in the economy = every resource used in gov spending- less resources available for
private sector – the result is that gov borrowing crowds out private sector- may lead to no increases in AD
§ FM economists- investment is more efficient If done by the private sector- gov targets investment poorly
§ Crowding out is felt most at full employment but not always the case. Transfer payments may have no impact on
output – wouldn’t cause crowding out as resources are taken from one group and given to another. When U/E is
high – extra gov spending could lead to crowding in where it encourages investment through the multiplier
§ Keynesians don’t agree with crowding out
Incomes inc proportion of gov spending inc
Evaluating crowding out
§ Bond yield at all time low- crowding out is unlikely
§ Depends on degree of spare capacity. Well targeted, timely stimulus spending can absorb under-utilised capacity-
crowding in- Keynesian multiplier
§ Future tax payers burdened with tax in l/r. May reduce incentives to work
§ Demand pull inflation and overheating- depends upon spare capacity, inelastic or elastic
§ Bond yields are low- reality and likelihood of crowding out is slim
§ Just a theory may not work in presence
§ Probability of crowding out is low with lots of spare capacity
Keynesian economists counter that well-targeted and timely stimulus spending helps to support growth, output, jobs and
competitiveness. Indeed higher government spending can be partially self-financing and an important policy option when
private demand is depressed
,4.5.2 taxation
Laffer - raising taxes on Rich - point where TRev decreases as tax rate inc - higher income tax = disincentive for workers
to work for higher incomes as heavily taxed. The income effect becomes negative whereby workers work -earn less to
reach satisfactory income = reducing income tax revenue. Higher taxes promotes tax evasion/ avoidance and
incentivising the highly skilled workers/entrepreneurs to emigrate to countries where tax rates are lower. Not only will
this reduce expected tax revenue for gov to use in redistributing income - dampen productive potential as innovation/
entrepreneurial spirit decreases. Free market
Example – France raised income tax around 2015- Brain drain
Lower tax rates – substitution effect > income effect- substitute leisure for more work- hence tax rev increases
Impacts of tax changes:
Income distribution:
Progressive tax system will inc the equality of income distribution as more money is proportionately taken from the
rich than from the poor. A regressive one will decrease income equality. Inheritance taxes= most progressive form of
taxation.
Ev: Using tax to redistribute income – doesn’t given poor anything- systems needs to be supported with benefits
Progressive, proportional and regressive taxes:
§ Progressive tax - those who are on higher incomes pay a higher marginal rate of tax; pay a higher % of their income
on tax. Direct taxes tend to be progressive, for example income tax.
§ Regressive tax - the proportion of income paid in tax falls as the income of the taxpayer rises. Higher incomes pay a
smaller percentage of their income on the tax. Most indirect taxes are regressive, for example everyone pays same
VAT -those on higher wages = represents a small proportion of their earnings compared to those on low wages.
§ Proportional tax - the proportion of income paid on tax remains the same whilst the income of the taxpayer changes
e.g. 10% of income is spent on tax, regardless of income. Everyone pays the same percentage of their income on the
tax.
Trade balance
§ MPC decreases = less income, improve C.A. deficit
§ MPI falls with higher tax rates
§ Long run less investment
§ When AD falls- don’t need to invest- reduce competitiveness When AD is high need more investment to replace over-
utilised resources
Capital output ratio- rate of investment
, Incentives to work:
High marginal rates of tax = discourage individuals from working. free market economists argue - the supply of
labour is relatively elastic and a reduction in marginal taxes on income will lead to a significant increase in work as
individuals work longer hours, accept promotions and more people join the workforce.
§ High taxes on high income earners could encourage them to move abroad and taxes on the poor may lead to a
poverty trap.
§ high income tax reduces incentives more than high vat. thus, a switch from direct to indirect taxes may increase
incentives.
§ However-no hard evidence for the link between income tax and incentives. Nordic countries have high taxes and
welfare benefits but have similar rates of growth compared to lower tax and gov spending countries like US and
UK.
§ It can be argued that higher taxes mean people have to work longer hours in order to maintain their income and
so even increases the incentive work.
Real output and employment:
§ Some taxes affect AD whilst others affect AS. A rise in direct taxes will reduce the level of disposable income =fall
in their spending = fall in AD. It could also cause a fall in leftover profits for businesses and therefore a fall in
investment. The effect this has on output will depend on where the economy is: whether it is at full employment
or not.
§ Higher indirect taxes and NICs increase costs for firms = decrease SRAS. Depend on where the economy is
producing.
