Economics Department

Week 2 fiscal Policy (Policy implementation)

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The following document is taken from the UK treasury's website (www.hm-treasury.gov.uk)   and provides a guide to the Government’s Fiscal Policy. Read the document and answer the questions that are asked.

The Government has taken significant steps to strengthen the framework for fiscal policy since taking office. Fiscal policy is now directed firmly towards maintaining sound public finances over the medium term, based on strict rules. Where possible it supports monetary policy over the economic cycle. This approach, together with the new monetary policy framework, provides the platform of stability necessary for achieving the Government's central economic goal of high and sustainable levels of growth and employment.

High quality external scrutiny of the conduct of fiscal policy plays a key role in ensuring that the benefits of the new framework are delivered fully. This paper aims to help understanding by providing a guide to analysing fiscal policy under the new framework.

It is important to understand the role each fiscal aggregate plays in analysis of policy. Using an inappropriate aggregate can result in misleading conclusions. For example, while the public sector net cash requirement is a good measure of the public sector’s financing needs, it is not the best measure of the impact of fiscal policy on the economy or the long-term sustainability of fiscal policy.

The paper focuses on decisions regarding the key fiscal policy aggregates, rather than decisions about individual spending or taxation policies, important though these are.

In addition to meeting the Government's key microeconomic objectives, decisions taken in the Budget on taxation and spending – and the balance between them – reflect the Government's key fiscal policy objectives of:

over the medium term,

• ensuring sound public finances and that spending and taxation impact fairly both within and across generations. In practice this requires that:

•   the Government meets its key taxation and spending priorities while avoiding an unsustainable and damaging rise in the burden of public debt; and

• those generations who benefit from public spending also meet, as far as possible, the costs of the services they consume; and

over the short term,

• supporting monetary policy, where possible, by:

• allowing the automatic stabilisers to play their role in smoothing the path of the economy in the face of variations in demand; and

• where prudent and sensible, providing further support to monetary policy through changes in the fiscal stance.

   

(1)   Analyse reasons why the Government has set these fiscal policy objectives

7 marks

(2)   What role might the Government want ‘automatic stabilisers’ to play ?

5 marks

(3)   What is meant by the ‘fiscal stance’?                                       2 marks

(4)   What are the dangers inherent in changing the fiscal stance?

6 marks

The new fiscal framework has been designed carefully to deliver these objectives. Central to the framework are five principles of fiscal management:

• transparency in the setting of fiscal policy objectives, the implementation of fiscal policy and the publication of the public accounts;

• stability in the fiscal policy-making process and in the way fiscal policy impacts on the economy;

• responsibility in the management of the public finances;

• fairness, including between generations; and

• efficiency in the design and implementation of fiscal policy and in managing both sides of the public sector balance sheet..

5) Explain why each of these principles might be considered to be desirable

10 marks

These principles were enshrined in the Finance Act 1998 and in the Code for Fiscal Stability, approved by the House of Commons in December 1998. The Code explains how these principles are to be reflected in the formulation and implementation of fiscal policy.

The Government has specified two key fiscal rules that accord with these principles. These are:

• the golden rule: over the economic cycle, the Government will borrow only to invest and not to fund current spending; and

• the sustainable investment rule: public sector net debt as a proportion of GDP will be held over the economic cycle at a stable and prudent level.

The fiscal rules provide benchmarks against which the performance of fiscal policy can be judged. The Government will meet the golden rule if, on average over a complete economic cycle, the current budget is in balance or surplus. The Government also believes that, other things equal, a modest reduction in net public sector debt to below 40 per cent of GDP over the economic cycle is desirable.

6) Analyse why might the Government wish to reduce the National Debt?

5 marks

In setting fiscal policy, the Government takes a deliberately cautious approach. This has to balance the costs of potentially underachieving the fiscal rules against those associated with running an unduly restrictive fiscal policy stance. It also recognises that some adjustment of the fiscal stance is possible within the cycle, if actual outturns and updated projections suggest the Government is no longer likely to meet its objectives.

This prudent approach is implemented, among other things, by adopting a cautious assumption about the economy's trend growth rate. The Government's economic policies are designed to raise this growth rate beyond the level assumed for fiscal policy purposes. For the purposes of fiscal planning, however, it would not be prudent to take credit for any success of these policies until firm evidence emerges. This approach ensures the risks of costly policy reversals are minimised.

7) Explain why the Government is likely to adopt a cautious approach when setting Fiscal Policy  5 marks

The article below is taken from Budget 2003, and looks at other ways in which fiscal policy can be used to influence the economy:

The amount of output produced per worker - productivity - has historically been lower in the UK than in other major economies. Closing this productivity gap will help to deliver greater economic prosperity and rising living standards in years to come. In the modern global economy, faster productivity growth requires flexible and dynamic businesses and a highly skilled workforce. Budget 2003 announces new measures to boost enterprise and skills, such as:

• new proposals to help small firms raise the finance they need to start up, develop and grow;
   
• reforms to reduce red tape and simplify tax for small businesses, to help break down the barriers to business success;
   
• new proposals to improve the supply of housing and to streamline and simplify planning decisions;
   
• £16 million to fund Enterprise Advisers to work alongside headteachers in deprived schools and give pupils experience of business;
   
• improved tax incentives to boost research and development and investment in information technology by small companies; and
   
• an extension of existing pilots to improve access to training among low-skilled people, and new reforms to promote migration as a source of skills and labour in the UK economy.

             8) Explain how the policies identified might help to close the productivity gap      5 marks

             9) Use AD/AS analysis to predict the likely impact on the economy.                          5 marks

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Total 50 Marks