The Monetary and Fiscal Policy in the UK - Case Study Example

An analysis of monetary and fiscal policy in UK One of the primary functions of a government is to attempt to manage its country’s economy thereby achieving current key financial objectives. These key objectives include keeping the rate of inflation low by maintaining price stability, maintaining low unemployment figures, promoting high economic growth and keeping a balance in international trade. These four objectives are formed by utilizing monetary, fiscal and supply-side policy tools which, in turn, control five types of taxes (Income, VAT, Insurance, Corporate and Excise). The government’s fiscal policies dictate the amount of taxes paid, by whom and to whom; as well as the redistribution of those monies. Economic growth and interest rates affect inflation rate. Interest rates, controlled by the Bank of England, fluctuate in an effort to balance these forces of economics. To properly analyze monetary and fiscal policies in the UK, a foundation must be laid defining the ingredients in the economic stew of which fiscal policies are determined. Each influences the other in a complex interaction which drives the monetary policy decisions. How this is accomplished, what bodies control these dynamics of the economy and a brief history of the beginnings of today’s system concludes with results of the system’s influence. The monetary policy, dictated by the governments inflation target (2-2.5 percent) is announced each year by the Chancellor of the Exchequer as a part of the Annual Budget Statement (Monetary Policy Framework, 2005). The Monetary Policy Committee (MPC) raises interest rates when prospective growth in domestic demand is strong. A low unemployment rate is one indicator of economic growth factor that leads to increased wages as employers aim to recruit and retain workers. This increases consumer wealth and fuels spending from labour income and increased household borrowing. If the economy is left to grow unchecked, this results in even higher inflation. Raising the interest rates behaves as a balance allowing the economy to grow, but keeping that growth in check, only growing steadily enough to keep inflationary pressures from building up in the economy. If raised too high, business is negatively affected, too low and inflation skyrockets (Interest Rates, 2000). The cause of inflation is one of those questions to which no one’s answer commands universal agreement and over which is heard continuous contentious debate. “Inflation is the observable outcome of a complex process of political and economic interaction in society” (Heymann, Leijonhufvud, 1995, p. 11). In such a context, which process causes which effect can become easily convoluted. “Behind the rise in a general price index lie the pricing decisions of innumerable firms and individuals. In a non-trivial sense, those actions are the most direct cause of inflation. But, of course, the decisions to revise prices are motivated by market and policy signals. And these, in turn, are at the end of other chains of causation” (Heymann, Leijonhufvud, 1995, p. 11). Each cause brings into view one or more prior causes of which it may be the effect. Some of these causes even circle back on themselves, effects at one stage becoming causes at another. “Building a complete model of these economic and extra-economic interactions is an impossible task. Of necessity, the economist must begin by deciding which links between variables he will concentrate on and how far he should try to go in the quest for a deep enough explanation” Heymann, Leijonhufvud, 1995, p. 11). A rise in money prices (inflation) is the effect that has to be explained, but in the absence of a universal, comprehensive inflation theory, alternative models must coexist, each of them with their strengths and weaknesses. When inflation is high, unemployment is low, and vice-versa. The unemployment rate is the most commonly used summary measure of the state of the labour market. Low unemployment raises worker bargaining power, allowing them to successfully push for higher nominal wages. “Reforms to the tax and benefit system, underpinned by the National Minimum Wage and the Working Tax Credit, have improved incentives to work, helping the labour market to respond flexibly to economic shocks, while preserving a degree of stability in workers incomes. Unemployment in the UK on the International Labour Organisation (ILO) definition is the lowest among the G7 economies and employment has risen to record highs” (Building a Britain, 2003). Government policy can control unemployment and inflation within a Keynesian policy and can tolerate a reasonably high rate of inflation as this would lead to lower unemployment – there would be a trade-off between inflation and unemployment. Monetary and/or fiscal policy (i.e., deficit spending) could be used to stimulate the economy, raising gross domestic product and lowering the unemployment rate. “Moving along the Phillips curve, this would lead to a higher