§ Income taxes cause a disincentive to work and therefore reduce LRAS as the most skilled workers go overseas and
more people become inactive.
Price level:
§ Taxes can impact LRAS, SRAS and AD. Therefore, these changes will impact price depending on where the
economy is producing.
§ Indirect taxes, particularly VAT, often cause cost push inflation.
FDI flows
§ Low taxes on profit and investment tend to encourage businesses to invest in a country since it will help them to see
a higher
Problem – game theory. Only attract more investment if your tax rate is lower than other countries who keep their
tax rate high.
Corporation tax- attracts FDI
§ FDI and planned FDI inc markedly since the tax cut was announced
Transfer payments- a redistribution of income and wealth made without goods or services being received in return
Automatic stabilisers- effects which help influence the path of economic growth due to cyclical changes in tax
revenue and welfare costs, without direct intervention by gov
Current expenditure- government spending on the day to day running of the country e.g. wages. An increase will see
a shift in the SRAS curve to the right
Capital expenditure- government spending on physical assets will help to develop infrastructure, allowing businesses
to operate effectively and efficiently. This will help shift the LRAS curve to the right and PPF outwards
Balanced budget- this occurs when government expenditure is equal to gov revenue through taxations
Budget deficit- where government expenditure exceeds tax rev
Budget surplus – where taxation exceeds government expenditure
Crowding in - when an increase in government spending investment leads to an expansion of economic activity (real
GDP) which incentivises private sector firms to raise the own levels of capital investment and employment.
Crowding out- rapid growth of government spending leads to a transfer of scarce productive resources from the
private sector to the public sector where productivity might be lower. Can also lead to higher taxes and i/r which
squeezes profits, investment employment in the private sector
Public sector debt- owed by central and local government and by public corporations
Quantitative easing- a central bank uses QE to inc the base supply of money in the banking system and encourage
banks to lend at cheaper I/R i.e. to small and medium sized businesses
Direct tax- A tax on income and wealth e.g. income tax or corporation tax where the burden of the tax cannot be
passed on to someone else
Indirect tax- imposed on producers (suppliers) by the government
Laffer curve- relationship between economic activity and the rate of taxation which suggests there’s an optimum tax
rate which maximises total revenue
Progressive tax- the marginal rate of income tax rises as incomes rises
Proportional tax- when the marginal rate of income tax is constant leading to a constant average rate of tax
Regressive tax- the rate of tax paid falls as incomes rise
Tax burden- measures total tax revenue as a % of GDP
Discretionary fiscal policy- deliberate attempts to affect the level and growth of AD using changes in gov spending,
direct and indirect taxation
Fiscal deficit- when government expenditure is higher than the revenue from taxes in a given year
National debt- a governments total outstanding debt- effectively what the government still owed from the budget
deficits accumulated over time
,National savings- total public and private sectors saving measured as a share of GDP. Saving is the difference
between income and consumption
Public sector- made up of central government, local government and public corporation
AAA credit rating – the best credit rating that can be given by credit rating agencies to corporate or governemtn
bonds, effectively indicating that the risk of debt default is negligible
External shocks – an unexpected event beyond the control of the country’s -large negative impact on its economy
LRPC- the long run Philips curve is assumed to be a vertical line at the natural rate of u/e where the rate of inflation
has no effect on the rate of u/e
Sovereign debt wealth- a broad term for the widespread problem of high government fiscal deficits and rising national
debts In many developed countries especially in the vulnerable countries inside European currency zone
Transfer pricing- method of pricing goods and services transferred within a multinational or trans-national company in
order to reduce tax burdens and maximise profits.
Cyclical budget deficit- temporary budget position, related to business cycle. Deficit may occur during a recession, tax
rev fall and expenditure of u/e benefits increases- gov increase sending to stimulate the economy
§ Size of the deficits is influenced by the state of the economy: in a boom, tax receipts are relatively high and
spending on unemployment benefit is low.
Structural budget deficit- a budget which is either in a deficit or surplus due to an imbalance in the revenue and
expenditure of the government, it exists at every point in the business cycle. Doesn’t matter if a county is in a boom or
recession, country would still run a deficit (planned spending)
§ The structural deficit is that part of the deficit which is not related to the state of the economy. This part of the
fiscal deficit will not disappear when the economy recovers.
