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Economic Modelling

Lecture 10

Fiscal Policy to Fine-Tune the Economy

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Objectives of Fiscal Policy

• Macroeconomic stabilisation • Higher growth rate of output• Full employment• Stable prices: • low rate of inflation• stable interest rate and exchange rates• Equity: horizontal and vertical• Efficiency in resource allocation• Provision of public goods• Externality• Market failure• Public private partnership

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Instruments of Fiscal Policy• Taxes

Direct (income, wealth)Indirect (VAT, Excise, Tariff and duties)Subsidies (consumption and production)

• SpendingPure Public goods ( defence, law and order, roads)Semi-public goods (education, health, sanitation)

• DebtBorrowing from the private sector -Crowding OutFrom the central banks -inflationary tax

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Who Bears the Burden of Taxes and How does tax-spending affect the economy?

• Stabilisation role• Economic certainty, growth dividend• Producers

Labour supply (work hours, leaves, retirement) Production: taxed sectors vs. subsidised sectorTrade: domestic vs. foreign goodsExcise duties

• ConsumersCurrent vs. future consumption Composition of consumption (VAT and market prices, Sin goods)

• Traders and investors Choice of trading partners Location investment

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Golden Rule of Fiscal Policy in the UK

• Over Economic Cycles

Government will borrow only to invest and not to fund current spending.

Ratio of public debt to GDP will be held at stable and prudent levels.

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Macroeconomic Stabilisation Role of Tax and Spending

Taxand Spending

G G

T

T = tY

IncomeYF

G = T

T > GSurplus in boom

T < GDeficit in recession

0

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Balanced Budget Multiplier with Lump-Sum Taxes

TcGIcc

Y 1011

1

11

1

cG

Y

1

1

1 c

c

T

Y

.

T

Y

G

Y

=1/(1-c1) - c1/(1- c1) = 1

The real national income is given by the IS Curve:

Positive Government expenditure multiplier:

Negative tax multiplier:

The balanced budget multiplier:

A change of 100 in both G and T also raised income by 100.Balanced change in G and T is not macro economically neutral.

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Automatic Stabiliser with Proportional Taxes

10 1 t

DYccC 10

TYYD

YttT 10

]tc-[c*)tcc-(1

1010

111

GIY

10 1 cConsumption:

Disposable income:

Tax Revenue

Income (IS curve): Y = c0 + c1YD + I + G

The multiplier = 1/(1-c1+c1t1) <1/(1- c1), so the economy responds less to changes in autonomous spending when t1 is positive.

High T when Y is high.Low T when Y is low.

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How much should be the tax rate to maximise the government revenue ?

Revenue

R-max

t-Rmaxt-Low tH Tax rate

R-low

Tax avoidanceTax evasion

Revenue=F(t)

Tax compliance

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Laffer Curve Model:A Numerical Example

2250 tttR W h e r e R i s r e v e n u e i n b i l l i o n o f p o u n d s , t i s t h e t a x r a t e .T h e t a x r a t e t h a t m a x i m i s e s t h e r e v e n u e i s g i v e n b y

0450

t

ttR

t = 1 2 . 5

T h e r e a r e t w o t a x r a t e s t h a t c a n r a i s e t h e s a m e r e v e n u e .2250200 tt

0100252 tt ;2

)100(42)25()25(1

t =

20,52

15251 t

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Tax Brackets and Effective Rates of Taxes for three Individuals

Individuals A B C Gross income 12000 27000 53000 Personal Allowances 4615 4615 4615 Taxable income 7385 22385 48385

Calculation tax At starting rate 192 192 192 At basic rate 1202.3 4502.3 6153.4 At higher rate 0 0 7394 Total tax payment 1394.3 4694.3 13739.4 Effective tax rate 0.116192 0.173863 0.259234 Starting rate 1920 0.1 Basic rate 27980 0.22