inflation rate, the cost of enjoying lower unemployment rates” (Wikipedia, 2005). Some would say that a more Keynesian approach is required which stresses demand. “For the Keynesian, it is demand that drives the economic system to which supply, within limits, adapts. Taking this approach, growth rates differ because the growth of demand differs between countries. The question then becomes why does demand grow at different rates between countries? One explanation may be the inability of economic agents, particularly governments, to expand demand. This explanation by itself, however, is not very satisfactory. The more probable explanation lies in constraints on demand. In an open economy, the dominant constraint is the balance of trade” (McCombie, Thirlwall, 2004, p. 21). To achieve a balance of inflation and unemployment, the government takes into account the waves of change that are taking place in our economy and society; changes in the roles and aspirations of women, the relationship between work and family, the increase in life expectancy and an increasingly diverse workforce and pattern of working hours. The government will need a framework that supports these social changes and will look to non-regulatory means to develop the framework, but where necessary, it will regulate in ways that also support full employment and higher productivity (Department of Trade and Industry, 2002). An increase in unemployment is often considered to be a reflection simply of a loss of jobs, while a decrease in unemployment is interpreted simply as people finding jobs. However, the reality of the labour force is that jobs are both lost and gained in large numbers during any given month. There are also people moving in and out of the labour force, as well as growth in the potential labour force as the population increases. These movements in and out of employment and the labour force can occur for a variety of reasons, of which losing a job is only one. Other examples include people taking the opportunity for a holiday between contracts, occupations where employment is seasonal, or leaving the labour force to care for children (Trends, 2004). High economic growth targets depend on government policies in areas such as taxation, protection of property rights, and provision of infrastructure services and education. The targets can also vary because of factors that governments cannot readily influence, such as underlying attitudes about saving, work effort, and fertility, and the availability of natural resources (Solmon, Zycher, 1993, p. 9). Source: Opinion Policy and Trade offs, 2004 Graph: The British economy has enjoyed a very long period of falling unemployment without any significant acceleration in inflation. RPIX - Retail Prices Index minus mortgage interest payments The government needs money to spend on health, education, law and order and all the other public services. For 2004/05, total government expenditure is estimated to be £488 billion. That is over one and a quarter billion pounds each day. The funds needed to provide these services comes from, of course, taxation (External Environment, 2006). Income taxes, probably the most important government assessment, raise well over a quarter of all tax revenue. It is charged on all income but the rate increases the more income is earned. “The first part is tax-free, but then once you have earned this personal allowance the tax rate is 10 percent for the next chunk of income. The rate then increases to 22 percent for a while and then to 40 percent for higher income. The level at which the rate changes is termed the tax band and these tend to be changed in the budget each year to keep up with inflation” (Theory 1, 2006). Value added tax (VAT) is a tax on spending called an indirect tax. VAT is a tax that you pay when you buy goods and services. Where VAT is payable, it’s normally included in the price of the goods or service you buy. Some goods don’t attract VAT. The VAT is paid on most goods and services in the UK at the standard rate, currently 17.5 percent. In some cases, for example children’s car seats and domestic fuel or power, a reduced rate of five percent is paid. “There are some goods on which VAT is not paid such as food books, newspapers and magazines, children’s clothes and special exempt items – for example equipment for disabled people” (Vat, 2006). VAT is charged at every stage of the production process, but firms can reclaim any VAT they pay, so the only people to actually pay VAT as a tax are the consumers. A company is required to keep a record of all the VAT they have paid on their supplies and all the VAT they have collected on their sales. The latter figure should be bigger and they pay the difference over to HM Customs and Excise who collect VAT. The net effect is that they pay no VAT, but they have to act as the tax collectors for Customs and Excise. National Insurance Contributions are paid by both employers and employees. They are collected through the pay as you earn (PAYE) income tax collection system. The