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Fiscal Policy - Effects

Author: Geoff Riley  Last updated: Sunday 23 September, 2012

Microeconomic effects of tax changes

  1. Taxation and work incentives:
  • Changes in income taxes affect the incentive to work. Consider the impact of a rise in income tax.
  • This has the effect of reducing the post-tax income of those in work because for each hour of work taken the total net income is now lower.
  • This might encourage the individual to work more hours to maintain his/her target income.
  • Conversely, the effect might be less work since the return from each hour worked is less.
  • Changes to the tax and benefit system seek to reduce the risk of the ‘poverty trap’ – where households on low incomes see little financial benefit from supplying extra hours of their labour
  1. Taxation and the Pattern of Demand
  • Changes to indirect taxes can alter the pattern of demand for goods and services
  • For example, the rising value of duty on cigarettes and alcohol is designed to cause a substitution effect and reduce the demand for what are perceived as “de-merit goods”.
  • The use of indirect taxation and subsidies is often justified on the grounds of instances of market failure. But there might also be a justification based on achieving a more equitable allocation of resources – e.g. providing basic state health care free at the point of use.
  1. Taxation and labour productivity
  • Some economists argue that taxes can have a significant effect on the intensity with which people work and productivity. But there is little strong empirical evidence to support this view. Many factors contribute to improving productivity – tax changes can play a role - but isolating the impact of tax cuts on productivity is extremely difficult.

The Laffer curve

  • Created by the US supply-side economist Arthur Laffer, this curve explores a relationship between tax rates and tax revenue collected by governments
  • It argues that as tax rates rise, total tax revenues grow at first but at a diminishing rate.
  • There may be a tax burden which yields the highest tax revenues. Beyond this, further hikes in taxation serve only to lower revenues
  • The Laffer curve has been used as a justification for cutting taxes on income and wealth - the argument being that improved incentives to work and create wealth will broaden the base of tax-paying businesses and individuals and also reduce the incentive to avoid and evade paying tax.
  • A Keynesian view is that lower direct taxes stimulate higher spending within the circular flow which itself boosts demand, output, profits and employment, all of which can drive tax revenues higher.
  • The Laffer curve came back into the news in spring 2009 when the Labour government announced a rise in the top rate of income tax designed to raise more than £5bn per year. Laffer curve supporters argue that it might fail to do this, perhaps even cause revenues to fall.

Fiscal Policy and the Economic Cycle

Many countries introduced a fiscal stimulus during the years 2008-2010 to boost confidence and demand and prevent a deflationary slump. But how effective is fiscal policy in the aftermath of a huge global demand shock? What are some of the consequences of a big rise in government borrowing?

  • Fiscal policy is the Government’s main demand-management tool.
  • Government spending, direct and indirect taxation and the budget balance can be used “counter-cyclically” to help smooth out some of the volatility of real national output particularly when the economy has experienced an external shock.
  • Discretionary fiscal changes are deliberate changes in taxation and govt spending – for example a decision by the government to increase total capital spending on road building.
  • Automatic fiscal changes (also known as ‘automatic stabilisers’) are changes in tax revenues and state spending arising automatically as the economy moves through the trade cycle.

Automatic stabilizers refer to how fiscal policy instruments will influence the rate of GDP growth and help counter swings in the business cycle.

  • During phases of high GDP growth, automatic stabilizers reduce the growth rate and avoid the risks of an unsustainable boom and accelerating inflation. With higher growth, the government will receive more tax revenues and there will be a fall in unemployment so the government will spend less on unemployment and other welfare benefits.
  • In a recession, because of lower incomes, people pay less tax, and government spending on unemployment benefits will increase. The result is an automatic increase in government borrowing with the state sector injecting extra demand into the circular flow.

Recent evidence from the OECD suggests that a government allowing the fiscal automatic stabilizers to work might help to reduce the volatility of the cycle by up to 20 per cent. The strength of the automatic stabilizers is linked to the size of the government sector (e.g. government spending as a % of GDP), the progressivity of the tax system and how many welfare benefits are income-related. In short automatic stabilizers help to provide a cushion of demand in an economy and support output during a recession.

Measuring the fiscal stance

  • A ‘neutral’ fiscal stance might be shown if the government runs with a balanced budget.
  • A reflationary fiscal stance happens when the government is running a budget deficit.
  • A deflationary fiscal stance happens when the government runs a budget surplus (i.e. G<T).

