Evaluate the macroeconomic effects of the UK government trying to reduce its budget
deficit, assuming economic growth remains weak. (25)
Economic growth is an increase in the amount of goods and services produced per head of
the population over a period of time. Budget deficit occurs when amount of government
spending exceeds total tax revenue received by the government. In order to reduce budget
deficit, government can decrease spending, increase taxation and reduce borrowing.
Decrease in government spending and increase in taxation mean that both public and
private sectors will have less jobs available due to less money available to invest in labour
thus leads to higher unemployment rate. Also, decrease in government spending will
directly reduce aggregate demand and increase in taxation will reduce aggregate demand
through reduced profits available for investment and reduced disposable income available
for consumption. As aggregate demand falls, demand for labour falls, further increasing
unemployment rate. Decrease in employment rate caused by reduced aggregate demand
will eventually lead to fall in long run aggregate supply, as shown by the graph below, as AD
falls from AD0 to AD1, LRAS has also fallen from LRAS0 to LRAS1. For example, in 2011, the
UK government has made student nurses to pay for their own education, this leads to fall in
supply of nurses and eventually fall in LRAS.
However, this depends on what areas of government spending are reduced, and what taxes
are raised. If the government is cutting spending on benefits for unemployed, then more
people will be forced into work, therefore unemployment will fall. If indirect taxes such as
VAT are raised, in order to maintain the standard of living by consuming the same amount
of goods and services, more people will be incentivized to work, reducing unemployment.
These measures to reduce fiscal deficit can also lead to higher inequality. If the government
cut spending on welfare payments for the relatively low-income group, income gap between
the poor and rich will be further enlarged. And as unemployment tends to happen on the
low-skilled labour rather than the high-skilled workers due to higher price elasticity supply
of labour, income inequality will be further worsened. In the UK, taking all the austerity
measures into account, including cuts to public services and changes to taxes and welfare,
the poorest tenth of the population are by far the hardest hit, seeing a 38% decrease in their
net income over the period 2010-15. By comparison, the richest tenth will have lost the
least, comparatively, seeing a 5% fall in their income.
However, progressive taxation system for income taxes means that higher income will have
to be taxed a higher proportion of their income, thus can redistribute the tax revenue to the
lower income through benefits, therefore reducing income inequality. Also, wealth
inequality can also be reduced if taxation on inherited wealth is raised.
Although with some side effects as listed above, UK government has successfully made use
of austerity to reduce fiscal deficit since 2010, the deficit has fallen considerably to 1.3% of
GDP this year (2019/20). However, debt has continued to increase from 63% of GDP in
2009/10 and is expected to be over 82% this year. In order to maintain low fiscal deficit as
well as minimizing the negative side effects austerity brings about, decrease in government
deficit, assuming economic growth remains weak. (25)
Economic growth is an increase in the amount of goods and services produced per head of
the population over a period of time. Budget deficit occurs when amount of government
spending exceeds total tax revenue received by the government. In order to reduce budget
deficit, government can decrease spending, increase taxation and reduce borrowing.
Decrease in government spending and increase in taxation mean that both public and
private sectors will have less jobs available due to less money available to invest in labour
thus leads to higher unemployment rate. Also, decrease in government spending will
directly reduce aggregate demand and increase in taxation will reduce aggregate demand
through reduced profits available for investment and reduced disposable income available
for consumption. As aggregate demand falls, demand for labour falls, further increasing
unemployment rate. Decrease in employment rate caused by reduced aggregate demand
will eventually lead to fall in long run aggregate supply, as shown by the graph below, as AD
falls from AD0 to AD1, LRAS has also fallen from LRAS0 to LRAS1. For example, in 2011, the
UK government has made student nurses to pay for their own education, this leads to fall in
supply of nurses and eventually fall in LRAS.
However, this depends on what areas of government spending are reduced, and what taxes
are raised. If the government is cutting spending on benefits for unemployed, then more
people will be forced into work, therefore unemployment will fall. If indirect taxes such as
VAT are raised, in order to maintain the standard of living by consuming the same amount
of goods and services, more people will be incentivized to work, reducing unemployment.
These measures to reduce fiscal deficit can also lead to higher inequality. If the government
cut spending on welfare payments for the relatively low-income group, income gap between
the poor and rich will be further enlarged. And as unemployment tends to happen on the
low-skilled labour rather than the high-skilled workers due to higher price elasticity supply
of labour, income inequality will be further worsened. In the UK, taking all the austerity
measures into account, including cuts to public services and changes to taxes and welfare,
the poorest tenth of the population are by far the hardest hit, seeing a 38% decrease in their
net income over the period 2010-15. By comparison, the richest tenth will have lost the
least, comparatively, seeing a 5% fall in their income.
However, progressive taxation system for income taxes means that higher income will have
to be taxed a higher proportion of their income, thus can redistribute the tax revenue to the
lower income through benefits, therefore reducing income inequality. Also, wealth
inequality can also be reduced if taxation on inherited wealth is raised.
Although with some side effects as listed above, UK government has successfully made use
of austerity to reduce fiscal deficit since 2010, the deficit has fallen considerably to 1.3% of
GDP this year (2019/20). However, debt has continued to increase from 63% of GDP in
2009/10 and is expected to be over 82% this year. In order to maintain low fiscal deficit as
well as minimizing the negative side effects austerity brings about, decrease in government
