Fiscal Policy Effects - Essay Example

? Topic: Lecturer: Presentation: Introduction The government uses various policies to ensure the economy is running properly. The Keynesian economists advocate the use of fiscal policy to ensure the economy achieves desired output and employment. Other economists advocate for use of monetary policy due to some problems with fiscal policy such as the crowding out effect. Britain is one of the countries that make use of fiscal policy to run the economy. This policy is used to stimulate aggregate demand especially when the economy is at a recession. However, fiscal policy is more effective in the short-run as in the long-run there is stabilizing economic forces that ensure the output moves back to its potential (Taylor, 2009). The fiscal policy involves increasing government spending or reducing taxes to stimulate aggregate demand or vice versa to reduce demand. Some countries focus on the supply-side of the economy to ensure a more permanent change. The paper will discuss the effects of fiscal policy on the economy. Taxation Expansionary fiscal policy involves cutting taxes and increasing government spending. Taxation is a source of revenue for the government to fund expenditure. If it decides to cut taxes, then it runs a budget deficit. A reduction in income tax leaves individuals with more disposable income to spend on consumption thus raising aggregate demand. As demand increases, the producers are forced to produce more and employ more factors of production. This leads to more output and employment and increased economic activity (Sexton, 2008). However, income tax can only be adjusted annually on the budget hence it is difficult to apply this policy. It also depends on whether the households use extra income for consumption and not saving since savings is a withdrawal from the circular flow of income. The government can also increase transfers such as unemployment insurance, and in turn disposable income leading to more consumption (Riley, 2006). Lower taxes and increased transfers act as an incentive for workers to add more hours and increase productivity hence increased output and employment. Increasing taxes acts as a disincentive to work. If workers get less income by the end of the day compared to what they were getting, they would be dissatisfied and would not be willing to work extra hours. However, some would put more hours to cover the lost income but would lose their productivity due to low morale. There would also be low labour supply as not many individuals would be willing to work leading to low output in the economy (Taylor, 2009). Indirect taxes can also be used to discourage consumption especially of demerit goods. A government can impose duty on alcohol and cigarettes leading to lower demand for the items hence low output and employment. Tax incentives such as Subsidies to producers on the other hand lead to decline in cost of production hence reduced prices and consequently increased demand. Increased demand leads to production of more output hence increased economic activity (Creel & Sawyer, 2009). A decline in corporation tax attracts domestic and foreign investors’ hence increased fixed capital spending on technology, labour skills, infrastructure (Mankiw, 2008). Tax allowance on research and development encourages innovation and more business start-up thus increased employment and consequently increased aggregate demand. Government Spending Fiscal policy entails increasing government spending but a contractionary fiscal policy involves reducing government spending to curb excess demand. A government spends on infrastructure, and provision of essential services such as education and health. This adds directly to the aggregate demand of the economy hence stimulating economic activity. The government can finance its spending by borrowing from abroad or domestic market as raising taxes can lead to further weakening of the economy due to reduced demand. Improved infrastructure leads to more investments due to opening up of new markets and entry of investors hence increased level of aggregate demand and economic activity (Tucker, 2010). The government incurs huge deficit due to reduced taxes and increased spending and this may offset the gains of fiscal policy. However, it can sell the debt to the private sector to finance the deficit by offering treasury bills and long-term government bonds. Due to increased government spending, the fiscal policy is accused of causing a crowding out effect where scarce resources are transferred from the private sector to public sector (Taylor & Woodford, 2007). Too much borrowing is also criticised as it results in sale of treasury bills and bonds at a higher interest rate. This discourages private investments and also consumption hence reduced demand. To finance the interest rates on borrowed funds, the government may in future increase taxes hence future higher burden of taxation. If households and businesses expect future tax burden, they save their funds instead of circulating in the economy hence reduced investments, aggregate demand, output and employment (Riley 2006). A reduction in government spending has the effect of reducing economic activity. If a government decides to cut expenditure on health, education and welfare benefits, this overburdens the households and their disposable income is reduced leading to cut in consumption and consequently decline in demand. This in turn leads to reduction of output and employment by the businesses hence slow economic growth. Health and education are essential in supplying a healthy and productive skilled workforce thus there will be shortage of supply of productive and skilled labour leading to low output and slow growth of the economy. Lack of infrastructure discourages investors hence decrease in investments and consequently output and employment (US Congress, 2010). According to the United States congress (2010), the economic effects of government fiscal policies depend on how the changes are financed. The government must therefore decide where the money for the implementation will come from since it determines success or failure of the policy. The fiscal policy is planned over a period of time and it is not easy to change some of the elements as they are fixed through a budgetary process. For example, if a government wishes to lower the starting income tax rate for lower income earners, it has to plan ahead since income tax rates are fixed annually and cannot be changed until the next budgetary allocation. If on the other hand it intends to use indirect taxes, these are more flexible. The government can decide to waiver duty on certain items to increase demand or give subsidies to producers to encourage production and reduce prices hence increase demand. If the government intends to increase spending, it has to decide where to get the funds to finance the expenditure. Increasing taxes may have a negative effect as it discourages consumption. Mankiw (2008) argues that the sale of debts can lead to higher interest rates thus discouraging private consumption and investments and increased tax burden in future thus encouraging households and businesses to save instead of consumption. The government can borrow from abroad or encourage domestic and foreign investments although too much borrowing can reduce the nation’s savings and capital stock leading to a lower national income in the long-run. The government should thus plan wisely for fiscal policy to work effectively. Conclusion Fiscal policy is very crucial in reviving the economy from an economic downturn. It involves use of discretionary measures to stimulate aggregate demand and consequently output and employment. However, careful planning is needed to ensure proper implementation as too much borrowing can lead to undesired consequences. The government should plan in advance where to get the funds for implementation of the policy as most of its elements are allocated during budgetary process. The policy can also be applied to stimulate the supply-side of the economy such as quality of labour force and technology advancement for long term effects to be experienced. References Congress of the US (2010). An Analysis of the Presidents Budgetary Proposals for Fiscal Year 2011. Congressional Budget Office. Creel, J., Sawyer, M. (2009). Current Thinking on Fiscal Policy. New York: Palgrave Macmillan Mankiw, G (2008) Essentials of Economics. USA: Cengage. Riley, G (2006). “Macroeconomics: Fiscal Policy Effects”. Tutor2u. July 23, 2011. http://tutor2u.net/economics/revision-notes/as-macro-fiscal-policy-effects.html Sexton, R (2008) Exploring Economics. USA: Cengage. Taylor, J (2009) Economics. USA: Cengage. Taylor, J., Woodford, M (2007) Handbook of Macroeconomics, Vol 1C. UK: Elsevier. Tucker, I (2010). Macroeconomics for Today, 6 ed. USA: Cengage. Read More