<4.3 FISCAL POLICY>

4.3.1: THE GOVERNMENT BUDGET

When we 'BUDGET', for a holiday we are planning how much we can spend relative to how much money we have available right?
Similarly, a GOVERNMENT BUDGET refers to the Government's own outline of projected income (revenue, usually from taxes) and planned expenses (Expenditure on schools, hospitals etc....)
- - - - If SPENDING > REVENUE => BUDGET DEFICIT *
        If SPENDING = REVENUE => BALANCED BUDGET
        If SPENDING < REVENUE => BUDGET SURPLUS
* Clearly a deficit must be FINANCED BY BORROWING which of course has to be repaid, which DIVERTS SPENDING AWAY FROM OTHER USES, and this debt is referred to as the 'PUBLIC DEBT'

--TASK--

Discuss whether a government should spend more than it raises in taxation.

4.3.2: GOVERNMENT EXPENDITURE

CURRENT EXPENDITURES: These include the DAY-TO-DAY payments required to run the government & public sector as well as provide MERIT GOODS that are UNDERPROVIDED by the free market. E.g. The wages & salaries of public employees such as teachers, police, members of parliament, military personnel, judges, dentists etc. It also includes payments for goods/services such as medicines for government hospitals
CAPITAL EXPENDITURES: These are investments in INFRASTRUCTURE & capital equipment. E.g. High speed rail projects; new HOSPITALS & SCHOOLS; new aircraft carriers
TRANSFER PAYMENTS: Payments made by the government for which no goods/services are exchanged. E.g. Unemployment benefits, disability payments, subsidies to producers & consumers etc. This type of government spending DOES NOT CONTRIBUTE TO GDP as income is only transferred from one group of people to another

--4-MARKER TASK--

EXPLAIN TWO REASONS WHY A GOVERNMENT MAY WANT TO CUT SPENDING ON EDUCATION.

4.3.3: WHY LEVY TAXES?

Ideally, government spending is financed through TAX REVENUE (Rather than BORROWING, which has to be repaid), but why is it they need to spend in the first place? Why can't it be left to the free market to decide what to produce?
- - TO CORRECT MARKET FAILURE: in many markets, there is a less-than-optimal allocation of resources from society's point of view, hence the government aims to SUBSIDISE MERIT GOODS, that would be UNDER-PROVIDED by the free market, such as NATIONAL HEALTH CARE, PUBLIC SCHOOLS, ROADS, etc... to pay for this they TAX DEMERIT GOODS that are OVER-PROVIDED by the free market, such as CIGARETTES and ALCOHOL.
  - TO PROMOTE EQUITY: The free market rewards the owners of factors of production, however, the distribution of these factors is unequal, and thus the wealthy are taxed to provide funds that can be utilised in reducing the opportunity gap between the rich & poor.
  - TO PROTECT DOMESTIC FIRMS: In a global economy, competition from cheaper imports can jeopardise domestic industries so governments attempt to PROTECT them by IMPOSING TARIFFS, which raises the price of these imports making the domestic output more desirable.
  - TO REDUCE INFLATION: If demand outstrips supply, general prices will start to rise, therefore the government can raise taxes to reduce the disposable income of its citizens which should reduce spending and inflationary pressures.

--6-MARKER TASK--

ANALYZE WHY GOVERNMENT IMPOSES TAXES.

--THINK AHEAD--

"...in this world nothing can be said to be certain, except death and taxes."

(Benjamin Franklin, 1789)

--4.3.4: CLASSIFICATIONS OF TAXES--

--DIRECT--

--INDIRECT--

--DEFINITION--

DIRECT TAXES are TAXES ON INCOME. The tax payment is paid directly by the person/firm that is responsible for paying it to the government.
CONSUMER => GOVERNMENT

--DEFINITION--

INDIRECT TAXES are TAXES PLACED ON GOODS AND SERVICES.
It is ADDED TO THE PRICES OF GOODS & SERVICES and it is INCLUDED IN THE PRICE PAID BY CONSUMERS while purchasing the good or service.
It is called indirect because it is paid indirectly through the producer, by the consumer to the government.
CONSUMER => PRODUCER => GOVERNMENT

