1. Fiscal Policy to Fine-Tune the Economy
Economic Modelling
Lecture 10
Fiscal Policy to Fine-Tune the Economy

2. 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

3. Instruments of Fiscal Policy
Taxes
Direct (income, wealth)
Indirect (VAT, Excise, Tariff and duties)
Subsidies (consumption and production)
Spending
Pure Public goods ( defence, law and order, roads)
Semi-public goods (education, health, sanitation)
Debt
Borrowing from the private sector -Crowding Out
From the central banks -inflationary tax

4. 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 sector
Trade: domestic vs. foreign goods
Excise duties
Consumers
Current vs. future consumption
Composition of consumption
(VAT and market prices, Sin goods)
Traders and investors
Choice of trading partners
Location investment

5. 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.

6. Macroeconomic Stabilisation Role of Tax and Spending
T = tY
T > G
Surplus in boom
G = T
Tax
and
Spending G G
T < G
Deficit in
recession YF
Income T

7. Balanced Budget Multiplier with Lump-Sum Taxes
The real national income is given by the IS Curve:
Positive Government expenditure multiplier: .
Negative tax multiplier:
The balanced budget multiplier:
=1/(1-c1) - c1/(1- c1) = 1
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.

8. Automatic Stabiliser with Proportional Taxes
Consumption:
Disposable income:
Tax Revenue
Income (IS curve):
Y = c0 + c1YD + I + G
High T when Y is high.
Low T when Y is low.
The multiplier = 1/(1-c1+c1t1) <1/(1- c1),
so the economy responds less to changes in
autonomous spending when t1 is positive.

9. How much should be the tax rate to maximise the government revenue ?
Tax compliance
R-max
Revenue
Tax avoidance
Tax evasion
R-low
Revenue=F(t)
Tax rate tH
t-Low
t-Rmax

10. Laffer Curve Model:A Numerical Example

11. Tax Brackets and Effective Rates of Taxes for three Individuals

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

13. Why Does the Tax Ratio Go Up and Down?

14. How High Should be Public Spending?
Costs of public spending
Cost and
Benefit
Of spending
C = B
Benefits of spending G*
Size of spending

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

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

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

18. References http:/www.hull.ac.uk/php/ecskrb Blanchard (5, 7, 26) ,
Aghevli B B (1977), Inflationary Finance and Growth, Journal of Political Economy, vol. 85, no.6 pp
Barro, R. J. (19740, "Are Government Bonds Net Wealth?," Journal of Political Economy pp
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
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,