,4.5.1 Public Expenditure
The government spends money for a number of reasons; macroeconomic management objectives. They aim for
equity and equality by providing services to individuals or groups who’d otherwise not receive them. Gov spending
can correct market failure by providing public goods and fixing externalities
Types of expenditure:
§ Capital government expenditure- l/t gov spending- spending on investment goods such as new roads, schools,
hospitals will be consumed in over a year
§ Current government expenditure- s/t. – general government final consumption plus transfer payments plus
interest payments
§ General final consumption is spending on goods and services that’ll be consumed within the next year, such as
public sector salaries
§ Transfer payments- gov payments for which there is no corresponding output, money is taken from one group
and given to another e.g. benefits and pensions. Not included in GDP
§ Gov spend money on interest payments for national debt
Major areas of expenditure:
§ defence (6%), protection (4%), education (12%), pensions (20%), welfare (15%), transport (2%) and health care
(18%).
§ 2014 Government spending was 38% of GDP. Finland – progressive taxation. Gini coefficient- 0.26
Composition and size of public expenditure:
§ In most mixed and free economies, the lower the average income of the country, lower is likely to be the
percentage of GDP spent by the Gov- poorer countries tend to have a lower tax revenue , due to avoidance,
inefficiency at collecting and a smaller amount of wealth to tax. Citizens in higher income countries demand
more services from their governments ; gov provided goods are income elastic=, access to improving
technologies more is demanded from NHS compared to demands of state healthcare in poorer countries.
§ However, amongst developed countries- significant differences in size of gov spending. For example USA has
much lower state spending - due to attitudes in that country.
§ Global Financial Crisis - huge increases in government spending as governments had to increase welfare
payments and some governments used taxpayer money to bail out of banks. 2010 pursued austerity to reduce
debt. Because of austerity- did not complement expansionary monetary policy
§ Europe and Japan will see pressure on government spending due to aging populations meaning larger pension
bills and higher levels of care needed.
Impacts:
Productivity and growth:
§ Free market economists- gov spending is wasteful and cause inefficiency. FM= profit motive whereas Gov has
a social welfare. However, the government is able to enjoy EOS when it provides goods= improves productivity.
§ Gov provide the, roads, necessary for the economy to run efficiently.
§ Education creates human capital necessary for growth whilst healthcare system reduces number of days
workers lose from serious illness. Spending on research and development may not be done by the private
sector and the government will undertake it to give businesses a long term competitive edge.
§ Keynesians- for gov intervention- multiplier effect. Higher growth and lower unemployment
,Impacts on living standards:
§ Government spending can cause large improvements in living standards- GOV corrects market failure -provides
public goods =improves social welfare.
§ They reduce absolute poverty - providing benefits and basic goods - education and healthcare. In developing
countries, GOV do not have the resources = leads to malnutrition, poor water etc.
§ There is some debate about how much the government can contribute to improved living standards. It is argued
gov will be inefficient at providing goods and services and will have a negative disincentive impact on workers,
meaning that output overall is reduced and so living standards fall.
§ Government suffers from the principal agent problem since they make decisions on behalf of the people and
individuals may have spent that money differently= there is a loss in welfare =fall in living standards. However,
the political system means that society decides the government and so therefore decides to an extent where it
would like money to be spent.
Crowding out (classical economist theory) – good evaluation point gov spending
Definition- when increased public sector spending leads to less private sector spending
If the government borrows from the private sector, there are fewer funds available for the private sector, which could
lead to crowding out- excessive gov borrowing increases the demand for loanable funds in the market - pushing up
equilibrium I/R making it more £££ for firms finance investment projects and reach their hurdle= reduce investment in the
economy harming both s/r and l/r econ growth
§ For Gov to spend money above their tax rev- gov has to borrow from individuals and businesses. However the
amount of money in the economy available to borrow doesn’t increase. Gov will thus be competing with private
sector for finance= higher I/R= discourage firms from investing and individuals from buying on credit. This therefore
will reduce both short run econ growth and Long run- reducing AD, LRAS, Productive potential
§ Limited number of resources in the economy = every resource used in gov spending- less resources available for
private sector – the result is that gov borrowing crowds out private sector- may lead to no increases in AD
§ FM economists- investment is more efficient If done by the private sector- gov targets investment poorly
§ Crowding out is felt most at full employment but not always the case. Transfer payments may have no impact on
