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