THE ROLE OF GOVERNMENT

Fiscal Policy
 Involves adjustments in the government’s taxation levels
 It can be used simultaneously with monetary policy to achieve macro – economic objectives
such as:
a) Full employment.
b) High levels of economic growth.
c) Low levels of inflation and price stability.
d) Balance of payment equilibrium.
e) Exchange rate stability.
Discretionary Fiscal Policy
 Deliberate changes to the levels of taxation and government expenditure in order to influence
aggregate demand.
Expansionary Fiscal Policy
 It involves increasing aggregate demand.

 Government will increase spending or cut taxes

 Low taxes will increase consumer spending because they have more disposable income.
 This may worsen the government budget deficit and the government will need to increase
borrowing.
 Excessive government expenditure leads to the crowding out effect.
 It crowds out private sector investment.
 The government can borrow funds from financial institutions leading to a situation where they
have little funds left.
 All firms in the economy will complete for the limited funds leading to excess demand for
loans.
 This excess demand for loans will lead to high interest rates and eventually discourage
investment.

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Evaluation
 In order to avoid the crowding out effect the government has to reduce excessive government
expenditure or find alternative sources of income to finance the deficit.
The impact of expansionary fiscal policy will depend on many factors:
a) What Else is Happening in the Economy?
 The U.S. tried to cut taxis in 2008? In theory this should boost spending however the economy
was experiencing falling house prices, lower confidence and a shortage of credit.
b) Crowding Out
 Does crowding out occur?
 Fiscal policy that involves higher spending and more government borrowing will lead to the
crowding out effect.
 The private sector has less to spend and invest therefore aggregate demand does not increase.
c) Time
 A key issue of expansionary fiscal policy is the state of the economy.
 If expansionary fiscal policy is pursued when the economy is close to the full capacity then
increased government borrowing is likely to cause the crowding out effect and high levels of
inflation.
 In a deep recession expansionary fiscal policy will not cause crowding out of inflation.
d) Supply Side Effect
 Lower income tax may increase the incentive to work.
 Higher government spending on education and training could increase long term labour
productivity but also government spending could be inefficient and wasteful – it depends on
what the government spends on.
Contractionary or Tight Fiscal Policy
 Involves reducing aggregate demand, that is, reduce government expenditure or increase taxes.

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 High taxes will reduce consumer spending (c)

 Tight Fiscal Policy will cause an improvement in the government budget deficit however
government may not want to adjust expenditure downwards for political reasons.
 Moreover, it is not easy to adjust taxation due to the resistance the government may get.
 Contractionary policy allows for increased private activity in a credit market this is known as
the crowding in effect.
 After a tax increase the government balance sheet shows more revenue.
 Similarly a spending cut is contractionary because it reduces aggregate demand
 A decrease in government borrowing could leave more money for private investment.
 There is less pressure on interest rates meaning more room for small borrowers.
 In the long run less government spending means fewer taxes, further increasing the pool of
available fund for the market
 However contractionary fiscal policy makes the populance less wealthy and decreases output or
national income.
Built in Stabilizers
 Refers to the automatic stabilization of macro – economic problems.
 The argument in this case is that the macro – economic problems will be solved without any
government intervention.
 The problems are solved naturally due to the changes in the business cycle.
 The limitation of built in stabilizers is that it is unlikely that micro-economic problems will
solve themselves automatically.
Advantages of Fiscal Policy
 Controls inflation
 Predict mistakes – government officials and economist predict what will occur in certain
economy over time and thus set fiscal policy or regulations to meet these assumptions however
false assumption can mean that the policy will hurt the economy.
 Can be used to boost the economy that is boosting aggregate demand for services and goods
across the country.
Critism of Fiscal Policy
Disincentives of Tax
 Increasing taxes to reduce aggregate demand may cause disincentives to work this causes a fall
productivity and aggregate supply however this may not happen if the income effect dominates.
Side Effects of Public Spending
 Reduced government spending to decrease inflation and could negatively affect public services
e.g. transport and education causing market failure and social in efficient.
 Poor information e.g. if government believes there is going to be a recession they will increase
aggregate demand however if this forecast is wrong and the economy grows too fast, the
government would cause inflation.

