Fiscal Policy As A Supply Side Tool

Essay, Research Paper

Fiscal Policy – Fiscal Policy as a Supply-side Tool

Supply-side policies are policies that aim to increase the capacity of the economy to produce. Fiscal policy usually acts on the level of demand in the economy and the deflationary and reflationary policies on pages 2 & 3 are often known as demand-side policies .However, it is also possible for fiscal policy to act on the level of supply as well.

Income tax will always have an effect on people’s incentives to work. This will be true at most income levels. If income tax at low income levels is too high, people may choose not to work but to remain on benefits instead. If income tax on high levels of income is too high, people may choose not to work so hard and take risks. Ultimately they may even choose to leave the country if taxes elsewhere are much lower (a “brain drain”).

Supply-side fiscal policies could therefore include:

? Cutting the lower and basic rates of tax to open up the gap between earnings in and out of work and ensure people have an incentive to work

? Increasing the level of personal allowances for the same reason

? Reducing the top rate of tax to encourage enterprise, risk-taking and the incentive to work hard

Why not try some of these policies on the Virtual Economy? Click on the 4th floor on the side bar or on the link at the top of the page to access the model and try these policies. Try any of them and see the effect they have on economic growth and unemployment. When you cut taxes ensure you cut government expenditure by an equivalent amount. This ensures that your policies have no overall impact on demand. In this way you isolate out the supply-side impact of your policies. You should see an overall increase in economic growth over time as your policies begin to take effect.

Fiscal Policy – Deflationary Fiscal Policy

Deflationary fiscal policyis likely to be most appropriate in times of economic boom. If the economy is growing at above its capacity this is likely to cause inflation and balance of payments problems. To try to slow the economy down the government could either raise taxes in some form or perhaps reduce government expenditure. Either of these will reduce the level of demand in the economy and therefore the level of economic growth. It may increase indirect taxes which will raise prices and deter people from spending so much, or it may increase direct taxes which will leave people with less money in their pockets and so stop them from spending so much.

Deflationary fiscal policies could therefore include:

? Increasing the lower, basic or higher rates of tax

? Reducing the level of personal allowances

? Reducing the level of government expenditure

Why not try some of these policies on the Virtual Economy? Click on the 4th floor on the side bar or on the link at the top of the page to access the model and try these policies. Try any of them and see the effect they have on the level of economic growth, unemployment and inflation. You should find growth reducing, unemployment increasing and inflation falling (after a time-lag perhaps).

Advisers – Fiscal Policy

Fiscal policy is the use of government expenditure and taxation to manage the economy. The main changes in fiscal policy happen once a year in the Budget. It is in the Budget that the Chancellor sets the levels of taxation and government expenditure for the next fiscal year. The fiscal year runs from 5th April one year until 4th April the following year. This is why the budget is usually in March. The changes in it come generally into effect in the following month. In the Virtual Economy life is a lot easier – you can make changes any time you like! Just use the link to the model in the top navigation bar or on the 4th floor in the side bar to get there from anywhere in the Virtual Economy.

Fiscal policy can be used in various different ways. It may be used to try to boost the level of economic activity when the economy is flagging a little. In this case it is called reflationary policy Alternatively the economy may be doing a little too well and in need of slowing down. In this case deflationary policy is called for. The final use for fiscal policy is as a tool of supply-side policy

The rest of the pages in this section go into more detail on each of these policies. To access them, use the links below, on the right-hand side or at the foot of the page:

To help imagine how these policies work think of the economy as a balloon. The air in the balloon is the level of demand or economic activity. If the balloon is a little low and short of air you want to reflate it, but if it is over-expanded and in danger of bursting then you deflate it. The same is true of the economy, though when it is over-expanded instead of bursting we get other problems such as higher inflation and a larger balance of payments deficit. Supply-side policies are then policies that manage the capacity of the balloon; making it bigger so it can take more air or making the balloon material more stretchy so it can expand further and so on.

Government Case Studies – The ‘policies’ Having chosen a government that you are going to consider for your case study, you now need to choose a policy. We have chosen four different styles of policy – choose one of them and then go to the Virtual Economy model to try them out. (You can also click on the 4th floor in the side panel or the top navigation bar to access the model.) Use the to note down the results of the policy. Policies A deflationary policy this policy reduces the level of aggregate demand in the economy and will therefore have the effect of reducing growth and inflation. Unemployment is likely to rise. Increase the basic tax rate from 23% to 25% Increase the higher rate of tax from 40% to 42% Increase the interest rate (base rate) by 1 percentage point Reduce government current expenditure by 3% A reflationary policy- this policy will boost the economy by increasing the level of aggregate demand. It will increase the level of economic growth, but may cause higher inflation as a result. Reduce the lower rate of tax from 20% to 18% Reduce the basic rate of tax from 23% to 20% Reduce the top rate of tax from 40% to 38% Reduce the interest rate (base rate) by 1 percentage point Increase the level of government current expenditure by 3% A supply-side policy – this sort of policy is aimed at boosting the potential level of output of the economy – the aggregate supply .In other words we want to increase the capacity of the economy to produce. We have cut taxes to try to encourage people to work harder and cut interest rates to encourage more investment. Increase the tax threshold on the basic rate from Ј27,100 to Ј35,000 Reduce the top rate of tax from 40% to 36% Reduce the basic rate of tax from 23% to 22% Reduce the interest rate (base rate) by 1 percentage point Cut both government current expenditure and capital expenditure by 1% A policy that redistributes income from better-off to the less well-off – this policy aims to change the distribution of income by raising top tax rates and lowering tax rates at the lower end of the income scale. It also increases benefits to help those not working. Increase the personal allowance from Ј4,195 to Ј10,000 Cut the lower rate of tax from 20% to 18% Cut the basic rate of tax from 23% to 20% Increase the top rate from 40% to 50% Reduce the tax threshold on the basic rate from Ј27,100 to Ј20,000 Increase income support by 5% Once you have chosen a policy, go to the model and try the policy out