Keynesian justification for a fiscal stimulus and avoiding fiscal austerity

  • The Keynesian school argues that fiscal policy can have powerful effects on AD, output and employment when an economy is operating below full capacity national output
  • Keynesians believe that there is a justified role for the government to make active use of fiscal policy measures to manage or fine-tune the level of aggregate demand particularly when monetary policy is proving ineffective. Here is the justification:
  • There is an automatic rise in the budget deficit to cushion the fall in AD caused by a shock such as the credit crunch. A higher deficit is needed to lift AD back towards pre-recession levels
  • If this works the budget deficit will improve as a result of higher tax revenues and reductions in welfare spending. A growing economy helps to shrink government debt as a percentage of GDP.
  • Keynesian economists oppose cutting government spending or raising taxes during a recession, they believe that fiscal austerity measures make a recession worse and risk causing a depression and deflation.

Monetarist economists believe that government spending and tax changes can only have a temporary effect on AD, output and jobs and that monetary policy is a more effective instrument for controlling AD and inflationary pressure.
The Fiscal Multiplier

“Economic history teaches us that a combination of tax cuts, running large fiscal deficits, substantial cuts in interests rates and more quantitative easing is likely, with a certain time lag, to have a substantial impact on demand in the economy and it may well be that the worst of the recession may well be behind us.”
Source: Professor David Miles, MPC member, April 2009

shutterstock_28225513The fiscal multiplier measures the final change in national income that results from a deliberate change in either government spending and/or taxation. Several factors affect the likely size of the fiscal multiplier effect.

  • Design: i.e. the important choice between tax cuts or higher government spending. Evidence from the OECD is that multiplier effects of increases in spending are higher than for tax cuts or increased transfer payments.
  • Who gains from the stimulus? If tax reductions are targeted on the low paid, the chances are greater that they will spend it and spend it on British produced goods and services.
  • Financial Stress: Uncertainty about job prospects, future income and inflation levels might make people save their tax cuts. On the other hand if consumers are finding it hard to get fresh lines of credit, they may decide to consume a high percentage of the boost to their disposable incomes.
  • Temporary or permanent fiscal boost: Expectations of the future drive behaviour today ... most of us now expect taxes to have to rise in the coming years. Will this prompt a higher household saving and a paring back of spending and private sector borrowing?
  • Monetary policy response: In the jargon, does monetary policy accommodate the fiscal stimulus (i.e. there are no offsetting rises in interest rates)? Consider a situation in 2011 when the Bank of England holds policy interest rates close at 0.5% even if inflationary pressures are rising - this will drive down real interest rates and perhaps boost demand still further. But the central bank has an inflation target to consider and there are heavy economic costs from persistently high inflation
  • The availability of credit: If fiscal policy works in injecting fresh demand, we still need the banking system to be able to offer sufficient credit to businesses who may need to borrow to fund a rise in production (perhaps for export) and also investment in fixed capital and extra stocks.
  • Openness of the economy: The more open an economy is (i.e. the higher is the ratio of imports and exports to GDP) the greater the extent to which higher government spending or tax cuts will feed into rising demand for imported goods and services, lowering the impact on domestic GDP.
  • Fiscal and monetary policy decisions in other countries: Modern economics are deeply inter-connected with each other. The UK government has decided to run a huge budget deficit - so what happens to government borrowing and interest rates in the EU, the USA and in emerging market countries will have an important bearing on prospects for a broadly based recovery in global trade and output which then affects the UK economy.

Problems with Fiscal Policy as an Instrument of Demand Management

In theory a positive or negative output gap can be overcome by the fine-tuning of fiscal policy. However, in reality the situation is complex.

Different types of lag

  1. Recognition lags: Inevitably, it takes time to for policy-makers to recognise a need for some active changes in spending or taxation.
  2. Imperfect information: Key data on the economy is often delayed and subject to revisions.
  3. Response lags: It takes time to implement an appropriate policy response. Tax cuts can feed through quite quickly but new capital expenditure is difficult to start; roads have to be planned, hospitals and schools designed – the response lags may run into years not months

Fiscal Crowding-Out

  • The “crowding-out hypothesis” is an idea that became popular in the 1970s and 1980s when free-market economists argued against the rising share of GDP being taken by the public sector
  • The crowding out view is that a rapid growth of government spending leads to a transfer of scarce productive resources from the private sector to the public sector where productivity might be lower
  • If the government chooses to run a bigger budget deficit, the government will have to sell debt to the private sector and getting individuals and institutions to purchase the debt may require higher interest rates. A rise in interest rates may crowd-out private investment and consumption, offsetting the fiscal stimulus.
  • Eventually higher government spending needs to be funded by higher taxes and this again acts as a squeeze on spending and investment by the private sector of the economy.

In fact, despite the growing budget deficit, UK bond yields on longer-dated government debt have remained low mainly due to the financial market’s appetite for relatively low-risk Treasury Bonds of different duration.
The fact that real interest rates on government bonds remain at historically low levels suggests that there isn’t an immediate funding crisis for western Governments who have chosen to use a fiscal stimulus as a counter-cyclical policy. Much of the funding for the borrowing – at least in the short term – will come from the rising savings of the private sector of rich advanced nations.