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Time Lags
 Fiscal policy can take too long to filter into the economy and it may be too late.
 Spending plans are only set once a year, there is also delay in implementing changes to
spending patterns this is called fiscal drag.
Budget Deficit
 Higher budget deficit require higher taxes in the future and may cause crowding out effect.
 Other components of AD e.g. if the consumer confidence is very low reducing taxes may not
lead to an increase in consumer spending.
It Depends on the Size of the Multiplier.
Crowding Out Effect

TAXATION
 A tax is a compulsory contribution imposed by a public authority on an individual, co –
operation or institution without any service rendered or given to the tax payer in return.
Direct tax
 It is paid directly to the government by the person on whom it is imposed.
 They are collected directly from the person making the payment and the burden cannot be
shifted e.g. income tax (PAYE) proportional.

Advantages Disadvantages

 Equitable – the burden cannot be shifted –  Inconvenient – they reduce the payer’s
equity can be obtained through progression disposable income.
 Low income earners are exempted  They are Evadable – it is easy for business
 Economical – the cost of collection is low. to invade direct taxes by giving incorrect
 They are mostly collected at the sources. information
 Certain – payers know how much is due  Affect the willingness ability to work and
from them and the authorities know the save if they are high.
amount of revenue they can expect.  If they are too heavy they discourage
 They also minimize corruption. savings and investments.
 Elastic – the state can use the direct taxes
if they suddenly need emergency funds.
 Productive – as a community grows the
return from direct taxes automatically
expands.
 Anti – Inflationary – they can be used to
control inflation.

Indirect Tax
 They are imposed on goods and services and are meant to be shifted to the consumer, they
include value added tax (VAT), excise duties.

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Advantages Disadvantages

 Changes in indirect tax can cause changes in  Makes distribution of income more unequal
the pattern of demand by varying relative because indirect taxes are more regressive
prices thereby affecting demand e.g. an than direct taxes.
increase in the duty on petrol.  Higher indirect taxes can cause cost push
 They are an instrument in correcting inflation if it leads to a rise in inflation
externalities – indirect tax can be used as a expectation.
means of making the polluter pay thereby  If indirect taxes are too high it creates an
internalizing external costs incentive to avoid taxes through boot legging.
 Costs of production and consumption.  Revenue from indirect tax can be uncertain
 Indirect taxes are not likely to distort the especially when inflation is low or when there
choices the people have to make between is a recession causing a fall in consumer
work and leisure and therefor have less spending.
effect on work incentives.  There is a potential loss of welfare from duties
 Can be changed more easily than direct taxes. e.g. Loss of producer and consumer surplus.
This gives policy makers more flexibility  Higher indirect taxes affect the household with
unlike direct taxes that can only be changed lower income.
once a year.  Many people are unaware of how much they are
 They are less easy to avoid. paying in direct tax.
 They provide an incentive to save thus help
to provide finance for capital investment.
 The use of indirect taxes leaves people free
to make a choice whereas direct taxes leave
people with less income in their pockets.

Progressive, Proportional and Regressive Tax

 Taxes can also be categorized as progressive, regressive or promotional and the distinction has
to deal with the behavior of the tax.
Regressive Tax
 They can also be thought of taxes where the marginal rate of tax is less than the average tax
rate.
 It refers to a tax where a smaller proportion of income is taxed at higher income levels e.g.
consumption tax like VAT.
Proportional Tax
 It is sometimes called a flat tax. It is a tax where everyone pays the same fraction of income tax
regardless of the income they earn.
 Proportional taxes can be described as taxes where the marginal and average tax rates are the
same
Progressive Tax
 It is tax where low income earners play a lower fraction of their income entities.
 Can also be thought of as taxes where the marginal rate of tax is higher than the average rate of
tax e.g. the first $1000 at 8%.