--EXAMPLES--

INCOME TAX
PROFITS TAX
CAPITAL GAINS TAX
INHERITANCE TAX
PROPERTY TAX

--EXAMPLES--

GENERAL SALES TAX (GST)
VALUE-ADDED TAX (VAT)
STAMP DUTY
CUSTOMS DUTY
EXCISE DUTIES

--ADVANTAGES--

(+) HIGH REVENUE as all workers above a certain income level MUST pay income taxes, the revenue from this tax is very high.
(+) REDUCE WEALTH-GAP as they are PROGRESSIVE IN NATURE – HIGHER TAXES ON THE RICH THAN ON THE POOR which helps reduce income inequality.

--ADVANTAGES--

(+) IMPOSSIBLE TO EVADE as THE TAX IS ALWAYS COLLECTED when the good or service is purchased so it CAN'T BE EVADED.
(+) CAN HELP REDUCE USE OF HARMFUL/DEMERIT GOODS, such as CIGARETTES & ALCOHOL.
(+) FLEXIBLE indirect tax rates are EASIER AND QUICKER TO CHANGE THAN DIRECT TAXES. Thus their EFFECTS ARE IMMEDIATE.

--DISADVANTAGES--

(-) HIGH-INCOME TAXES LOWERS WORK-INCENTIVE as people may PREFER TO STAY UNEMPLOYED (and receive govt. unemployment benefits) OR WORK UNPRODUCTIVELY if their income is taxed too heavily.
(-) HIGH BUSINESS TAXES LOWERS ENTREPRENEURIAL-INCENTIVE as they demotivate entrepreneurs from starting new businesses.
(-) DIFFICULT TO INCREASE as they are VERY UNPOPULAR WITH THE PUBLIC and FIRMS, who may RELOCATE ('BRAIN DRAIN').
(-) ABILITY TO AVOID PAYING
- INCOME that is PAID IN CASH may not be DECLARED to the tax authorities.
- FIRMS CAN USE LEGAL LOOPHOLES INCOME and escape having to pay any tax.
  - HIGHER COST OF COLLECTION as the govt. has to USE MORE RESOURCES TO CATCH these TAX EVADERS.

--DISADVANTAGES--

(-) LEADS TO INFLATION as the prices of products will increase when indirect taxes are added to it, causing inflation.
(-) WORSENS INCOME INEQUALITY as the tax is REGRESSIVE* since all people pay the same amount of money, irrespective of their income levels, the tax will fall heavily on the poor than the rich as it takes more proportion of their income.
(-) ENCOURAGES BLACK MARKET as high domestic prices can encourage SMUGGLING.

PROGRESSIVE

As INCOME RISES (FALLS),

TAX RATE (%) RISES (FALLS)

PROPORTIONAL

As INCOME RISES (FALLS),

TAX RATE (%) REMAINS FIXED

*REGRESSIVE

As INCOME RISES (FALLS),

TAX RATE (%) FALLS (RISES)

--TASK--

Copy the following table into your books and then plot the first two columns, with INCOME on the X-AXIS, and the TAX PAID on the Y-AXIS.
Then add a MORE PROGRESSIVE tax with rates of 10%, 30%, and 60%. What can you conclude about TAX PROGRESSIVITY and INCOME REDISTRIBUTION?

LINK

--THINK AHEAD--

A PRINCIPLE (原则) is a kind of rule, belief, or idea that guides you, so, when the government designs progressive tax systems in which those more able to pay, pay more and those unable to pay much, pay less yet receive equal access to any resources made available, what PRINCIPLE is this system immediately trying to demonstate?

--4.3.5: PRINCIPLES OF TAXATION--

⭐--1. EQUITY--⭐

IS THE TAX PAYMENT BASED ON YOUR ABILITY TO PAY AND DOES EVERYONE STILL HAVE EQUAL ACCESS?

EQUITY is another word for 'fairness' and means that the tax rate you are charged is based on your ability to pay. In other words poorer people have a lower ability to pay and therefore should pay less, but still, importantly, still have equal access to the merit goods and services provided by the gov't.
Eg. In HK public schools are open to everyone regardless of income levels.

