A2 Economics: 2. Fiscal policy & crowding out

The “crowding-out hypothesis” is an idea that became popular in the 1970s and 1980s when free-market economists argued against the rising share of GDP being taken by the public sector.

• The crowding out view is that a rapid growth of government spending leads to a transfer of scarce productive resources from the private sector to the public sector where productivity might be lower
• If the government runs a big budget deficit, it will have to sell debt to the private sector and getting individuals and institutions to purchase the debt may require higher interest rates. A rise in interest rates may then crowd-out private investment and consumption, offsetting the fiscal stimulus

• Eventually higher government spending needs to be funded by higher taxes and this again acts as a squeeze on spending and investment by the private sector of the economy.

Rational Expectations View

• According to a school of economic thought that believes in ‘rational expectations’, when the government sells debt to fund a tax cut or an increase in expenditure, a rational individual will realise that at some future date he will face higher tax liabilities to pay for the interest repayments.

• Thus, he/she should increase his savings as there has been no increase in his permanent income

• The implications are clear. Any change in fiscal policy will have no impact on the economy if all individuals are rational. Fiscal policy in these circumstances may become ineffective.

Balanced budget fiscal expansion

• This concept has become a major topic of conversation in the debate over the economic effects of fiscal austerity in many countries in the European Union and beyond. Put simply, a balanced budget fiscal expansion occurs when a change in government spending is matched by an equal change in taxation so that there is a neutral effect on the annual fiscal deficit but with the hope that real national income will expand.
• Central to the concept is that the fiscal multiplier effects of say a £10bn rise in government spending are higher than the negative multiplier effects of an equivalent £10bn rise in taxes

Keynesian response to the crowding out view and rational expectations view

• The probability of 100% crowding-out is remote, especially if the economy is operating below its capacity and if there is a plentiful supply of saving available to purchase newly issued state debt

• Keynesian economists such as Paul Krugman argue that fiscal deficits crowd-inprivate sector investment. Well-targeted, timely and temporary increases in government spending can absorb under-utilised capacity and provide a strong multiplier effect that generates extra tax revenue.

A2 Economics: 1. Government Expenditure - Current Vs Capital spending

Lets start with a multiple choice question to warm you up....


Government spending is spending by the public sector on goods and services such as education, health care and defence.

Total UK government spending was around £745 billion in 2015. This was 43% of GDP. Of this, £50 billion was on capital spending. Spending on public services such as education & health is 22% of GDP.

Social welfare protection is the largest element of government spending, with the NHS and Education the biggest single departmental items.

Government Current and Capital Spending

Current spending – on providing public services

• Salaries of NHS employees
• Drugs used in health care
• Road maintenance budget
• Army logistics supplies

Capital spending – new public infrastructure

• Construction of new motorways and bridges
• New equipment in the NHS
• Flood defence schemes
• Extra defence equipment

Economic Importance of Government Spending

• Is a Key Component of Aggregate Demand
• Has a big Regional Economic Impact
• Important in providing Public & Merit Goods
• Can help achieve greater Equity in Society

How Government Spending can affect Incomes

Welfare state transfers

• Universal child benefits / unemployment benefit
• Public (state) pensions
• Conditional welfare transfers e.g. Conditional on attending unemployment programmes
• Targeted welfare payments- linked to income

State-provided services (in-kind benefits)

• Education - reduces inequality of market incomes
• Health care – state provided health services
• Social housing e.g. Provided by local authorities
• Employment training

Trickle down economics: A comoon essay question

Useful when planning a commonly asked essay question of advantages of free market and inequality.

Trickle down economics is a term used to describe the belief that if high-income earners gain an increase in salary, then everyone in the economy will benefit as their increased income and wealth filter through to all sections in society.