  • The Keynesian response to the crowding-out hypothesis is that the probability of 100% crowding-out is remote, especially if the economy is operating well below its capacity and if there is a plentiful supply of saving available that the government can tap into when it needs to borrow money.
  • There is no automatic relationship between the level of government borrowing and the level of short term and long term interest rates.  Much of existing UK government debt is long-term with an average maturity of 14 years – this means that Britain is less exposed to problems of having to find money to repay lots of short term public sector debt.

Keynesian Crowding-In

  • Some Keynesian economists argue that in an economic depression, fiscal deficits crowd-in rather than crowd-out private sector investment
  • In the aftermath of an economic shock, many countries operate with spare capacity that puts big downward pressure on business profits and jobs.
  • Well-targeted timely and temporary increases in government spending can absorb the under-utilised capacity and provide a strong multiplier effect which then generates extra tax revenue.

The Rational Expectations View

  • According to a school of economic thought that believes in ‘rational expectations’, when the government sells debt to fund a tax cut or an increase in expenditure, a rational individual will realise that at some future date he will face higher tax liabilities to pay for the interest repayments.
  • Thus, he should increase his savings as there has been no increase in his permanent income
  • The implications are clear. Any change in fiscal policy will have no impact on the economy if all individuals are rational. Fiscal policy in these circumstances may become ineffective.

Government borrowing and the National Debt

Budget Deficits and Budget Surpluses in 2010

% of GDP


Budget Deficit


Budget Surplus







Saudi Arabia




South Korea














Does a budget deficit matter?

A persistently large budget deficit can be a problem. Three of the reasons for this are as follows:

  1. Financing a deficit: A budget deficit has to be financed through the issue of debt. In a world where financial capital flows freely between countries, it can be fairly easy to finance a deficit. But if the budget deficit rises to a high level, in the medium term the government may have to offer higher interest rates to attract sufficient buyers of debt. This raises the possibility of the government falling into a debt trap where it must borrow more simply to repay the interest on accumulated borrowing.
  2. A government debt mountain: As state debt rises, there is an opportunity cost involved because interest payments on bonds might be used in more productive ways, for example on health services or extra investment in education. 100 basis points equates to 1 per cent. Every 5 basis points (0.05%) saved on £220bn of new debt pays one year’s salary for 46,000 teachers. Higher public sector debt also represents a transfer of income from people and businesses that pay taxes to those who hold government debt and cause a redistribution of income and wealth in the economy.
  3. Crowding-out - the need for higher interest rates and higher taxes. If a larger budget deficit leads to higher interest rates and taxation in the medium term and thereby has a negative effect on growth in consumption and investment spending, then a process of ‘fiscal crowding-out’ is said to be occurring. There must be a limit to which taxpayers are prepared to pay for government spending. The Institute of Fiscal Studies has estimated that that to reduce the UK budget deficit over the next five years will require every person in the UK to pay over £1250 of extra taxes each year.
  4. Risk of capital flight: Some economists believe that high levels of state borrowing and debt risk causing a ‘run on a currency’. This is because the government may find it difficult to find sufficient buyers of debt and the credit-rating agencies may decide to reduce the rating on sovereign debt. Foreign investors may choose to send their money overseas perhaps causing a currency crisis

Potential benefits of a budget deficit

  1. Government borrowing can benefit growth: A budget deficit can have positive effects if it is used to finance capital spending that leads to an increase in the stock of national assets. For example, spending on transport infrastructure improves the supply-side capacity of the economy. And increased investment in health and education can boost productivity and employment.
  2. The budget deficit as a tool of demand management: Keynesian economists support the use of changing the level of government borrowing as a legitimate instrument of managing aggregate demand. An increase in borrowing can be a useful stimulus to demand when other sectors of the economy are suffering from weak or falling spending. If crowding out is not a major problem - fiscal policy can play an important counter-cyclical role “leaning against the wind” of the economic cycle

A debate about the structural budget deficit

The size of the structural budget deficit is an estimate of what the budget balance would be if the economy was at potential output i.e. that output level when resources are being used at normal levels of capacity utilisation.

As they emerge from recession, many countries are experiencing a negative output gap, with GDP below its potential which causes tax revenues to be lower and welfare spending to be higher.

According to the OECD, the UK is estimated to have run a structural budget deficit of 2.6% of potential GDP from 1995–2009 but as a result of the recession and stimulus policies the structural budget deficit jumped to nearly 8% of GDP in 2009 and 6% of potential GDP in 2010.

The debate over what to do with government spending has centred on how quickly to take steps to reduce this structural deficit. The Coalition government has decided to make deeper spending cuts now rather than wait for a stronger economic recovery to arrive. They want to make early progress in cutting the deficit and control the escalating level of accumulated national debt.

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