--2. CERTAINTY--

IS THE TAX EASY TO WORK OUT FOR YOURSELF?

A tax should be easy to understand, and households and firms should be able to calculate the amount of tax required to be paid by them

--3. CONVENIENCE--

IS MAKING THE TAX PAYMENT EASY TO DO?

A tax should be easy to pay. Nowadays it can all be done via the internet

--4. ECONOMY--

IS THE COST OF TAX COLLECTION < THE TAX REVENUE?

The cost of implementing and collecting the taxes must be kept to a minimum and shouldn’t exceed the tax revenue itself.

--5. FLEXIBILITY--

DOES THE TAX REVENUE AUTOMATICALLY CHANGE?

It should be possible to change the tax if economic activity changes or government aims change.
The revenue from some taxes changes automatically to offset economic booms and slumps.
For example, tax revenue rises from income tax and sales tax, without any change in the rates, when there is an economic boom. This is because more people will be employed, incomes will rise and people will spend more.

--6. EFFICIENCY--

DOES THE TAX IMPROVE ECONOMIC PERFORMANCE?

A tax should improve the performance of markets or at least not significantly reduce the efficiency of markets.
For example, a tax on pollution may result in a cleaner environment, and also Income tax rates should not be set so high that they discourage effort

--TASK--

OK so we have reviewed the 6 principles of an 'ideal' tax system. Now I want you to consider the following school proposal, sent home to your parents:
Dear Parents, the school has taken the decision to add an extra charge to your child's school fees based on your household income level, this extra charge is to go into a progressive school lunch fund that guaranatees every student a set-lunch and snack. We are basing this on the 6 principles used for progressive tax systems so we would be greatful for your feedback on this matter.
Your job is to evaluate this proposal in terms of the 6 principles detailed above, then give you own opinion as to whether you agree or disagree with it. Explain your reasoning? Below is a sentence starter....
"If I was to compare the school's decision to add an extra charge to our school fees based on our parents' income levels, and use this extra money to guaranatee that every student receives a set-lunch and snack., to the 6 principles of taxation, I would say that it does/doesn't meet the equity principle, because.....", furthermore in terms of certainty...."
"In conclusion, I wholeheartedly agree/disagree, with this idea because...."

--THE TAX BURDEN--

THE TAX BURDEN relates to the amount of TAX PAID by people and firms AS A % OF GDP. The higher the tax burden, the greater the percentage of people’s and firms’ income taken through tax.
Which country has the highest tax burden?

--TASK--

Looking at the infographics presented above and the one below can you make any conclusions about tax burden and economic development? Can you explain why this might be?

--THE TAX BASE--

THE TAX BASE refers to the TOTAL NUMBER of TAX SOURCES that a government uses to earn TAX REVENUE. We can say that....
"The WIDER the tax base the MORE direct/indirect taxes imposed"
"The NARROWER the tax base the FEWER direct/indirect taxes imposed"
A WIDE BASE leads to SMALLER TAX RATES
A NARROW BASE leads to LARGER TAX RATES
"Why is WIDE preferred?"

--TASK--

OK so we said earlier that...

"The WIDER the tax base the MORE direct/indirect taxes imposed"

"The NARROWER the tax base the FEWER direct/indirect taxes imposed"

We can also say...

"A WIDER base leads to SMALLER tax rates"

"A NARROWER base leads to LARGER tax rates"

But why? How come fewer sources leads to higher rates?

Imagine that you need to raise $100 to fund a new microwave for the school canteen do you...

A. Collect the money by taxing chocolate bars sold in the canteen?...or...

B. Tax all items in the canteen—sandwiches, drinks, fruit, stationery?

Which one did you choose? Why did you reject the other option?

--THE INCIDENCE OF TAX--

THE INCIDENCE OF TAXATION refers to the distribution of the burden of an INDIRECT TAX, shared between consumers and producers.
- - In the case of products with INELASTIC DEMAND, CONSUMERS BEAR MOST OF THE TAX. This is because the producers can pass on a high proportion of the tax in the form of a higher price as they know it will not reduce the demand significantly.
  - In contrast, if products have ELASTIC DEMAND it is PRODUCERS BEAR MOST OF THE TAX. This is because they know that they cannot pass on much of the tax to consumers as such a move would bring down their sales.