employer must make appropriate deductions from earnings and make payments of both his and his employees contributions each month (National Insurance Contributions, 2005). National insurance began as a fund maintained by government to pay out to individuals who are unemployed, incapacitated or widowed and for when retirement age is reached. To receive a state pension on retirement, you have to have paid enough national insurance to qualify. “If youre employed and earn above £94 a week (the earnings threshold) and up to £630 per week you pay 11 per cent of this amount as Class 1 NICs. You also pay one per cent of earnings above £630 a week as Class 1 NICs. You will pay a lower amount as an employee if you are a member of your employers pension scheme. If youre self-employed you pay Class 2 NICs at a flat rate weekly amount of £2.10. You also pay Class 4 NICs as a percentage of your taxable profits - you pay eight percent on annual taxable profits between £4,895 and £32,760 and one percent on any taxable profit over that amount. If your earnings in the 2005-2006 tax year are expected to be less than £4,345, then you may be entitled to the Small Earnings Exception (SEE), meaning you dont have to pay any Class 2 NICs” (Money, Tax and Benefits, 2006). Corporation tax is a tax on corporate earnings (and often includes capital gains) of a company. Earnings are generally considered gross revenue less expenses. However, corporate expenses that relate to capital expenditures are rarely deducted in full (such as the entire cost of a company truck) and are often deducted over the useful life of the asset purchase (Direct Tax, 2006). This is charged on company profits and the rate varies according to the size of the business. It is effectively an income tax for business as their income is their profit. Businesses do also have to pay local business taxes (business rates) to local authorities in the area they are located in, but corporation tax is collected by the Inland Revenue. The tax system is complex: “If a company’s profits are under £10,000 pa, there is no Corporation tax. Unless a dividend is paid. Then corporation tax is payable on the dividend at a rate of 19 percent. If a company’s profits are more than £10,000 but less than £50,000 the Corporation tax will be charged at a marginal rate on all of its profits, such that at £50,000 all profits are taxed at 19 percent. If a company’s profits are over £50,000 but less than £300,000pa, Corporation tax will be charged at a rate of 19 percent on all of its profits. If a company makes over £300,000, Corporation tax will be c30 percent of all profits” (UK Tax Rates, 2003). Excise duties are taxes imposed on certain types of products including alcohol and tobacco which are produced in the UK. Customs duties apply to products imported to the UK (Excise Duty, 2006). “These are also taxes on spending and so are termed indirect taxes, but they are taxes on specific goods. Excise duties are charged on alcohol, tobacco, petrol and gambling. They are collected by HM Customs and Excise and tend to be increased each year in the Budget. This is because they are usually set at a fixed rate and so need to be increased to ensure that the revenue from them keeps up with inflation. Many of them are also intended to try to reduce consumption because of the harmful social costs that may be generated as a result (pollution from petrol, etc.)” (Theory 1, 2006). Also included in government taxation are Inheritance tax and Capital Gains Tax. Inheritance tax is collected at varying rates. “From 6 April 2005, the first £275,000 of value transferred in life or on death is taxed at a nil rate. Chargeable lifetime transfers exceeding £275,000 within any seven year period are taxed at 20 percent. The excess over £275,000 passing on death, or gifted within seven years of death, is taxed at 40 percent. The tax rate is reduced by taper relief for gifts made more than three years before death with a credit for any inheritance tax already paid” (Inheritance Tax, 2004). Capital Gains Taxes (CGT) is charged on net gains, for example, “total chargeable gains realised during a tax year after deducting total allowable losses realised in the year. The first £8,500 of an individuals net gains realised during the tax year is free of CGT. The excess is taxed as if it were the top slice of income, at the rates that apply to savings income, namely 10 percent on the first £2,090, 20 percent on the next £30,310 and 40 percent on the balance” (Capital Gains Tax, 2005). Husbands and wives are subject to CGT separately, each with their own annual exemption and tax rates. Transfers between spouses living together are not liable to CGT. Three main types of policy tools – fiscal, monetary and supply-side policies – are at government’s disposal in order to achieve the objectives of keeping the rate of inflation low, preserving low unemployment, promoting high economic growth and maintaining a balance in international trade. “Fiscal policy is using the levels of government expenditure and