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 Examples are income tax and co – operate tax.

Why Do Government Impose Taxes
 To finance government expenditure
 To reduce income inequality e.g. the use of progressive tax.
 To prevent excessive economic fluctuation such as inflation and deflation.
 To promote economic growth.
 To increase investment e.g. tax exemption.
 Import duties to raise competitiveness against foreign goods as well exemption of domestic
firms importing raw materials.
 To influence the balance of payment position, that is, higher taxes in the form of import duties
to restrict spending on foreign goods
 Encourage by abolishing or lowering export tax
 To protect people by imposing indirect taxes on liquor, beer and cigarettes.
 To discourage car ownership due to congestion in roads, high import duties on cars are
imposed.
 To encourage mechanization and automation.
 Foreign worker levy to make the cost of foreign workers more expensive.
1.2

1
progressive
0.8

0.6
proportional
0.4

0.2 regresive

0
0 0.2 0.4 0.6 0.8 1 1.2

BUDGET DEFICIT
 A budget deficit refers to a situation where government expenditure is greater than revenue.
 A budget deficit is among the major problems that are faced by many developing countries.
Reasons for Budget Deficit
Low Levels of Tax
 In less economically developed countries many people are employed in the informal sector and
hence they invade tax.

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Narrow Tax Base

 Less tax revenue is collected and the tax collection mechanisms are inefficient thus they are
high incidences of tax evasion.
High Levels of Expenditure
 Expenditure is high because of high population growth thus there is always need to improve
medical and educational facilities.
 Infrastructure is poorly developed thus the government spends a lot of money in improving
infrastructure.
Droughts and Other Shocks.
 The government is forced to spend a lot of money to give relief.
Poor Economic Management by the Government
Expansion Fiscal Policy.
Cost of Wars (Unexpected Spending)
Financial Intervention to Bail out Banks and Other Financial Institutions.
Aging In Population.

Socio – Economic Problems of a Budget Deficit

High Levels of Interest Rates and Inflation.
 The budget deficit can either be financed by local, international or external sources.
 External sources include borrowing funds from World Bank and IMF.
 The problem is that it leads to a debt crisis or situation where debt servicing will be too high for
a country.
 The government can either borrow from the formal or non - formal sector.
 Borrowing from the financial sector is inflationary and it leads to an increase in interest rates
(crowding out effect)
 On the other hand borrowing from the non-financial sector is non-inflationary.
 In order to reduce inflation and interest rate, it is necessary to reduce the budget deficit to a one
digit level.
 When the budget deficit as a % of GDP is less than 10% or is very low, interest rate levels will
be reduced.
 Budget deficit implies low taxes and high government expenditure. This will cause aggregate
demand to increase and this is inflationary.
High Taxes and Lower Spending
 In the future the government may have to increase taxes or cut spending in order to reduce the
deficit.
 Increasing taxes will reduce disposable income and lower standards of living
 Reducing government assistance in all sectors of the economy will lower standards of living as
well

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Increases Interest Rates

 If the government sells more bonds it is likely to cause interest rates to increase in order to
attract investors.
 The increase in interest rates will push up other interest rates as well.
Poverty
Unemployment
Low Levels of Economic Growth.
Higher Debt and Interest Rate Payment.
Increased Aggregate Demand