--THINK AHEAD--

"How would you feel if I told you that the maximum grade you could ever get for IGCSE Econ is a 'C', regardless of your efforts? Would you be willing to study hard?"

"If I said you must get an A* in order to progress to the IBDP Economics, course, would you work harder or just give up?"

"If the gov't taxed every student in HK with a flat HKD 5k each per year, do you think that would impact anyone at this school?", "What about local schools?"

4.3.6: IMPACTS OF A (RISE) IN TAXATION

--ON THE INCENTIVE TO WORK/INVEST--

--DIRECT--

DISINCENTIVE TO WORK:

- - The HIGHER the DIRECT INCOME TAX RATE, the LOWER the INCENTIVE TO WORK

DISINCENTIVE TO INVEST:

- - The HIGHER the DIRECT CORPORATION TAX RATE, the LOWER the INCENTIVE for NEW BUSINESSES start, or EXISTING FIRMS to expand.

--INDIRECT--

HIGHER INDIRECT TAXES, => HIGHER COSTS OF LIVING:
- INCENTIVE TO WORK INCREASES as people now have to work harder and longer in order to maintain their STANDARD OF LIVING. Is this realistic?
- DISINCENTIVE TO WORK as people are able to buy less with their income, so therefore LOSE MOTIVATION and stop work.

--TASK--

If we were to plot income tax rate % (X-axis) against students willing to go to University (Y-axis), what pattern would eventually develop? How would universities be impacted?.
"As income taxes rises, the incentive to go to University will,....furtermore universities will be reluctant to..."

--TASK--

Similarly, If we were to plot tuition fees (X-axis) against students willing to go to University (X-axis), what pattern would eventually develop? Explain your answer. Do you think indirect tax on tuition fees or a rise in income tax would have the most impact on student numbers?
"As the cost of studying rises,..."

--ON GOV'T TAX REVENUES--

GOVERNMENT TAX REVENUE:

- - There is a relationship between increasing tax rates & the level of government revenues received
  - The broad idea is that AS DIRECT TAX RATES RISE, A POINT WILL BE REACHED WHERE DISINCENTIVIZED WORKERS WORK LESS AND FIRMS INVEST LESS (OR EVEN SHRINK/SHUTDOWN), resulting in lower incomes & less government tax revenue.
  - We can illustrate this using the "LAFFER CURVE".
  - More people will actively seek to avoid paying tax (tax avoidance) or try to move their income elsewhere.

--DIRECT--

Do higher taxes always lead to higher tax revenues? Well, as we saw above, HIGH INCOME AND PROFITS TAXES CAN ACT AS A DISINCENTIVE TO WORK AND INVEST, therefore, IF TAX LEVELS are CONTINUOUSLY INCREASED, then TAX REVENUES WILL EVENTUALLY PEAK and then DECLINE.
Furthermore, this people that give up work will likely need some form of GOVERNMENT WELFARE to support them which reduces the government's tax revenue further.

--INDIRECT--

Similar to the direct tax, after a while people will stop spending and may turn to CHEAPER ALTERNATIVES (Maybe IMPORTS) or even buy BLACK MARKET goods, which will cost the government more to POLICE.

--TASK--

If we swap gov't revenues for your school's revenue what is wrong with the assumption that regularly increasing tuition fees will result in greater revenues for the school? Can they do this continually?

--ON INCOME DISTRIBUTION (EQUITY)--

--DIRECT--

- - A PROGRESSIVE INCOME TAX SYSTEM collects a greater amount of tax from high-income earners to redistribute to those with lower incomes, hence INCOME INEQUALITY is REDUCED.
  - However, as mentioned above, if the TAX RATE IS TOO HIGH, then it can DISCOURAGE people and firms from working. In fact, they can even relocate to low-tax countries, or use special methods to hide their money from taxation.

--INDIRECT--

If the government also has very HIGH REGRESSIVE TAXES such as GST then the burden wll fall more heavily on low-income earners WORSENING INEQUALITY.

