The UK Fiscal Policy - Report Example

FISCAL POLICY Lecturer: Introduction The coalition government of the UK came into power in May at a time when there was anongoing government pursued expansionary fiscal policy started in 2009 (Law, 2010). As part of the expansionary fiscal policy, the then government planned to cut VAT as a way of boosting consumer spending. Even though economists agree that this was a move that helped the country to respond to the deep recession which led to a fall in the GDP of the country by 6%, it also had its own negative impacts (Wilson, 2010). For example the expansionary fiscal policy caused government borrowing to rise in the 2009/2010 fiscal year as government tax revenue lowered amidst the recession (Law, 2010). As a response to this, the coalition government introduced the conservative-liberal democrat coalition government agreement, which was a broad spectrum of plan to govern the country. As part of the agreement, there were fiscal strategies aimed at improving the economy of UK. This paper critically appraises the fiscal strategy of the coalition government by reviewing the element of it whilst assessing the impact of the strategy on the economy. Three major components of the agreement will be reviewed which are deficit, spending, and taxation. The impact will also be viewed from the perspective of aggregate demand, saving and investment, and distribution of income. 2. Components of the Conservative–Liberal Democrat coalition agreement fiscal strategy It is common to find any fiscal strategy that focus on deficit, spending, and taxation. But when a particular fiscal strategy is being criticised, it is important to compare what is entailed in it to what has been studied in literature. This way, it is possible to identify any theory-practice gaps. To do this, the coalition government’s policy strategy is reviewed in relation to economics literature. 2.1 Deficit There were specific fiscal strategies that focused on the deficit of the country as part of the coalition agreement. More specifically, the agreement aimed to tackle the budget deficit and national debt through the use of parliament as a major stakeholder (Bourguignon and Morrison, 2002). As can be seen from figure 1, the 2009/10 financial year saw a high level of government deficit, creating the need to act swiftly. Figure 1: UK Government deficit 2006 to 2014 Source: HM Treasury Public Finance (2014) The first attempt was to cut the structural deficit by £6 billion in the 2010/11 financial year. When this plan is related to existing literature and economic theories, there are different positions that can be found among various authors. Comparing the impact of budget deficit and national debt on the deficit of the country, Bourguignon and Morrison (2002) observed that the government has much control over its budget than national debt and so it is always prudent that any drastic strategies that are made to reduce deficit be focused more on the budget deficit. This is because even when the government receipts are low for a particular year, a reduction in spending that is triggered by high level of discipline in budget deficit can ensure that the government deficit sees a reduced debt over a particular year. With this said, it was expected that as the coalition government focuses on both budget deficit and national debt, it would give particular attention to the government budget balance. If for nothing at all, the budget deficit in incurred on a yearly basis but the national debt is longitudinal in nature as it has existed over a period and will continue to be measured into the future (Hogg, Baskerville & Lemelin, 2005). These issues notwithstanding, the coalition agreement’s major focus on deficit rested with reducing government borrowing and thus the national debt (Wilson, 2010). 2.2 2010 Spending Review Government spending has been said to be one other important component of any fiscal policy (Barro & Vittorio, 1994). With this idea well noted by the coalition government, there was a spending review made in 2010 which committed the government to focus its spending on social interventional services. Some of these included increase National Health Service (NHS) funding, increased funding for disadvantage pupils, and public sector pension (Hazell & Yong, 2012). Even though the review proposed to maintain UK’s nuclear deterrent, it made plans to replace the Trident system for something else that guaranteed value for money (Liberal Democrats, 2010). Writing on government spending, Henderson (2009) indicated that most governments, as part of their fiscal policy strategies which aim to cut down on deficit have developed socially unfavourable attitudes towards spending. That is, government reduces spending in the public area that focuses on the vulnerable so much that standard of living eventually becomes poor. This approach to spending is something that has been criticised as lacking innovation for economic empowerment (Barro & Vittorio, 1994). The fact that the coalition government did not take the option of cutting spending for the ordinary citizen but to reduce government expenditure on such things as the Trident system which is yet to guarantee value for money can be said to be a step in the right direction. 2.3 Budget Responsibility and National Audit Act 2011 As a government’s fiscal policy also focuses on the use of revenue generated mainly through taxes, strategising the way out for government’s tax system has always been a priority for most government (Hogg, Baskerville & Lemelin, 2005). For the coalition government, its approach to strategising the tax system it inherited into a new one was enshrined in the Budget Responsibility and National Audit Act 2011. As part of the Act, there was an agreement to increase the personal income tax allowance to £10,000 by 2015 (Hazell & Yong, 2012). The government also planned to partially scrape the proposed 1% rise in National Insurance which it came to inherit. In essence, greater parts of the strategy made on taxation aimed at freeing the lowest salaries out of the tax system. Whiles doing this, plans were also put in place to increase government revenue through increased taxes in the areas of aviation and non-business capital gains, whiles reducing the number of tax avoidance. When this policy is viewed from the perspective that the coalition government came at a point when there was recession, it can be praised as being people-centred. Within a larger economic perspective however, it will be appreciated that even if the government spending is low for a given year and it is not able to generate enough revenue, its deficit will still be high (Henderson (2009). 3. Impact of the fiscal strategy on the economy One of the best ways to assess the economic viability of the fiscal policy of the coalition government is to measure the impact that the strategy had on major macroeconomic variables. In the light of this, three such variables are analysed in relation to the fiscal strategy. 