Government Policies

Government policies are designed and adopted to achieve macro-economic targets set by the
government. There are four main macroeconomic policies which any government uses, these are:

 Fiscal policy
 Monetary policy

 Exchange rate policy

 Supply side policy

Fiscal Policy

Fiscal policy involves the use of government spending, taxation and borrowing to influence both
the pattern of economic activity and also the level and growth of aggregate demand, output and
employment.

A rise in government expenditure, or a fall in the burden of taxation, should increase aggregate
demand and boost employment. The size of the resulting final change in equilibrium national
income is determined by the multiplier effect

Fiscal policy is also used to influence the supply-side performance of the economy. For example,
changes in fiscal policy can affect competitive conditions individual markets and industries and
change the incentives for people to look for work and for companies to invest and engages in research
and development.

Government capital spending on transport infrastructure and public sector investment in

education and health can also have a direct but unpredictable effect in the long run on the
competitiveness and costs of businesses in every industry.

Government spending

Spending by the public sector can be broken down into three main areas:

Current Government Spending: i.e. spending on state-provided goods & services that are provided
on a recurrent basis every week, month and year, for example salaries paid to people working in public
sector and resources used in providing state education and defence. Current spending is recurring
because these services have to be provided day to day throughout the country.

Capital Spending: Capital spending would include infrastructural spending such as spending on new
motorways and roads, hospitals, schools and prisons. This investment spending by the government
adds to the economy’s capital stock and clearly can have important demand and supply side effects in
the medium to long term.

Transfer Payments: Transfer payments are government welfare payments made available through
the social security system including the Jobseekers’ Allowance, Child Benefit, the basic State Pension,
Housing Benefit and Income.

 These transfer payments are not included in the national income accounts because they are not
a payment for output produced directly by a factor of production. Neither are they included in
general government spending on goods and services.

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  The main aim of transfer payments is to provide a basic floor of income or minimum standard
of living for low income households in our society and they provide a means by which the
government can change the overall distribution of income in a country.

Government Spending and Fiscal Policy Objectives

Government spending is justified on economic and social grounds including the desire to correct for
perceived market failure when the market mechanism might fail to provide sufficient public and merit
goods for social welfare to be maximized.

The Government has main goals of fiscal policy to be the following:

Funding government spending: To meet the government’s spending and tax priorities without a
damaging rise in the burden of government debt

The benefit principle: This principle seeks to ensure that those who benefit from public services such
as the benefits from education, health and transport also meet as far as possible the costs of the
services they consume

Macroeconomic stability: Fiscal policy in is now designed to support monetary policy in ‘smoothing
the path of aggregate demand over the economic cycle’ and in contributing to an environment of
sustainable growth and stable inflation – this is the main macroeconomic objective of fiscal policy.

Redistribution of income: To ensure that government spending and taxation impact fairly within and
across generations – fiscal policy should be equitable to current and future generations.

Therefore we justify government spending on these grounds:

 To provide a socially efficient level of public goods and merit goods

 To provide a safety-net system of welfare benefits to supplement the incomes of the poorest in
society – this is also part of the process of redistributing income and wealth

 To provide necessary infrastructure via capital spending on transport, education and health
facilities – an important component of a country’s long run aggregate supply

Sources of Government Revenue

Taxation: taxes are imposed to generate revenue so that public spending can be financed, to
discourage production and consumption of de-merit goods or to redistribute income.

Direct taxes – are paid directly to the tax authority by the individual taxpayer – usually through “pay
as you earn” (PAYE). Burdon of Tax liability cannot be transferred onto someone else. Normally
direct taxes are progressive in their nature so are considered fair and just and these are also helpful in
re- distribution of income.

Indirect taxes –are imposed on production, import and consumption of goods and services. Indirect
taxes are considered unfair as these taxes are regressive and cause disparity in the society. Indirect
taxes include VAT, GST and a range of excise duties. The burden of an indirect tax can be passed on
by the supplier to the final consumer – depending on the price elasticity of demand and supply for the
product.

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Arguments for Using Indirect Taxation:

 They are a useful instrument in controlling and correcting for externalities – all governments
have moved towards a more frequent use of indirect taxes as a means of making the polluter
pay and “internalizing the external costs” of production and consumption.
 Indirect taxes are less likely to distort the choices that people have to between work and
leisure and therefore have less of a negative effect on work incentives. Higher indirect taxes
allow a reduction in direct tax rates (e.g. lower starting rates of income tax).

 Indirect taxes can be changed more easily than direct taxes – this gives economic policy-
makers more flexibility when setting fiscal policy. Direct taxes can only be changed once a
year at Budget time.