--TASK--

(1) Imagine your school cafeteria charges students for lunch

Rich students bring big lunchboxes from home and regularly buy extra food at the cafeteria.

Poor students bring only small lunchboxes and can nly afford to buy basic food at the cafeteria.

(2) Now, the school conducts two changes: raises lunch prices and decides to take a portion of the rich students’ lunch to give to the poorer students. What is the impact on the two sets of students?

"When lunch prices rise, it is the same impact as a regressive indirect tax as it has the following impact on income distribution, lower income students..., whereas for wealthier students they...."

"When the school starts to take a larger and larger portion of the wealthier students lunch, it is the same impact as a progressive income tax as it has the following impact on income distribution, lower income students..., whereas for wealthier students they...."

--ON UNEMPLOYMENT--

--DIRECT--

If say profits taxes are too high businesses may not expand or may even shut down, making their staff unemployed.
Entreprenuers will not be incentivised to start businesses.

--INDIRECT--

Higher indirect taxes will deter consumers which in turn will lower profits which may lead businesses to cut staffing.

--TASK--

Using the explanations above explain how an increase in income taxes and an indirect tax on paper products would impact the number of teachers at your school.
"If the level of income tax increased at our school, it would be likley that..."
"Similarly if there was a significant increase in the price of paper,..."

--INFLATION--

--DIRECT--

- - Higher direct taxes LOWERS THE DISPOSABLE INCOME of workers, possibly resulting in HIGHER WAGE DEMANDS, which INCREASES THE COST OF LABOUR which will be passed on to CONSUMERS IN THE FORM OF HIGHER PRICES.

--INDIRECT--

- - Higher INDIRECT taxes on popular RAW MATERIALS such as sugar RAISES THE COSTS OF PRODUCTION for firms who in turn RAISE PRICES TO MAINTAIN THEIR PROFIT MARGINS

--TASK--

Using the explanations above explain how an increase in income taxes and an indirect tax on paper products might impact the the tuition fees that you have to pay.
"If the level of income tax increased at our school, our tuition fees might..."
"Similarly if there was a significant increase in the price of paper,..."

--THE TRADE BALANCE--

THE TRADE BALANCE (X-M):

An increase in taxes can reduce disposable income which is likely to reduce the level of imports
This may improve the trade balance (exports - imports)

--DIRECT--

HIGHER DIRECT TAXES => LOWER INCOMES => LESS SPENDING ON IMPORTS => IMPROVEMENT IN THE TRADE BALANCE

--INDIRECT--

HIGHER INDIRECT TAXES => HIGHER PRICES => PRICE OF EXPORTS RISING => LESS EXPORTS DEMANDED => WORSENING OF TRADE BALANCE

--TASK--

Using the explanations above explain how an increase in income taxes and an indirect tax on paper products would impact the the tuition fees that you have to pay.
"If the level of income tax increased at our school, our tuition fees might..."
"Similarly if there was a significant increase in the price of paper,..."

--FOREIGN DIRECT INVESTMENT (FDI)--

If the rate of CORPORATION/PROFITS TAX INCREASES relative to other countries, it may result in LESS INWARD FOREIGN DIRECT INVESTMENT by multi-national corporations (MNCs), who will set up operations in LOWER-TAX countries.
Furthermore, DOMESTIC MNCs may decide to RELOCATE to lower-tax countries.
This will of course impact UNEMPLOYMENT and ECONOMIC GROWTH.

--TASK--

This is a big one. There are 7 paragraphs to write related to impacts.

--THINK AHEAD--

"If the school wants to boost the basketball team’s success and overall student involvement, should they add extra support or simply tell students to ‘try harder’?"

4.3.7: DEFINITION OF FISCAL POLICY

--DEFINITION--

FISCAL POLICY refers to the PLANNED DECISIONS made by the government regarding their SPENDING and TAXATION PLANS aimed at INFLUENCING THE LEVEL OF DOMESTIC SPENDING on GOOD and SERVICES MADE IN HK (Also called the level of AGGREGATE DEMAND).