output – wouldn’t cause crowding out as resources are taken from one group and given to another. When U/E is
high – extra gov spending could lead to crowding in where it encourages investment through the multiplier
§ Keynesians don’t agree with crowding out
Incomes inc proportion of gov spending inc
Evaluating crowding out
§ Bond yield at all time low- crowding out is unlikely
§ Depends on degree of spare capacity. Well targeted, timely stimulus spending can absorb under-utilised capacity-
crowding in- Keynesian multiplier
§ Future tax payers burdened with tax in l/r. May reduce incentives to work
§ Demand pull inflation and overheating- depends upon spare capacity, inelastic or elastic
§ Bond yields are low- reality and likelihood of crowding out is slim
§ Just a theory may not work in presence
§ Probability of crowding out is low with lots of spare capacity
Keynesian economists counter that well-targeted and timely stimulus spending helps to support growth, output, jobs and
competitiveness. Indeed higher government spending can be partially self-financing and an important policy option when
private demand is depressed
,4.5.2 taxation
Laffer - raising taxes on Rich - point where TRev decreases as tax rate inc - higher income tax = disincentive for workers
to work for higher incomes as heavily taxed. The income effect becomes negative whereby workers work -earn less to
reach satisfactory income = reducing income tax revenue. Higher taxes promotes tax evasion/ avoidance and
incentivising the highly skilled workers/entrepreneurs to emigrate to countries where tax rates are lower. Not only will
this reduce expected tax revenue for gov to use in redistributing income - dampen productive potential as innovation/
entrepreneurial spirit decreases. Free market
Example – France raised income tax around 2015- Brain drain
Lower tax rates – substitution effect > income effect- substitute leisure for more work- hence tax rev increases
Impacts of tax changes:
Income distribution:
Progressive tax system will inc the equality of income distribution as more money is proportionately taken from the
rich than from the poor. A regressive one will decrease income equality. Inheritance taxes= most progressive form of
taxation.
Ev: Using tax to redistribute income – doesn’t given poor anything- systems needs to be supported with benefits
Progressive, proportional and regressive taxes:
§ Progressive tax - those who are on higher incomes pay a higher marginal rate of tax; pay a higher % of their income
on tax. Direct taxes tend to be progressive, for example income tax.
§ Regressive tax - the proportion of income paid in tax falls as the income of the taxpayer rises. Higher incomes pay a
smaller percentage of their income on the tax. Most indirect taxes are regressive, for example everyone pays same
VAT -those on higher wages = represents a small proportion of their earnings compared to those on low wages.
§ Proportional tax - the proportion of income paid on tax remains the same whilst the income of the taxpayer changes
e.g. 10% of income is spent on tax, regardless of income. Everyone pays the same percentage of their income on the
tax.
Trade balance
§ MPC decreases = less income, improve C.A. deficit
§ MPI falls with higher tax rates
§ Long run less investment
§ When AD falls- don’t need to invest- reduce competitiveness When AD is high need more investment to replace over-
utilised resources
Capital output ratio- rate of investment
, Incentives to work:
High marginal rates of tax = discourage individuals from working. free market economists argue - the supply of
labour is relatively elastic and a reduction in marginal taxes on income will lead to a significant increase in work as
individuals work longer hours, accept promotions and more people join the workforce.
§ High taxes on high income earners could encourage them to move abroad and taxes on the poor may lead to a
poverty trap.
§ high income tax reduces incentives more than high vat. thus, a switch from direct to indirect taxes may increase
incentives.
§ However-no hard evidence for the link between income tax and incentives. Nordic countries have high taxes and
welfare benefits but have similar rates of growth compared to lower tax and gov spending countries like US and
UK.
§ It can be argued that higher taxes mean people have to work longer hours in order to maintain their income and
so even increases the incentive work.
Real output and employment:
§ Some taxes affect AD whilst others affect AS. A rise in direct taxes will reduce the level of disposable income =fall
in their spending = fall in AD. It could also cause a fall in leftover profits for businesses and therefore a fall in
investment. The effect this has on output will depend on where the economy is: whether it is at full employment
or not.
§ Higher indirect taxes and NICs increase costs for firms = decrease SRAS. Depend on where the economy is
producing.
§ Income taxes cause a disincentive to work and therefore reduce LRAS as the most skilled workers go overseas and
more people become inactive.
Price level:
§ Taxes can impact LRAS, SRAS and AD. Therefore, these changes will impact price depending on where the
economy is producing.
§ Indirect taxes, particularly VAT, often cause cost push inflation.
FDI flows
§ Low taxes on profit and investment tend to encourage businesses to invest in a country since it will help them to see
a higher
Problem – game theory. Only attract more investment if your tax rate is lower than other countries who keep their
tax rate high.
Corporation tax- attracts FDI
§ FDI and planned FDI inc markedly since the tax cut was announced
