1. Fiscal and Supply-side Policy

2. The History of Fiscal Policy
• ‘Sound finance’ approach
• A balanced budget and low tax & spend
1850s-1950s
• Use of fiscal policy in demand management
• Keynesian belief that government should actively manage aggregate demand
1950s-1970s running a deficit if necessary
• Return to principles of ‘sound finance’ and balanced budgets
• Fiscal policy used to promote aggregate supply, not demand
1980s-2008? • Cutting taxes not to boost demand but to create incentives to work and invest
Note the links with the changing role of monetary policy which has
replaced fiscal policy in the modern era as the demand management tool.

3. 2008-present
• In the latter years of the Labour government increased public
spending took precedent over fiscal discipline
• Following the financial crisis and subsequent recession the Labour
Government briefly reverted to Keynesian demand
management, reducing VAT and dramatically increasing spending
• The Code for Fiscal Stability was suspended
• ‘Loose’ fiscal discipline before the crisis and policy after the crisis
left the UK with large deficit
• The election of the coalition government resulted in the
introduction of ‘austerity’ to reduce the budget deficit (‘sound
finance’)
• Monetary policy alone had to deal with falling demand, firstly by
lowering interest rates to almost zero, then through a programme
of quantitative easing

4. http://www.guardian.co.uk/news/datablog/2012/mar/21/budget-2012-spending-tax-visualised#
How far have we strayed from a balanced budget?

5. Keynesian Fiscal Policy
• The free market creates volatile business cycles
• Insufficient AD leads to persistent unemployment
• Running a deficit can inject money into the economy
when needed
• Fiscal policy can be used to stabilise the economy
once back to full employment
• Assumption that the multiplier effect is large
“If economists could manage to get themselves thought of as
humble, competent people on a level with dentists, that would be
splendid.”
John Maynard Keynes

6. Supply-side Fiscal Policy
• Rejection of use of fiscal policy to manage demand as
this is inflationary in the short term and in the long term
the deficit must be paid off
• With increasing imports the multiplier effect didn’t work
and merely created inflation
• Public spending and tax to be reduced to allow private
sector to flourish
• Fiscal policy used as a micro-economic tool to target
incentives for workers and firms
Most of the energy of political work is devoted to correcting the effects of
mismanagement of government.
Milton Friedman

7. Examples of fiscal supply side policy
• Incentives to work Giving incentives to
people to work
• Minimum wage
• Welfare to work Ensuring industry have
• Education spending skilled labour available
• Reducing corporation tax
Incentives to invest
• Enterprise zones
Tackling regional
decline and structural
unemployment

8. The middle way
The choice does not have to be between fiscal demand management or a
balanced budget. There are automatic stabilisers that even out the
economic cycles.
Reduced exports Higher Weak pound Excess demand in
= lower AD unemployment improves X-M economy
Higher benefit Welfare payments Wage levels rise to
Budget deficit payments and fall and tax draw workers into
lower tax income revenues increase labour force
Reduces impact Surplus budget
of contractionary takes heat out of
multiplier economy
Dampening deflationary effects Dampening inflationary effects

9. Automatic stabilisers soften boom and bust
This leads to the conclusion that it
is important to balance the budget
not over an annual cycle but over
the period of the economic cycle.
There is a difference between the
cyclical budget deficit (caused by
the automatic stabiliser) and the
Government deficit rises in a structural budget deficit (an
recession... imbalance in the economy which
leads to a deficit even when the
And falls during a boom.
economy is growing at the trend
rate)
Context – The Government are attempting to reduce the deficit during a period of low
or negative growth. Is it reasonable to expect to ‘balance the books’ when the
economy is not booming?

10. Let us not forget though that fiscal policy is not
just about...
Economic management
i.e. As a tool to achieve macro objectives
It is also about...
Managing the allocation of resources
e.g. Affecting consumption of merit/demerit goods, limiting
externalities, controlling monopolistic excesses, creating incentives
to work, save or invest
Altering the distribution of income and wealth
i.e. The use of progressive taxation and redistributive public spending

11. Trade-off between equity and efficiency
Greater equality can be achieved
by;
• Free state services
• Welfare support
• Progressive taxation
• Pre-1979 approach
But the resultant dependency
culture requires;
• Lower taxes and benefits to
get people off benefits
• Allowing rich to keep more
of their money to invest and
create growth and jobs = greater inequality but less absolute poverty

12. And the related debate...
How big should government be?
Big governments can crowd out the private sector in
two ways;
Resource crowding out whereby resources aren’t
available for the private sector as they are employed
by the public sector
Financial crowding out whereby
• Higher taxes to pay for spending reduce consumption
on private goods
• Government borrowing (e.g. Bond issues) are
attractive investments which divert funds from
private investment

13. However...
Taxing the rich and giving to the poor CAN increase consumption as people on lower
incomes have a higher propensity to consume.
During periods where spare capacity exists the public spending can usefully employ
resources without crowding out the private sector. Furthermore, if the spending is on
capital projects (e.g. road building) the private sector may experience higher demand as
government commissions projects.
The above two points lead to calls during a
recession for redistribution of income and
government infrastructure projects - like the huge
road building effort in the US during the Great
Depression.

14. One more problem with big government...
The Laffer curve
If 100% of income is taxed then
there would be no incentive to
do anything! No economic
activity would therefore result
in no tax income.
If 0% of income is taxed then there
This model is named after the supply-side
is also no tax income.
economics Arthur Laffer. What is not clear is Government income from tax
at what level of taxation government increases as the rate of tax
revenues go into reverse? Some economists
argue that in the Keynesian era of big
increases, and falls after a
government the ‘tax burden’ was excessive certain tax rate is reached as
and lower revenues were the result. It is the disincentives send
interesting to consider that this logic leads to economic activity into reverse.
the conclusion that to increase tax income a
fall in taxation is necessary.