 Indirect taxes are less easy to avoid by the final tax-payer who might be unaware of how much
indirect tax they are paying.

 Indirect taxes leave people free to make a choice whereas direct taxes leave people with less
of their gross income in their pockets

Arguments against Using Indirect Taxation

 Many indirect taxes make the distribution of income more unequal (less equitable) because
indirect taxes are more regressive than direct taxes
 Higher indirect taxes can cause cost-push inflation which can lead to a rise in inflation
expectations

 Revenue from indirect taxes can be uncertain particularly when inflation is low or there is a
recession causing a fall in consume spending

 There is a potential loss of economic welfare (taxes can create a deadweight loss of consumer
and producers surplus)

 Higher indirect taxes affect households on lower incomes who are least able to save in the first
place

 Many people are unaware of how much they are paying in indirect taxes – this goes against
one of the basic principles of a good tax system – namely that taxes should be transparent.

Progressive, proportional and regressive taxes

With a progressive tax, the marginal rate

of tax rises as income rises. I.e. as people
earn more income, the rate of tax on each
extra pound earned goes up. This causes a
rise in the average rate of tax (the
percentage of income paid in tax).

With a proportional tax, the marginal

rate of tax is constant. For example, we
might have an income tax system that
applied a standard rate of tax of 25%
across all income levels. If the marginal
rate of tax is constant, the average rate of
tax will also be constant.
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With a regressive tax, the rate of tax falls as incomes rise – I.e. the average rate of tax is lower for
people of higher incomes. Most examples of regressive taxes come from excise duties of items of
spending such as cigarettes and alcohol.

The main objectives of a tax system

The burden of tax: To keep the tax burden as low as possible (the burden of tax for a country can be
measured by the % of GDP taken in taxes and is shown in the chart above)

laffer’s curve

To improve incentives: The government believes that reducing tax rates on income and business
profits helps to sharpen incentives to work and create wealth in the economy as a strategy to enhance
long-run growth

Tax spending rather than income: To shift the balance of taxation away from taxes on income
towards taxes on spending – this is because it is thought that taxes on income have a greater effect on
work incentives

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Equitable taxes: To ensure taxes are applied equally and fairly to everyone. Equality is not always
the same as fairness – see the notes below on the canons of taxation

Correct for market failure: As with many other governments in other countries, the UK government
believes in the use of taxes to make markets work better (including taking account of externalities) –
this is an important microeconomic objective. The government is committed to using the tax system as
an instrument of correcting for market failures.

Principles of a good tax system

Efficiency - an efficient tax system raises sufficient revenue to pay for government spending, without
creating negative distortions such as reducing work-incentives for individuals and investment
incentives for companies

Equity – the principle of equity is that taxes should be fair and based on people's ‘ability to pay’.
Income tax satisfies this condition because it is a progressive tax system, the marginal and average rate
of tax rises with income – but some indirect taxes may not – for example the duty on cigarettes is said
to have a regressive effect on the overall distribution of income

The ‘benefit principle of taxation’ – this principle is that taxes paid by people have a link with the
benefit that the person paying the tax actually receives from government spending. However, there are
some problems with too much emphasis on the benefit principle. Firstly if ignores the redistributive
aims of taxation. A second problem is that the benefit principle assumes correct revelation of
preferences by consumers – whereas in reality many consumers do not have to pay for the public
goods and services provided for them (consider the ‘free rider problem’). It is also difficult for the
government to assess individual benefits from public goods.

Transparency and certainty - taxpayers should understand how the system works and should be able
to plan their tax affairs with a reasonably degree of certainty. Taxes should also be difficult to evade –
we know that in many countries there is a fast-growing industry that provides information to people on
how to reduce their tax liabilities. Collection costs should be kept to an acceptable level so that the
costs of collection are very low relative to the total tax revenues collected.

The microeconomic effects of fiscal policy

Taxation and work incentives: Consider the impact of an increase in the basic rate of income tax or
an increase in the rate of national insurance contributions. The rise in direct tax 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 to encourage less work since the higher tax might act as
a disincentive to work. Of course many workers have little flexibility in the hours that they work. They
will be contracted to work a certain number of hours, and changes in direct tax rates will not alter that.

Taxation and the Pattern of Demand: Changes to indirect taxes in particular can have an effect on
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 among consumers and thereby reduce the demand for
what are perceived as “de-merit goods”. In contrast, a government financial subsidy to producers has
the effect of reducing their costs of production, lowering the market price and encouraging an
expansion of demand.

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.