taxation to try to influence the course and trends of the economy. Fiscal policy can be a fairly blunt tool as this method is only changed to any great extent in the Budget given by the Chancellor each year (usually in March). This means that all necessary policy changes have to be squeezed into this one time, although the Pre-Budget Statement given by the Chancellor in December gives some indications of future policy changes and helps businesses to plan ahead” (External Environment, 2006). Changes in the tax system can be useful for promoting medium to long-term change in the economy and will often be used to try to improve incentives for people or firms to change their behaviour. “For example, the landfill tax is intended to try to reduce the amount of waste that goes into landfill and encourage recycling. The government can use fiscal policy to try to boost the economy by either spending more (injecting more money into the economy) or by taxing less (allowing people to keep more of their earnings and therefore spend more). Doing the opposite would help slow the economy down” (External Environment, 2006). Monetary policy of the government influences the economy by the management of interest rates and the money supply. It is the major instrument implemented for the short to medium-term management of the economy, “but interestingly, the government gave away control over monetary policy in 1997. They handed it over to the Bank of England, and through a committee called the Monetary Policy Committee (MPC), the Bank of England is now responsible for keeping inflation within one percent either side of the target set by the Chancellor. This target is currently two percent. Supply-side policies are medium to long-term policies that are aimed at improving the potential of the economy to produce. In other words, they are aimed at improving the capacity of the economy. They may include policies to encourage investment, or perhaps policies to improve incentives for people to work harder” (External Environment, 2006). Source: Theory 1, 2006 BANK OF ENGLAND HISTORY In the mid 17th century, England and in particular London was on the brink of a tremendous expansion of trade. The need for funds in order to drive the trade of the country became vital thus a national bank was established. It was founded in1694 as a commercial bank by William Paterson with a capital of £1.2 million, which was advanced to the government in return for banking privileges, including the right to issue notes up to the amount of its capital. “In 1709 the capital was doubled; the charter was renewed in 1742, 1764, and 1781. The bank’s facilities proved a great asset in English commercial, and later industrial, expansion” (Bank of England, 2006). The bank’s functions were both public and private; it safeguarded the English pound and also operated for private profit. The Bank Charter Act of 1844 assured efficient regulation. It also laid the foundation for the bank’s modern structure. Nationalisation, after the Second World War, made little difference to the workings of the Bank. The Bank remained the Treasurys adviser, agent and debt manager. “During and for years after the war it administered exchange control and various borrowing restrictions on the Treasurys behalf. However, a revival of interest in monetary policy during the high inflation period of the seventies ultimately led to a re-evaluation of the role of the Bank of England” (Background, 2005). The 1946 Bank of England Act made no mention of the Bank’s essential reasons for being, its purpose. It seems to have been taken for granted that everyone knew what its role was. About a decade ago it was decided to define three core purposes. “The first two – the maintenance of monetary stability and the maintenance of the stability of the financial system – are key objectives of central banks pretty well everywhere. Our third core purpose - the promotion of the efficiency and effectiveness of the financial system in serving the interests of the wider economy - was more unusual for a central bank, but arose from a long-standing tradition of catalytic involvement in the development of our financial system.” The Bank of England Act of 1998 carried over these three principles into the new statutory framework. “There are certainly some very important changes in the more precise nature of the Bank’s role. In relation to monetary stability, the Bank, through its new Monetary Policy Committee, now has independent responsibility for the operation of monetary policy and for achieving consistently low inflation as defined by the Chancellor” (George, 2000). In 1998, the Bank of England assumed full operational responsibility for monetary policy and was given its independence as a central bank. “Debt Management on behalf of the government was continued through the creation of the UK Debt Management Office, an executive agency of HM Treasury. The Banks regulatory functions passed to the Financial Services Authority” (Background, 2005). As government sets both objectives, co-ordination