Higher rate 29,900

or above 0.4 Allawances 4615

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VAT16%

Corporation tax8%

Excise duties9%

National insurance16%

Income tax29%

Council tax4%

Other13%

Business rates5%

C3: GOVERNMENT RECEIPTS

Structure of Public Revenue in the UK (www.HM-Treasury.gov.UK/Economic Data and Tools)

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32.5

33

33.5

34

34.5

35

35.5

36

36.5

37

37.5

38

38.5

39

39.5

1980-81

1982-83

1984-85

1986-87

1988-89

1990-91

1992-93

1994-95

1996-97

1998-99

2000-01

2002-03

2004-05

2006-07

%

C2: Tax-GDP ratioForecast

Why Does the Tax Ratio Go Up and Down?

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How High Should be Public Spending?

Costs of public spending

Benefits of spending

G*

C = B

0

Cost andBenefit Of spending

Size of spending

15

Social security27%

Other health and personal social

services4%

NHS15%

Transport3%

Education13%Defence

6%

Law & order6%

Other expenditure12%

Housing & environment5%

Industry, agriculture & employment

4%

Debt interest5%

B4: GOVERNMENT SPENDING BY FUNCTION

(www.HM-Treasury.gov.UK/Economic Data and Tools)

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B3: Total managed expenditure

37

39

41

43

45

47

49

1980-81 1982-83 1984-85 1986-87 1988-89 1990-91 1992-93 1994-95 1996-97 1998-99 2000-01 2002-03

% o

f G

DP

Forecast

(www.HM-Treasury.gov.UK/Economic Data and Tools)

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-8

-6

-4

-2

0

2

4

6

8

10

1980-81 1982-83 1984-85 1986-87 1988-89 1990-91 1992-93 1994-95 1996-97 1998-99 2000-01 2002-03 2004-05 2006-07

% o

f G

DP

Public sector net borrow ing Surplus on current budget

ForecastA4: BUDGET BALANCES

(www.HM-Treasury.gov.UK/Economic Data and Tools)

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References• Blanchard (5, 7, 26)• http://www.statistics.gov.uk/themes/economy/default.asp• http://www.ifs.org.uk/public/bn20.pdf, http://www.hm-treasury.gov.uk , • Aghevli B B (1977), Inflationary Finance and Growth, Journal of Political Economy, vol. 85, no.6

pp. 1295-1307.• Barro, R. J. (19740, "Are Government Bonds Net Wealth?," Journal of Political Economy

pp. 1095-1117.• Bhattarai (2003) Macroeconomic Impacts of Taxes: A General Equilibrium Analysis, University of

Hull. • Bhattarai K. (2001) A Prototype Multi-Sectoral Multi-household General equilibrium Tax Model,

Hull Advances in Policy Economics Working paper no. 9 forthcoming in Problems and Perspective Management, Spring 2004.

• Bhattarai K. and J. Whalley (1999) “Role of labour demand elasticities in tax incidence analysis with hetorogeneous labour” Empirical Economics, 24:4, pp.599-620.

• Bhattarai and J Whalley (2000) “General Equilibrium Modelling of UK Tax Policy” in S. Holly and M Weale (Eds.) Econometric Modelling: Techniques and Applications, pp.69-93, the Cambridge University Press, 2000.

• Clark Tom , M Elsby and S Love (2001) Twenty Five Years of Falling Investment? Trends in Capital Spending on Public Services, Institute of Fiscal Studies.

• Dilnot A, C.Emmerson and H.Simpson (2002) The IFS Green Budget: January, Institute of Fiscal Studies, Commentary 87, 7 Ridgemount Street, London WC1E 7AE.

• Emmerson C. and C Frayne (2002) Challenges for the July Spending Review, • HM Treasury (2002) Reforming Britain’s Economic and Financial Policy, Palgrave.• Institute for Fiscal Studies (2002), The IFS Green Budget, Janaury.• Shoven, J.B. and J. Whalley (1984) “Applied General-Equilibrium Models of Taxation and

International Trade: An Introduction and Survey,” Journal of Economic Literature 22, 1007-1051

•http:/www.hull.ac.uk/php/ecskrb