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Taxation and labour productivity: Some economists argue that taxes can have a significant effect
on the intensity with which people work and their overall efficiency and productivity. But there is little
substantive 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.

Taxation and business investment decisions: Lower rates of corporation tax and other business
taxes can stimulate an increase in business fixed capital investment spending. If planned investment
increases, the nation’s capital stock can rise and the capital stock per worker employed can rise.

The government might also use tax allowances to stimulate increases in research and development and
encourage more business start-ups. A favourable tax regime could also be attractive to inflows of
foreign direct investment – a stimulus to the economy that might benefit both aggregate demand and
supply. The Irish economy is often touted as an example of how substantial cuts in the rate of
corporation tax can act as a magnet for large amounts of inward investment.

Capital investment should not be seen solely in terms of the purchase of new machines. Changes to the
tax system and specific areas of government spending might also be used to stimulate investment in
technology, innovation, the skills of the labour force and social infrastructure.

Problems with Fiscal Policy

In theory a positive or negative output gap can be relatively easily overcome by the fine-tuning of
fiscal policy. However, in reality the situation is complex and many economists argue for ignoring
fiscal policy as a tool for managing aggregate demand focusing instead on the role that monetary
policy can play in stabilising demand and output.

Recognition lags and policy time lags: Inevitably, it takes time to for government policy-makers to
recognise that AD is growing either too quickly or too slowly and a need for some active discretionary
changes in spending or taxation. It then takes time to implement an appropriate policy response –
government spending plans are subject to a three year spending review and cannot be changed
immediately. Likewise the tax system is highly complex – for example – income tax can only
normally be changed once a year at the time of the Budget. Indirect taxes can be changed more
quickly but they have less of an effect on the level of aggregate demand. It then takes time for the
change in fiscal policy to work, as the multiplier process on national income, output and employment
is not instantaneous.

Fiscal Crowding-Out: The essence of 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.
For example, if the government seeks to reflate AD by reducing taxation, or by increasing government
spending, then this may lead to a budget deficit. To finance the deficit the government will have to sell
debt to the private sector. Attracting 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.

Government borrowing: The level of government borrowing is an important part of fiscal policy and
management of aggregate demand in any economy. When the government is running a budget deficit,
it means that in a given year, total government expenditure exceeds total tax revenue. As a result, the
government has to borrow through the issue of debt such as Treasury Bills and long-term government
Bonds. The issue of debt is done by the central bank and involves selling debt to the bond and bill
markets.

Government Budget

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Problems with budget deficit

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

Financing a deficit:A budget deficit has to be financed on day-to-day basis, the issue of new
government bonds or certificates to domestic or overseas investors can do this. But it may be that 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 government debt. This in turn will have a negative effect on
economic growth

A government debt mountain: In the long run, government borrowing adds to the accumulated
National Debt. This means that the Government has to spend more each year in debt-interest payments
to holders of government bonds and other securities. There is an opportunity cost involved here
because this money might be used in more productive ways, for example an increase in spending on
health services or extra investment in education. It 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

Crowding-out - the need for higher interest rates and higher taxes: Eventually the budget deficit
has to be reduced. This can be achieved by either by cutting back on public sector spending or by
raising the burden of taxation. 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.

Wasteful public spending: Neo-liberal economists are naturally opposed to a high level of
government spending. They believe that a rising share of GDP taken by the state sector has a negative
effect on the growth of the private sector of the economy. They are sceptical about the benefits of
higher spending believing that the scale of waste in the public sector is high – money that would be
better off being used by the private sector.

Potential benefits of a budget deficit

Government borrowing can benefit economic growth: A budget deficit can have positive
macroeconomic effects in the long run if it is used to finance extra capital spending that leads to an
increase in the stock of national assets. For example, spending on the transport infrastructure improves
the supply-side capacity of the economy. And increased investment in health and education can bring
positive effects on productivity and employment.

The budget deficit as a tool of demand management: Keynesian economists would 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. The argument is that the government can and
should use fiscal policy to keep real national output closer to potential GDP so that we avoid a large
negative output gap.

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Monetary policy

Monetary Policy refers to a policy adopted by central bank to manage money supply so that macro-
economic objectives can be achieved. It involves changes in the base rate of interest to influence the rate
of growth of aggregate demand, the money supply, and ultimately price inflation.

Monetarist economists believe that monetary policy is a more powerful weapon than fiscal policy in
controlling inflation. Monetary policy also involves changes in the value of the exchange rate since
fluctuations in the currency also impact on macroeconomic activity (incomes, output, and prices)

Changes in short term interest rates affect the spending and savings behavior of households and
businesses over time and therefore feed through the circular flow of income and spending.