Remedies for a Budget Deficit

Increasing Revenue
 The government can increase its sources of revenue through:
a) Widening the tax base
b) Investing in income generating projects.
Creating More Employment Opportunities.
 So that people may fall within the tax bracket
Rationalisation of Expenditure.
 Cut down expenditure on things that are not income generating.
 Ministries should make sure that they spend within their budget.
Reduce Government Expenditure
 Government expenditure can be reduced by merging ministries that perform similar functions in
order to avoid duplication.
Improving the Tax Collection Mechanism.
Evaluation
There is no simple answer to whether budget deficit is harmful or helpful because it depends on a
number of factors.
1. When the Budget Occurs
 The Keynesians suggests that a budget deficit during a recession is good thing.
 Government spending is used to kick start the economy.
 The deficit spending will promote higher growth which will enable higher taxes in the future.
 However if the deficit occurs during a period of strong economic growth the deficit will crowd
out the private investors.
2. It Depends on why they are Borrowing.
 If the government borrows to invest and improve infrastructure it may be able to overcome
market failure and improve the productive capacity of the economy.
 However if government borrows and misspends the money or uses it as transfer payments they
maybe a limited increase in productive capacity.
3. It Depends On The Cost Of Borrowing
4. It Depends On The Future Prospects Of The Economy.

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Conclusion
So Does a Budget Deficit Matter?
 Yes a budget deficit matters but there is no simple answer.
 It is reasonable to suggest that over the course of the business cycle government should seek to get as
close as possible to balancing the structural deficit.
 However, they may be a good reason to run the deficit e.g. if the government wishes to fund public
investment which offers a decent rate of return.
 Also in a recession a budget deficit can play an important role in managing AD.
 In a recession the traditional fears of a budget deficit i.e. inflation, interest rate, crowding out often just
don’t occur.
 Government spending financed by borrowing from the private sector can return to the economy to full
employment quicker.

SUPPLY SIDE POLICIES

 These are government attempts to increase productivity and shift aggregate supply to the right

 Most supply side policies aim to enable the free market to function more efficiently by reducing
government interference
Privatization
 This involves the selling of state owned assets to the private sector.
 It is argued that the private sector is more efficient in running business because they have a profit motive
to reduce costs and develop better services
Deregulation
 This involves reducing barriers to entry to make the market more competitive
 Competition tends to lead to lower prices and better quality of goods
Reducing Income Tax
 It is argued that lower income tax increase the initiative to work harder leading to more output
Increased Education and Training
 Better training can lead to improved labour productivity and increase AS
 Often there is under provision of education in the market economy, leading to market failure

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 Therefore the government may need to subsidies suitable education and training schemes
 However government intervention will cost money, requiring higher taxes, it will take time to have an
effect and government my subsidise the wrong type of training
Reducing the Power of Trade Unions
 This will reduce the amount of time spent on strikes and increase the efficiency of firm
Reducing State Welfare Benefits
 This may encourage the unemployed to take up jobs
Providing Better Information about Jobs
 This may reduce frictional unemployment
Deregulate Financial Markets
 This will allow more competition and lower borrowing costs for firms and consumers
Lower Tariff Barriers
 This will increase trade
Improving Transport and Infrastructure
 Due to market failure this is likely to need government intervention to improve transport and reduce
congestion
 This will help firms to reduce costs
Deregulate the Labour market
To increase competitiveness government can make it easy to hire and fire workers
Removing unnecessary red Tape and Bureaucracy which add to a Firms Costs

Benefits of Supply Side Policies

Lower Inflation
 Shifting aggregate supply to the right will lead to lower prices
 By making the economy more efficient, supply side policies will help reduce cost push inflation
Lower unemployment
 Supply side policies help to reduce structural, frictional and real wage unemployment and therefore seek
to reduce the natural rate of unemployment
Improved economic growth
 Supply side policies will increase the sustainable rate of economic growth by increasing AS
Improved Trade and Balance of Payments
 Making firms more productive and competitive means that they will be able to export more
Supply Side Objectives
 Improve incentives and invest in people skills
 Increase labour and capital productivity
 Increase the occupational and geographical mobility of labour
 Increase capital investment as well as R and D by firms
 Promoting more competition and stimulate a faster pace of invention and innovation
 Provide a platform for sustained non-inflationary growth of an economy
 Encourage the start up and expansion of new firms

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