How the trickle-down effect may work

If the richest gain an increase in wealth, then

• They will spend a proportion of this extra wealth.
• The extra wealth will cause an increased demand for goods and services, causing higher employment and rise in wages.
• The higher wages will also cause a multiplier effect, e.g. if more chauffeurs are employed by the rich, the chauffeur will gain increased income and, in turn, they will increase spending in local businesses.
• Alternatively, the wealthy may invest their increased wealth. If the wealth is invested in new businesses, it will create new jobs and increase incomes of those employed.
• Higher spending and investment will stimulate economic activity leading to a rise in tax revenues (higher income tax, higher VAT).
• Higher tax revenues can fund public programmes such as healthcare, education and welfare payments to the poor.

Criticisms of trickle-down economics

However, others criticise this belief in ‘the trickle-down effect. In particular, the wealthy have a higher marginal propensity to save. In recent years, wealth has been saved in off-shore accounts to avoid paying tax.

Also, some studies suggest that increased income inequality can lead to this inequality being solidified through educational opportunities, wealth accumulation and the growth of monopoly/monopsony power. Furthermore, increased inequality may lead to lower rates of economic growth.

A recent report by the OECD found that since the start of the credit crisis in 2008, inequality has widened in many countries; however, this inequality has led to lower rates of economic growth not higher.

This graph from an OECD report suggests that inequality is responsible for lower GDP. The OECD estimates that the UK economy would have been more than 20% bigger had the gap between rich and poor not widened since the 1980s.

Source: OECD Focus – Inequality and Growth 2014

Trickle down effect and tax cuts

An important element of the trickle-down effect is with regard to income tax cuts for the top-income earners. It is argued that cutting income tax for the rich will not just benefit high-earners, but also everyone. The argument is as follows:

1. If high-income earners see an increase in disposable income, they will increase their spending and this creates additional demand in the economy. This higher level of aggregate demand creates jobs and higher wages for all workers.
2. Alternatively, increased profits for firms may be reinvested into expanding output. This again leads to higher growth, wages and incomes for all.
3. Lower income taxes increase the incentive to for people to work leading to higher productivity and economic growth.

Criticisms of the trickle-down effect

• High-income earners have a high marginal propensity to save. Therefore, the increased disposable income from a tax cut does not filter into other sections of the economy because it is saved not spent.
• Higher incomes may be used to accumulate wealth; this wealth accumulation leads to further capital gains and income from assets – leading to even higher levels of income and wealth inequality. The economist Thomas Piketty argues that, unchecked, inequality can grow because the wealthy can keep re-investing their dividends and profit.
• Higher GDP doesn’t address the fundamental inequality of capitalist society. Even if tax cuts did lead to higher economic growth, higher output does not necessarily lead to higher real incomes for all. Low-income workers may be left behind in certain types of economic growth. The UK recovery 2011-14 has been notable for low real income growth.
• Budget deficit. Cutting taxes in the US led to an increase in the budget deficit. (from 2.7% of GDP in 1980 to 6% of GDP in 1983) Although this provides a temporary fiscal boost, a budget deficit creates problems for the future economy (possibility of higher interest rates, higher taxes in the future)
• Wrong target. If you want to reduce relative poverty, it makes sense to target income tax cuts and benefits at those who need it. Cutting taxes for the rich, in the hope some may trickle down to the poorest is a very inefficient way of working.
• Cutting taxes does not necessarily increase incentives to work (both the substitution and income effect are at work and may cancel each other out).
• It was hoped cutting income tax would encourage people to work overtime and work more hours. But in practice, this didn’t occur.
• The wealthy can invest the extra wealth in assets, such as housing. However, this pushes up house prices, increasing the cost of living for lower-income groups.

Fiscal Policy and inequality - Essay plan

Here is an essay plan for a question on inequality. "Discuss the extent to which fiscal policy alone can reduce income inequality."

IMF (2015) "Fiscal policy is the primary tool for governments to affect income distribution"

Income inequality
Skewed distribution, large gap between rich and relatively poorer households
Measured by 

• Gini coefficient: Coefficient ranges from zero to one (perfect inequality)

Show contextual awareness 

• Low income inequality in countries such as Sweden, Finland, Slovenia (all have Gini of less than 0.3)
• UK income inequality has been declining in recent years (Gini for final income of 0.34)
• Much higher in countries such as South Africa, China, USA

Remember! Analyse first and then evaluate!