3.1 Aggregate demand and the level of economic activity According to Liberal Democrats (2010), as part of the recession which the coalition government inherited in 2010, the total demand for final goods and services in the UK economy had gone down. This means that aggregate demand (AD) was low as the purchasing power of consumers was very low. As a result of the fiscal strategy which sought to reduce taxation among lower earners, it was possible to retain a lot of earned money among workers. Consequently, the aggregate demand within the economy began improving with the coming of the fiscal strategy. Meanwhile, because there was so much demand for goods and services, economic activity especially at the retail level was also affected positively because the extent of rush for retail goods went up significantly. It would also be appreciated that part of the taxation policy also sought to burden suppliers and manufacturers less. As a result of this, price levels could be kept low within the period (Mankiw & William, 2011). Relating this situation to Pigou’s wealth effect, it would be noted that where there is higher price levels, lower real wealth is created because of lower consumption spending (Sexton and Fortura, 2005). By implication, lower price meant higher real wealth due to increased consumption. 3.2 Savings and Investment in the economy Comparing the contribution of the corporate world to individual spenders and retailers, Sexton and Fortura (2005) posited that an economy’s major strength in savings and investment rest with active economic activity by the corporate world. Meanwhile, before the coalition government’s fiscal policy, Larch and Nogueira (2009) observed a situation where government supported the corporate world so much with earnings made from its borrowings. That is, government borrowed more to support the macro economy so as to improve microeconomic activity. Because of this, the UK attracted a lot of foreign investment which improved the level of savings within the UK economy. As part of the policy strategy however, there was a massive cut on government borrowing as a means of keeping low deficit. Resultantly, businesses that otherwise relied on government macroeconomic support for growth became virtually paralysed because a major source of their capital support was taken away (Mankiw & William, 2011). As can be seen in figure 2, lower economic growth was recorded from 2010 to 2012 as a direct response to the impact of the policy strategy on savings and investment (Larch & Nogueira, 2009). Figure 2: UKs GDP from 2007 to 2014 Source: World Bank Group (2015) 3.3 The distribution of income How the country’s GDP is distributed among the population is said to constitute the income distribution of that country (Hazell & Yong, 2012). This means that all things being equal, when the population of a country is maintained but its GDP drops, income distribution will also drop. The reverse argument can also be said to be true. From a classical economic perspective however, it is not always sufficient to look at the income distribution from the broader GDP spectrum. Rather, it is important consider main factors of production, land, labour and capital (Larch & Nogueira, 2009). The implication that this gives to monetary planners is that in order to maintain a reasonable and sound distribution of income, all factors of income distribution must be adequately considered. Knowing this, the coalition government made plans to ensure that the shocks that were experienced as part of the declining economic growth will not have an impact on the population. At least if not all the population, the most vulnerable of them, which is those who were the low income earners. It was for this reason that income tax allowance was slashed significantly. In principle therefore, even though GDP did not grow, it was still possible to ensure a stable distribution of income. 4.0 Conclusion It has been established that the fiscal strategy of the coalition government as was contained in the conservative-liberal democrat coalition agreement were taken from three major perspectives which were deficit, spending, and taxation. In terms of deficit, the government attempted to reduce deficit by focusing on both national debt and budget deficit. The fact that the government’s emphasis was on borrowing as part of national debt interventions can however be said to defeat the need to ensure fiscal discipline that is within the government’s power. However, policies on spending and taxation were both done to favour the ordinary citizen. There was a clear reflection of the approaches in the fiscal strategy on macroeconomic variables. For example demand and level of economic activity went high because people were taxed less, giving them enough purchasing power. Savings and investment in the economy was however affected negatively because instead of generating revenue from individuals, the corporate world became the government’s major target. On the whole, it can be said that the fiscal strategy was both economic and political in nature. This is because whiles it ensured economic stability, it also looked for ways of freeing the people who voted the government into office from hardship. References Barro R. & Vittorio G. (1994). European Macroeconomics, Ch. 15–16. London: Macmillan. Bourguignon, F. & Morrison, C. (2002) “Inequality among world citizens: 1890–1992”, American Economic Review, vol. 92, no. 4, pp. 727–744. Hazell, R. & Yong, B. (2012). The Politics of Coalition: How the Conservative-Liberal Democrat Government Works, Ch 14. London: Hart Publishing. Henderson D. R. (2009). Concise Encyclopedia of Economics (2nd ed.), Ch. 2-5. Indianapolis: Library of Economics and Liberty. HM Treasury Public Finance (2014). UK Fiscal Policy. [Online] Available at http://www.economicshelp.org/macroeconomics/fiscal-policy/fiscal_policy/ [April 05, 2015] Hogg, W., Baskerville, N. & Lemelin, J. (2005). "Cost savings associated with improving appropriate and reducing inappropriate preventive care: Cost-consequences analysis". BMC Health Services Research 5: 20 Larch, M. & Nogueira J. M. (2009): Fiscal Policy Making in the European Union – An Assessment of Current Practice and Challenges, Ch 2-5. New York: Routledge. Laws, D. (2010). 22 Days in May, Ch. 5-9. London: Biteback. Liberal Democrats (2010). Conservative Liberal Democrat Coalition Agreement [Online] Available at http://www.libdems.org.uk/latest_news_detail.aspx?title=Conservative_Liberal_Democrat_coalition_agreements&pPK=2697bcdc-7483-47a7-a517-7778979458ff [April 05, 2015] Mankiw, N. G. & William M. S. (2011). Macroeconomics. Canadian ed., 4th ed., Ch. 2-4. New York: Worth Publishers, 2011. Sexton, R. & Fortura, P. (2005). Exploring Economics, Ch. 6 New York: Ultimate Press Limited Wilson, R. (2010). 5 Days to Power, Ch. 3-8. London: Biteback. World Bank Group (2015). United Kingdom GDP. [Online] Available at http://www.tradingeconomics.com/united-kingdom/gdp [April 04, 2015] Read More