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Economic Modelling Lecture 10 Fiscal Policy to Fine-Tune the Economy 1 Objectives of Fiscal Policy • • • • • • • • • • • • Macroeconomic stabilisation Higher growth rate of output Full employment Stable prices: low rate of inflation stable interest rate and exchange rates Equity: horizontal and vertical Efficiency in resource allocation Provision of public goods Externality Market failure Public private partnership 2 Instruments of Fiscal Policy • Taxes Direct (income, wealth) Indirect (VAT, Excise, Tariff and duties) Subsidies (consumption and production) • Spending Pure Public goods ( defence, law and order, roads) Semi-public goods (education, health, sanitation) • Debt Borrowing from the private sector -Crowding Out From the central banks -inflationary tax 3 Who Bears the Burden of Taxes and How does tax-spending affect the economy? • Stabilisation role • Economic certainty, growth dividend • Producers Labour supply (work hours, leaves, retirement) Production: taxed sectors vs. subsidised sector Trade: domestic vs. foreign goods Excise duties • Consumers Current vs. future consumption Composition of consumption (VAT and market prices, Sin goods) • Traders and investors Choice of trading partners Location investment 4 Golden Rule of Fiscal Policy in the UK • Over Economic Cycles Government will borrow only to invest and not to fund current spending. Ratio of public debt to GDP will be held at stable and prudent levels. 5 Macroeconomic Stabilisation Role of Tax and Spending T = tY G=T Tax and G Spending T>G Surplus in boom G T<G Deficit in recession 0 YF Income T 6 Balanced Budget Multiplier with Lump-Sum Taxes The real national income is given by the IS Curve: 1 Y c0 I G c1T 1 c1 Positive Government expenditure multiplier: . Negative tax multiplier: Y 1 G 1 c1 c1 Y T 1 c1 Y Y =1/(1-c1) - c1/(1- c1) = 1 G T A change of 100 in both G and T also raised income by 100. Balanced change in G and T is not macro economically neutral. 7 The balanced budget multiplier: Automatic Stabiliser with Proportional Taxes C c0 c1YD Consumption: Disposable income: YD Y T T t 0 t1Y Tax Revenue Income (IS curve): 0 c1 1 0 t1 1 Y = c0 + c1YD + I + G 1 Y * [c 0 - c1 t 0 I G ] (1 - c1 c1 t 1 ) The multiplier = 1/(1-c1+c1t1) <1/(1- c1), so the economy responds less to changes in autonomous spending when t1 is positive. High T when Y is high. Low T when Y is low. 8 How much should be the tax rate to maximise the government revenue ? Tax compliance R-max Tax avoidance Tax evasion Revenue R-low Revenue=F(t) t-Low t-Rmax tH Tax rate 9 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 = 1 2 t 2515 5,20 1 2 10 Tax Brackets and Effective Rates of Taxes for three Individuals Individuals Gross income Personal Allowances Taxable income At starting rate At basic rate At higher rate Total tax payment Effective tax rate Starting rate Basic rate A B 12000 27000 4615 4615 7385 22385 Calculation tax 192 192 1202.3 4502.3 0 0 1394.3 4694.3 0.116192 0.173863 Higher rate 1920 27980 29,900 or above Allawances 4615 C 53000 4615 48385 192 6153.4 7394 13739.4 0.259234 0.1 0.22 0.4 11 Structure of Public Revenue in the UK (www.HMTreasury.gov.UK/Economic Data and Tools) C3: GOVERNMENT RECEIPTS Business rates 5% Other 13% Council tax 4% VAT 16% Corporation tax 8% Excise duties 9% Income tax 29% National insurance 16% 12 Why Does the Tax Ratio Go Up and Down? 13 How High Should be Public Spending? Costs of public spending Cost and Benefit Of spending C=B Benefits of spendin 0 G* Size of spending 14 B4: GOVERNMENT SPENDING BY FUNCTION Social security 27% Other expenditure 12% Housing & environment 5% Law & order 6% Defence Industry, agriculture & 6% employment Debt interest 5% 4% Other health and personal social services 4% NHS 15% Transport 3% Education 13% (www.HM-Treasury.gov.UK/Economic Data and Tools) 15 16 (www.HM-Treasury.gov.UK/Economic Data and Tools) (www.HM-Treasury.gov.UK/Economic Data and Tools) 17 References • • • • • • • • • • • • • • • Blanchard (5, 7, 26) http://www.statistics.gov.uk/themes/economy/default.asp http://www.ifs.org.uk/public/bn20.pdf, http://www.hm-treasury.gov.uk , Aghevli B B (1977), Inflationary Finance and Growth, Journal of Political Economy, vol. 85, no.6 pp. 1295-1307. Barro, R. J. (19740, "Are Government Bonds Net Wealth?," Journal of Political Economy pp. 1095-1117. Bhattarai (2003) Macroeconomic Impacts of Taxes: A General Equilibrium Analysis, University of Hull. Bhattarai K. (2001) A Prototype Multi-Sectoral Multi-household General equilibrium Tax Model, Hull Advances in Policy Economics Working paper no. 9 forthcoming in Problems and Perspective Management, Spring 2004. Bhattarai K. and J. Whalley (1999) “Role of labour demand elasticities in tax incidence analysis with hetorogeneous labour” Empirical Economics, 24:4, pp.599-620. Bhattarai and J Whalley (2000) “General Equilibrium Modelling of UK Tax Policy” in S. Holly and M Weale (Eds.) Econometric Modelling: Techniques and Applications, pp.69-93, the Cambridge University Press, 2000. Clark Tom , M Elsby and S Love (2001) Twenty Five Years of Falling Investment? Trends in Capital Spending on Public Services, Institute of Fiscal Studies. Dilnot A, C.Emmerson and H.Simpson (2002) The IFS Green Budget: January, Institute of Fiscal Studies, Commentary 87, 7 Ridgemount Street, London WC1E 7AE. Emmerson C. and C Frayne (2002) Challenges for the July Spending Review, HM Treasury (2002) Reforming Britain’s Economic and Financial Policy, Palgrave. Institute for Fiscal Studies (2002), The IFS Green Budget, Janaury. Shoven, J.B. and J. Whalley (1984) “Applied General-Equilibrium Models of Taxation and International Trade: An Introduction and Survey,” Journal of Economic Literature 22, 1007-1051 18 •http:/www.hull.ac.uk/php/ecskrb