Monetary policy - transmission mechanism

A change in interest rates has wide-ranging effects on the economy. Some of these “transmission
mechanisms” are explained below. In each case we consider a cut in interest rates.

1. Housing market & house prices (wealth effects): High interest rates increase the cost of mortgages and
reduce the demand for most types of housing. A fall in interest rates should stimulate higher demand and
prices. This should increase consumption associated with house buying and the rise in prices will increase
total housing wealth and make consumers more confident about their personal finances

2. Effective disposable incomes of mortgage payers: If interest rates fall, the income of homeowners who
have variable-rate mortgages with their building society or bank will increase – leading to a rise in their
effective purchasing power

3. Credit demand: Low interest rates encourage people to spend using credit and should boost demand for
"big ticket" consumer durables and high street spending generally

4. Investment & Stock building: Firms take interest rates into account when deciding whether to proceed
with investment spending. A fall in rates should increase business confidence and raise planned fixed
investment

5. Exchange Rates: Lower rates might lead to a depreciation of the rupee exchange rate and boost demand
for Pakistani producers who sell in internationally traded markets. A rise in the growth of exports is an
injection of AD and increases the factor incomes of those in work

6. A Redistribution of Income for Savers & Borrowers: When interest rates fall, there is a re-distribution
of income away from lenders towards those with variable rate loans. People with net savings also stand to
lose out from big cuts in interest rates

INTEREST RATES AND BUSINESSES

Investment & Stock building: Firms take interest rates into account when deciding whether or not they go
ahead with new capital investment spending. A fall in interest rates should help to increase business
confidence and raise the level of planned fixed investment. See the pages on investment theory and the
discussion of the marginal efficiency of capital.

Exchange Rates: Lower interest rates might cause a depreciation of the exchange rate and boost demand
for domestic producers who sell goods and services in internationally traded markets. A rise in the growth

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of exports is an injection of aggregate demand into the economy and increases the factor incomes of those
in work. This should lead to an increase in the equilibrium level of national income and a multiplier effect.
Time Lags: Remember that although a change in interest rates clearly affects the economy in many ways,
there are inevitable time lags involved.

Exchange rate policy

Exchange rate policy: it is a policy designed by the government mainly to achieve BOP equilibrium
but it can also be used to achieve macro-economic targets. if government wants to encourage
exports and to dampen to imports, it depreciates exchange rate against other currencies.
Depreciation of exchange rate makes the import prices higher and according to economic theory,
higher the prices lower will be the demand so demand for imported goods declines which reduces
the import bill for the country. on the other hand, due to depreciation of exchange rate, prices of
domestically produced goods become cheaper in the foreign market so demand for local goods in
the international market goes up and export bill for the country increases. This increase in exports
and decrease in imports helped government to improve its BOP.

However, it must be remembered that depreciation of exchange rate is going to do the above stated
impact if demand for imports and exports is price elastic. Depreciation of exchange rate may also
cause inflation as value of money decreases along with goods and services less available in the
economy which may trigger cost push inflation.

Supply side policies

Any policy which is designed to encourage aggregate supply in the economy, in other words it is used
to increase the potential of the economy. with supply side policy ppc shifts outwards in the future, it is
normally a long term policy. Government invests and encourages private sector investment in
infrastructure, education, health, power generation, communication, transport networks and in real
estates. Basic objective of supply side policy is to trigger economic development so that economic
activity can be increased, employment opportunities can be generated, living standards can be
improved and exports can be increased.

Tools/instruments of supply side policy

 Using the tax system to provide incentives to help stimulate factor output, rather than to alter
demand, is often seen as central to supply-side policy. This commonly means reducing direct
tax rates, including income and corporation tax. Lower income tax will act as an incentive for
unemployed workers to join the labour market, or for existing workers to work harder. Lower
corporation tax provides an incentive for entrepreneurs to start and so increase national output.
 Other supply-side policies include the promotion of greater competition in labour
markets, through the removal of restrictive practices, and labour market rigidities, such as the
protection of employment and reducing trade union powers.
 Measures to improve labour mobility will also have a positive effect on labour productivity,
and on supply-side performance. This improves labour market flexibility.
 Better education and training to improve skills, flexibility, and mobility – also called human
capital development. Spending on education and training is likely to improve labour
productivity and is an essential supply-side policy option, and one favoured by recent UK
governments. A government may spend money directly, or provide incentives for private
suppliers to enter the market. Government may also set and monitor standards of teaching, and
force schools to include a skills component in their curriculum.
 The adoption of performance-related pay in the public sector is also seen as an option for
government to help improve overall productivity.
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