Analyse how fiscal policy can reduce income inequality

(1) Increase in level of means-tested welfare benefits such as income support / housing benefit - targets help on those families in relative poverty in greatest need

Evaluation: Increased complexity and cost of running welfare, risk of poverty trap from withdrawal of income-related benefits, risk of more families gaming the system; doesn’t address root causes of inequality such as low pay / skills gaps

(2) Increase the marginal rate of income tax for top earners e.g. from 45% to 50% - designed to make the tax system more progressive.

Evaluation: Higher top rate taxes might lead to increased tax avoidance, tax evasion, a possible brain drain of highly skilled people. Risk of lower total tax revenues (tax rates beyond the optimal point in a Laffer Curve diagram). Lower revenue affects ability of government to provide public and merit goods

(3) Introduce a progressive consumption tax e.g. higher rates of VAT on luxury products / lower VAT on essential items (e.g. energy)

Evaluation: Who decides what is a luxury product? VAT is already zero on much household spending.

(4) Increase in the income tax free allowance e.g. from £11,600 to £13,000 - this is designed to improve work incentives because people start paying income tax at higher incomes. Government could also increase the level at which people start to pay national insurance contributions.

Evaluation: Helps people in lower-paid jobs but many of the relatively poor are not in work e.g. structurally unemployed, retired, suffering from chronic illnesses. Lifting the income tax free allowance is also expensive - would it be made available to all?

Further evaluation of the question

Focus on the stem word 'alone'

Introduce some alternatives into the discussion:

1. A higher national minimum wage / + widespread adoption of a more generous living wage
2. Supply-side policies to improve occupational mobility of labour / address skills gaps which keep people out of work
3. Address the chronic shortage of and high price of housing which impedes geographical mobility of labour 
4. Policies to introduce competition into markets to increase contestability and lower real prices e.g. helping to lower energy bills
5. A more ambitious regional  and industrial policy to address long-term inequalities in employment and income in depressed regions/localities

Finish off the essay with a final reasoned comment 

e.g. There are some powerful forces (such as globalisation) driving income and wealth inequality in many societies, to what extent can fiscal policy alone reverse these factors? Strategies to increase employment in higher-skilled, emerging industries might be the most effective long term strategy?

High levels of government debt and common use of fiscal austerity may have made redistribution a lower priority for many governments.

In-kind benefits, such as education spending and better quality of and access to health care can also affect the inequality of market incomes in the long run.

Excellent and timely link to an article from the BBC discussing supply side policies in the UK. This video (Click here to access) discusses programmes aimed at getting the structurally unemployed back to work.

Questions to think about:

How successful would this policy be? (will it work/is it working)
Are there any downsides/costs to this policy?

Essay Model Answer - Protectionism and current account

Evaluate the significance for the UK balance of payments on the current account of increased use of protectionist policies around the world. (25 Marks)

Protectionist policies are used to prevent the number of imports, and encourage people to purchase domestic goods/services, these include tariffs and quotas. These policies are used to help reduce the deficit a country may have-the UK has a trading deficit, mostly due to the fact it imports more than it exports. They protect domestic industries in several ways; a tariff is a tax places on imported goods and a quota limits the number of imports brought into the country. Protectionist policies also include non-tariff barriers such as rules and regulations with regard to health and safety. The balance of payments on current account is made up of four components; 1) trade in goods 2) trade in services 3) investment income 4) balance transfers. 

Currently the UK has a deficit in the trade of goods (imports-exports). This could be made further if there was an increase in protectionist policies around the world. Exports from the UK is already minimal, if protection policies such as tariffs were put in place it could reduce the number of them even further. This is because the price of UK exports would increase. This means people abroad would no longer buy UK goods and would put domestic businesses that rely on exports at risk.  

However, it is likely the UK would retaliate by placing tariffs on imports coming into the UK. Therefore if the UK was to became more efficient in producing goods, sales would increase heavily domestically. The tariff will also depend on the type of good, if it is inelastic it is unlikely to have any effect e.g. oil. Therefore tariffs may have little effect on the UK's balance of trade.