15. Big or small?
Other factors which affect the decision on how
big government should be are;
1. Efficiency – does government or the private
sector deliver goods more efficiently?
2. Equity – to what extent do we sacrifice
efficiency for equity? For example, private
dentistry may be more efficient but would it
exclude certain people from treatment?

16. Government size over time
The size of the state is usually driven by public sector spending., which in turn is
influenced by war, political ideology and economic orthodoxy. Public spending is
often measured by the ratio between public expenditure and national income.
The Big Picture
• Public spending steadily increased throughout the 20th century
• From around 10% to over 40% of GDP
The Peaks
• Spending increased sharply in the two World wars
• Peak in 1982/3 at 46.75%
• By 2005/6 it was again above 42%, rising to over 50% after the recession in 2008/9
Does public spending = share of output?
• Some public spending is on ‘transfers’ i.e. using tax revenues to redistribute money via
welfare benefits. This spending is not taking resources away from the private sector and is
not generating an output.
• The governments actual contribution to output is more like 20-30% of the total GDP

17. http://www.guardian.co.uk/news/datablog/2012/mar/21/budget-2012-spending-tax-visualised#
Look again at what we are spending this money on.

18. What makes a good tax?
Having considered how much we tax, let us now consider what
constitutes a ‘good’ tax.
And we may add efficiency
Equitable
and flexibility to this list.
VAT is levied at a flat rate (currently 20%). It is
therefore a proportionate tax as the rate does not
Adam change in relation to income. To some extent people
can choose whether to pay VAT as they choose
Certain
Smith’s Economical whether to purchase goods. Some goods are exempt
Cannons from VAT (e.g. children’s clothes) in an attempt to
of Taxation avoid discouraging purchase. VAT is relatively easy to
collect as firms must levy the tax and pay on behalf of
the consumer, and therefore convenient to those being
taxed. However, it is open to avoidance when ‘cash in
hand’ purchases are made. VAT can be changed
quickly and raises around £100 billion a year without
Convenient significant cost. It is generally a good tax, although not
progressive.

19. Monetary and Fiscal harmony
The Big Picture – The need to reduce the deficit has taken precedent over all other objectives. A ‘sound
finance’ approach to fiscal policy dominates, with the refusal to follow the Keynesian approach of
increasing demand in a downturn through deficit spending. Interest Rates, potentially a demand-boosting
alternative, have no room for falling further and should if anything increase to curb inflation. Quantitative
easing has propped up a flailing economy. Falling real incomes and high unemployment are the painful
medicine to a period of excessive consumption and debt. The question is whether the medicine will work
Improving economic welfare
or will a ‘lost decade’ result as the economy cannot lift itself out of a prolonged slump?
Interest Rates being used for demand
Control of management, although redundant in promoting
increased demand at present and not as yet rising to
inflation curb cost-push inflationary pressures. Other policies
are needed.
Macro-economic Drive to achieve a balanced budget through austerity
and pay down national debt. Quantitative easing
stability employed to attempt to maintain credit availability to
promote aggregate demand and supply.
Intention to reduce size of the state and create
Long-run growth competitive and efficient markets which will drive
the recovery.

20. Limitations of fiscal policy
•Increased PSNCR may require increased money •Long time to have an effect (e.g. education)
supply therefore inflation and no benefit to •Social effects (e.g. cutting benefits)
output •Difficult to predict effects
•Borrowing must be paid back, with interest
•Blunt tool
•Risk when large debts build up
As a demand
As a supply-
management
side tool
tool
To To correct
redistribute market
wealth failure
•Brain drain •Not possible to accurately assess costs
•Disincentives to work and benefits
•Political pressures •Difficult to predict effects of policy
•May make industries less internationally
competitive
•Political resistance

21. Other supply-side policies
• Privatisation / Deregulation
• Liberalising financial markets
• Open economy – reduce barriers to trade
• Well functioning labour markets (where wage
levels are allowed to fall, firms can hire and
fire, and the natural rate of unemployment is
minimised)

22. EU Perspective
Greater integration with Europe means the
transfer of national economic powers to
Controls over
budget deficits European institutions (e.g. the ECB). Those
(3% of GDP)
countries which have adopted the Euro can
no longer use interest rates as a demand
management tool. This causes problems if
Possible move their economic cycle is out of sync with the
toward a
common fiscal rest of Europe. The use of fiscal policy for
framework or
tax counter-cyclical management is also limited
harmonisation? by rules over deficits.
Single currency means loss
of monetary control at a The benefits however include currency
national level stability, free trade and movement of
resources, and access to fiscal support and
large ‘bail-out funds’.
The argument for greater fiscal integration
is that this would bring economic cycles in
Greece has a massive deficit and poorly structured economy. They
are under pressure to pay down their debts but the massive ‘austerity’ line and remove national competitive
cuts required will be devastating to an already depressed economy. If advantages which distort the patterns of
they had their own currency its value would be falling rapidly boosting trade. The argument against is that this
exports and reducing imports, bringing demand into the economy. would further remove powers from national
They would also have monetary tools at their disposal to promote government to respond ‘locally’ to
consumption and investment. As part of the Euro they are instead
economic shocks and pressures.
suffering from a strong German economy pulling up the value of the
Euro. They have, however, benefitted from European bail-outs.