between both branches of macroeconomic policy has been improved. The fiscal and monetary frameworks are characterized by high levels of openness, transparency, and accountability. “A recent paper by HM Treasury suggests that the new framework is better coordinated than the previous arrangements where the Chancellor set both UK interest rates and fiscal policy” (HM Treasury, 2005). The MPC cut interest rates by ¼ percent to 4½ percent on 4 August and at present, published data suggests that the British economy is holding steady (Smith, 2005). “Although the retail sector continues to exhibit some weakness, the broader CIPS service sector (or PMI) indicator for August held quite steady,” said John Greenwood (Chief Economist, AMVESCAP) - an investment management company based in London (Smith, 2005). “Rapid monetary growth continues as sterling M4 has continued to grow at double-digit rates (10.2% year-on-year in August), with M4 lending growing only fractionally more slowly (9.7% year-on-year in July). Business lending has been picking up, offsetting slower lending growth to the personal sector” (Smith, 2005). Residential property continues to stay level with the number of loans approved for home purchase slightly progressing. Data for manufacturing, industrial production and business investment have held their levels in recent months. Labour earnings have also remained steady. “CPI inflation data for August showed a month-on-month increase of 0.4 percent and the year-on-year figure jumped to 2.4 percent. Industrial input prices have risen strongly (+12.9% year-onyear in August), while output prices (+3.0% in August) have been contained by competition and margin compression” (Smith, 2005). The objective of the Bank of England Bank’s monetary policy is to maintain the value of the currency and to providing a framework for non-inflationary economic growth by controlling the interest rate. The Bank is accountable to Parliament who enacts economic law and collects revenues to stimulate the economy directly, through spending. The principal means of accountability for the Bank is via Annual Report and Accounts to the House of Commons Treasury Committee. The Bank decides the level of short-term interest rates to attain the governments stated inflation target. Interest rates are the pulse of the economic heart controlling inflation and stimulate economic growth for the country but Britain is not homogeneous. Whenever interest rates rise it might be appropriate for certain parts of the country, but is wrong for some sectors of the economy, some regions or even some companies. “But policy can never be set with the interests of one sector, or one region, let alone one company in mind. And it isn’t. I can assure you that policy is not set with the South East of England in mind. But equally, it is not set either in the sole interest of the North East of England or Scotland. It is set for the United Kingdom as a whole” (King, 1999). The Labour Government has several current objectives that have thus far proven at least somewhat successful such as stable low inflation, sustainable growth as measured by the rate of growth of real gross domestic product, low unemployment and higher levels of capital investment. “All of these factors have helped to increase the supply-side potential of the economy which has contributed to a period of non-inflationary growth” (Tutor2U, 2004). Parliament raising revenues and efforts to reduce spending have performed well in tandem with the Bank’s monetary policies designed to increase the flow of money. References “Background: DMO, HM Treasury and Bank of England Information.” (2005). Debt Management Office. Accessed 26 January 2006 from “Bank of England.” (2006). Bartleby.com. Accessed 26 January 2006 from “Building a Britain of Economic Strength and Social Justice.” (9 April 2003). CCH. Accessed 26 January 2006 from “Capital Gains Tax.” (2005). Dyer Partnership. 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Accessed 26 January 2006 from < http://www.iea.org.uk/files/upld-article91pdf?.pdf> Solmon, Lewis and Zycher, Benjamin. (1993). Economic Policy, Financial Markets and Economic Growth. Boulder, CO: Westview Press. “Theory 1 – Types of Taxation – Is There Anything That Isn’t Taxed?” (2006). Bank Biz/Ed. Accessed 26 January 2006 from “Trends in the Unemployment Rate Over Recent Decades.” (2004). Budget 2004/2005. Accessed 26 January 2006 from Tutor2U. (2004). “Opinion Policy and Trade offs.” Accessed 26 January 2006 from < http://www.tutor2u.net/economics/revision_focus_2004/A2_Economic_Policy_Objectives_and_Trade_Offs.pdf> “UK Tax Rates.” (2003). Lester Sybersolve. Accessed 26 January 2006 from “VAT – Value Added Tax.” (2006). DirectGov. Accessed 26 January 2006 from < http://www.direct.gov.uk/MoneyTaxAndBenefits/Taxes/BeginnersGuideToTax/BeginnersGuideToTaxArticles/fs/en?CONTENT_ID=4015895&chk=8gHIJf> Wikipedia contributors. (2005). “Phillips curve.” Wikipedia, The Free Encyclopedia. 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