By placing quotas on exports, the UK would have limit the amount of goods/services exported. Due to the restricted number, it is likely the price for the exported good would increase, which could possibly lead to decreased demand. The UK have a surplus in their trade in services. By limiting the amount, this surplus could deteriorate as less banks for example could set up abroad. This would heavily effect the UK's balance of payments. 

However, as previously said the number of UK exports is already low, therefore quotas may not have a significant impact on the trade of goods. This is because the UK has a deficit as is, and this is NOT due to protectionist policies. This suggests that if protectionist policies were put in place, the UK balance of payments would be mildly effected as they are a predominantly importing country. 

Non-tariff barriers such as administration costs will also effect the UK balance of payments. This will make it difficult for the UK to export goods due to regulations such as health and safety. This could increase there trade deficit as they will be restricted on the amount of exports. The UK will most likely enforce similar laws to imports, this will make trade all together more difficult. If the UK is limited to the number of exports, domestic industries will suffer as they can no longer sell their goods abroad and the only market they access to are the domestic markets. Therefore the trade deficit will worsen.

However non-tariff barriers wont be significant in limiting the number of exports. It is unlikely administration will reduce the amount of exports to have a significant impact on the balance of trade. The Uk is also part of the EU which is their main trading bloc, this means that if other countries use protection policies the UK wont be heavily effected as they will maintain their relationship with the EU. 

Overall, if protectionist policies around the world were to increase it could worsen the UK deficit. This is due to a fall in the level of exports and the inability to set up businesses abroad. However it would depend on how strong the protectionism policies were and if the EU were involved. The fact that the UK doesn't export large amounts suggests that it might a very limited effect on the UK balance of payments of current account. 

Essay model answer - Determinants of demand for imports

This is a 20 mark answer. It could be asked as a 25 marker. You would add one more point to this essay to gain the extra marks.

Assess the main economic determinants of a country's demand for imports (20)

An import is a good or service that has been brought in from abroad. The money from the specific import will go back to the country it came from. Imports are apart of balance of payments, and if imports too high it can ultimately cause a trade deficit.

Income elasticity of demand plays a key role in determining the amount of imports a country will demand. People in the UK are experiencing a period of increasing disposable income, this means they will demand more imports-the richer people feel, the more imports they will buy. Imports are seen to be a of better quality or luxury goods when compared to domestic products, for example wine from France. This is because of the increased choice of products. UK consumers will purchase imports as they are exposed to readily available, higher quality products. Therefore a rise in income will likely result in increased imports.

However, income elasticity of demand may not be as significant. People may choose to save their money rather that purchase expensive imports. Due to the current state of the of the UK people wont have the confidence to 'splash' money around. It is more likely that people will save money, this could therefore decrease the demand of imports.

Comparative advantage is when a lone country as a lower opportunity costs. This means it is more efficient for a country to focus on producing what they have comparative advantage in, and import the good/services that they don't. For example the UK have comparative advantage in pharmaceuticals. This means that countries around the world would demand pharmaceuticals from the UK as they are nest at producing them. Therefore the demand for imports from the UK would increase, as countries were better off importing them rather than producing their own pharmaceuticals.

However, comparative advantage may not work in the long run unless they reinvest. For example, the UK used to have comparative advantage in ships, however they did not reinvest and lost this advantage. The demand for the product may decrease all together. The increasing discoveries of new technology means that the demand of products will fall in specific areas, and therefore imports will decrease.

Finally, countries may lack vital resources such as oil which will lead to an enormous increase in demand for imports. In the UK it impossible for them to produce enough oil to go round. Therefore, as it is an inelastic good, they have no choice but to import.

Overall, countries demand imports for several reasons. Imports on a global scale are increasing due to various factors such as a decrease in protectionist polices. The most significant detriment of a countries demand for imports is due to income elasticity demand, as it has allowed the number of imports demanded to increase rapidly.