Question

What are the concepts of government spending, taxation, and borrowing? Provide an example of fiscal policy in each of the three areas.

Answer 1

If the tax revenues of a government are inadequate to pay for a specified rate of government spending then a country must borrow to make up the difference, this is a deficit in the budget. Governments often consider it necessary to borrow to finance their expenditure. Recession causing increasing jobs Decrease in consumer spending, decrease in revenues leading to lower tax revenue Increase in financial inactivity leading to higher welfare expenditure Deliberate use of fiscal stimulus by a government to boost aggregate demand Increase in debt interest rates leading to higher debt service expenses Demographic factors leading to higher government pensions

Government expenditure involves buying products and services, such as a fleet of new vehicles for public staff or national defense rockets. Government spending is a instrument of fiscal policy because it has the authority to increase or decrease real GDP. The government can affect economic output by changing government spending.

In relation to the main impact of government spending on the economy, this expenditure multiplies through the economy as it impacts companies that sell the government's purchased products and services. Consumers then spend paychecks from those companies that they earn, stimulating even more real GDP.

For example, when Larry's Limos receives a large order for more government vehicles, his sales increase, and he hires more employees who earn a paycheck from the company. Once they cash their paycheck, they spend this money on goods and services, and the effect of a single increase in government spending now leads to a much greater result - an effect that economists call the multiplier effect.

Taxes are a fiscal policy instrument because the average consumer's revenue is affected by tax modifications and changes in consumption lead to changes in real GDP. The government can therefore affect economic output by changing taxes. There are several ways in which taxes can be altered. First, it is possible to raise or lower marginal tax rates. Second, they can be completely eliminated or the tax rules can be changed.

Each year, the government borrows funds from U.S. citizens and foreigners to cover its budget deficits. It does this by selling securities (Treasury bonds, notes, and bills)—in essence borrowing from the public and promising to repay with interest in the future.

The UK coalition government has a deficit-reduction policy with the emphasis on cutting government spending in some areas in real terms and a series of direct and indirect tax increases:

Key policies for deficit reduction:

• Rise in VAT to 20%
• Rise in employee national insurance contributions
• Deep cuts in real government spending e.g. for local authorities
• Welfare caps including £26k pa cap on welfare for each family

Some taxes have been cut

• A series of cuts to corporation tax - down to 20% in 2015
• Freezing of fuel duties (meaning a cut in real terms)
• Increases in the real value of the income tax free allowance
• Freezing of council tax (so that council tax falls in real terms)