--THINK AHEAD--

The school wants to increase spending in it's cafeteria:

"If the principal gave every student some lunch money, lowered the price of cafeteria meals and also paid some students to work in the cafeteria do you think that this will lead to more of your school lunches being sold?", "Do you think having more money in your pockets means you will always spend?"

4.3.8: FISCAL POLICY MEASURES

--INTRODUCTION--

- As mentioned in the definition, fiscal policy is aimed at influencing DOMESTIC SPENDING on 'Made in HK', but who does the spending?
  - - 1. +HOUSEHOLD SPENDING = CONSUMPTION SPENDING (C)
      2. +BUSINESS SPENDING = INVESTMENT SPENDING (I)
      3. +GOVERNMENT SPENDING = GOVERNMENT SPENDING (G)
      4. +FOREIGN SPENDING = EXPORT SPENDING (X)
      5. LESS any spending on 'Not-Made in HK', AKA IMPORT SPENDING (M)
- SPENDING = C + I + G + X - M /or/ C + I + G + NX

--TASK--

Give an example for each type of spending.

"Household spending refers to....., an example would be...."

--EXPANSIONARY--

EXPANSIONARY FISCAL POLICY is aimed at INCREASING SPENDING "But how to create more spending?"
The gov't can simply INCREASE ITS OWN SPENDING so the 'G↑' component of spending RISES.
The gov't can LOWER DIRECT and INDIRECT TAXES, so consumers have MORE money to spend leading to a RISE in consumption spending C↑
The gov't can LOWER PROFIT TAXES, so firms have MORE money to spend leading to a RISE in investment spending I↑.

--CONTRACTIONARY--

CONTRACTIONARY FISCAL POLICY is aimed at DECREASING SPENDING "But how to create LESS spending?"
The gov't can simply DECREASE ITS OWN SPENDING so the 'G↓' component of spending FALLS.
The gov't can RAISE INCOME TAXES, so consumers have LESS money to spend leading to a FALL in consumption spending C↓
The gov't can RAISE PROFIT TAXES, so firms have LESS money to spend leading to a FALL in investment spending I↓.

--TASK--

Using yourself, your government, and your school as the example explain how the governmnet can use expansionary fiscal policy to encourage you to spend more money. End your answer with "...and vice versa"

"Expansionary fiscal policy will encourage me to spend more by...."

4.3.9: EFFECTS OF FISCAL POLICY...

--EXPANSIONARY--

--CONTRACTIONARY--

--...ON INFLATION--

EXPANSIONARY FISCAL POLICY => INCREASE IN AGGREGATE DEMAND (RIGHTWARD SHIFT) => INCREASE IN AVERAGE PRICE LEVEL => INFLATIONARY
CONTRACTIONARY FISCAL POLICY => DECREASE IN AGGREGATE DEMAND (LEFTWARD SHIFT) => DECREASE IN AVERAGE PRICE LEVEL => DEFLATIONARY

--...ON UNEMPLOYMENT--

EXPANSIONARY FISCAL POLICY => INCREASE IN AGGREGATE DEMAND (RIGHTWARD SHIFT) => INCREASE IN OUTPUT LEVEL => INCREASE IN EMPLOYMENT.
CONTRACTIONARY FISCAL POLICY => DECREASE IN AGGREGATE DEMAND (LEFTWARD SHIFT) => DECREASE IN OUTPUT LEVEL => DECREASE IN EMPLOYMENT.

--...ON ECONOMIC GROWTH--

EXPANSIONARY FISCAL POLICY => INCREASE IN AGGREGATE DEMAND (RIGHTWARD SHIFT) => INCREASE IN OUTPUT LEVEL => INCREASE IN GDP.
CONTRACTIONARY FISCAL POLICY => INCREASE IN AGGREGATE DEMAND (LEFTWARD SHIFT) => DECREASE IN OUTPUT LEVEL => DECREASE IN GDP.

--DIAGRAM TASK--

Sketch TWO diagrams in your book, one showing the impact of an expansionary fiscal policy and one showing the impact of a contractionary fiscal policy. Then comment on the impacts on inflation, unemployment and economic growth. I will help you with this. It has links to the micro model if that helps.

FISCAL 1.pdf

FISCAL 2.pdf

2-Markers

6-Markers

8-Markers

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