Macroeconomic Analysis 2003
Fiscal Policy 1: Tax and Spending Multipliers
Refer: Public Finance excel file from the
hm-treasury.co.uk
Lecture 14
1
Objectives and Instruments of the
Fiscal Policy
• Objectives
–
–
–
–
• Instruments
– Tax: How high should
it be?
– Spending: how should
it be allocated
– Debt: how can it be
stabilised
Stabilisation
Redistribution
Growth
Public services
• Pure public goods
• Semi-public goods
Lecture 14
2
Fiscal Policy with the IS-LM Model: Keynesian Model
IS1
IS2
M
 kY    r
P
LM
i2
i1
1

Y
c0  I r   G  c1T 
1  c1
o
Y1
Y2
Keynes assumes that Investment is not that sensitive to the
interest rate. LM is flat because high liquidity preference.
Lecture 14
3
Fiscal Policy to Bring Economy from Recession to Recovery
LAS
e
P

P
 a y  y   s
AS:
ADf
t
Ph
Pf
Pr
AD1
Overheating
c
Fine
tuning
B
M
LM: P  kY    r
1
c  I r   G  c T 
Y

IS:
1 c
A
0
1
1
Y

1M
1 



c

I

kY

G

c
T

 0  
1 
1  c1 

P





o
Yr
Fiscal Instruments
YN
Tax cuts
Under employment to Full Employment
More spending
Lecture 14
Higher public borrowing
4
39.5
39
Forecast
C2: Tax-GDP ratio
38.5
38
37.5
37
%
36.5
36
35.5
35
34.5
34
33.5
33
32.5
1980-81
1982-83
1984-85
1986-87
1988-89
1990-91
1992-93
Lecture 14
1994-95
1996-97
1998-99
2000-01
2002-03
2004-05
5
2006-07
C3: GOVERNMENT RECEIPTS
Business rates
Other 5%
13%
Council tax
4%
VAT
16%
Corporation tax
8%
Excise duties
9%
Income tax
29%
Lecture 14
National insurance
16%
6
How much should be the tax rate be to
maximise the government revenue ?
Revenue
R-max
R-max
R1
Rt  50t  2t 2
Rt  50t  2t 2
Tax rates
t1
Optimal tax
Rate
Lecture 14
t2
Tax rates
Higher tax causes
Tax avoidance
Tax evasion
Smuggling 7
A Simple Laffer Curve Model:A Numerical
Example
Rt  50t  2t 2
Where R is revenue in billion of pounds, t is the tax rate.
The tax rate that maximises the revenue is given by
Rt
 50 4t  0  t = 12.5
t
There are two tax rates that can raise the same revenue.
200 50t  2t 2 
2  4(100)
)
25

(

)
25

(

t 2  25t 100 0 ; t ,t 
=
1 2
2
t ,t  2515  5,20
1 2
2
Lecture 14
8
Higher Labour Income Tax Reduces Labour Supply
LS1
LS0
w(1+t)
w
0
L1
Lecture 14
L0
9
Higher Tax rate on Capital Income (interest) Reduces
Capital Accumulation
Higher tax rate
discourages private
Investment
r(1+tr)
r
0
K0
K1
Lecture 14
10
How much should a government tax and spend and how
should tax revenue and government expenditure behave
over the cycle?
Benefit
Cost
T=T(Y)
T
Costs
Benefits
Surplus
T-G>0
G
T-G<0
Tax, Spending
Lecture 14
T-G=0
Y
11
B3: Total managed expenditure
49
Forecast
47
% of GDP
45
43
41
39
37
1980-81
1982-83
1984-85
1986-87
1988-89
1990-91
1992-93
Lecture 14
1994-95
1996-97
1998-99
2000-01
2002-03
12
B4: GOVERNMENT SPENDING BY FUNCTION
Social security
27%
Other health and personal social
services
4%
NHS
15%
Other expenditure
12%
Housing & environment
5%
Transport
3%
Law & order
6%
Industry, agriculture & employment
Debt interest
4%
5%
Lecture 14
Defence
6%
Education
13%
13
How much are People Getting from the Government on Average?
£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,
Lecture 14
table 8.1
14
Predominance of Social Security and Health Expenses in Public Spending
Education
Culture,
Health
and
Social
Central
media
and
person
al
securi
ty
Admin
sport
service
s
Total
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
Lecture 14
15
10
A4: BUDGET BALANCES
Forecast
8
6
% of GDP
4
2
0
-2
-4
-6
-8
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
Public sector net borrow
ing
Lecture
14 Surplus on current budget
16
10
A5: CYCLICALLY ADJUSTED BUDGET
BALANCES
8
Forecast
6
% of GDP
4
2
0
-2
-4
-6
-8
1980-81
1982-83
1984-85
1986-87
1988-89
1990-91
1992-93
1994-95
Public sector net borrow ing
Lecture 14
1996-97
1998-99
2000-01
2002-03
2004-05
2006-07
Surplus on current budget
17
Balance budget multiplier: Spirit for Public Speding
Equilibrium national income:
1

Y
c0  I  G  c1T 
1  c1
Government expenditure multiplier:
Y
1

G 1  c1
Adverse tax multiplier:
c1
Y

T
1  c1
Balanced budget multiplier:
Y Y
1
c


 1 1
G T 1  c1 1  c1
National income changes by the amount of tax.
Equal change in G and T is not macro economically neutral.
Lecture 14
18
Automatic Stabiliser: Cyclical Fine Tuning of the Economy
National Income:
Y  C  I G
Consumption function:
C  c0  c1YD
Disposable income
YD  Y  T
T  t 0  t1Y
Proportional tax function:
Assume
I
and
G as constants.
Equilibrium Income:
Y
1
* [c 0 - c1 t 0  I  G ]
(1 - c1  c1 t 1 )
Y
1
1


Automatic Stabiliser:
G (1 - c1  c1t1 ) 1  c1 
Lecture 14
19
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.
Y
1
1


G (1 - c1  c1t1 ) 1  c1 
• 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 theLecture
fiscal
policy
is
called
an
14
20
automatic stabiliser.
70
Forecast
A11: PUBLIC SECTOR NET
DEBT
65
60
55
% of GDP
50
45
40
35
30
25
20
1970-71
1973-74
1976-77
1979-80
1982-83
1985-86
1988-89
Lecture 14
1991-92
1994-95
1997-98
2000-01
2003-04
21
2006-07
Budget Deficit and Debt
G  T   0
Balanced Budget:
Change in debt = Primary deficit plus debt servicing
Primary Budget Deficit:
B  G  T   rB
G  T   0
B  0

B
r
B
 T  G   rB
A primary surplus is required to pay the interest if debt is to remain
constant
Bet Borrowing Requirement as a Proportion to GDP:
B G  T  rB


Y
Y
Y
Lecture 14
22
Sustainable Debt: Condition on growth rate of Output and Interest rates
 B  B Y B
  

Y Y
Y  Y
(1)
B
B
 B
B
 B  B
    g
  
g 
Y
Y
Y
Y 
Y  Y
B G  T  rB


From the Previous page:
Y
Y
Y
B
B G  T rB
 B
    g 

Y
Y
Y
Y
Y 
B
 B  G T
  
 r  g 
Y
Y
Y 
T G
B
 B
   0 
 r  g 
Y
Y
Y 
Lecture 14
(2)
(3)
(4)
(5)
(6)
23
Inflation Tax: Seigniorage
Revenue
From the R*
Inflation tax
*
Lecture 14
Inflation rate
24
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
Lecture 14
25