Applied Economics

Module code N32771

Effects of recent changes in fiscal policy on the firm

Tutor Ms. Denise Staunton Year 2012 FETAC Level 6

Student: Alexandru Grecu 23 November 2012

Fiscal policy decisions have a widespread effect on the everyday decisions and behaviour of individual households and businesses The purpose of this assignment is to analyse some of the microeconomic effects of fiscal policy while considering the links between fiscal policy and aggregate demand and key macroeconomic objectives. In the first part of my study I will look in to how the microeconomic effects of fiscal policy affect the following: 1. Taxation and work incentives 2. Taxation and the Patterns of Demand 3. Taxation and Labour Productivity 4. Taxation and business investment decisions The second part I will be focused on the macroeconomic effect of fiscal policy on areas such: 1. Inflation 2. Growth and 3. Levels of employment.

The microeconomic effects of fiscal policy on:

1. Taxation and work incentives Changes in income taxes have a major effect on the incentive to work. If we are considering the impact of an increase in the basic rate of income tax or an increase in the rate of national insurance contributions, the rise in direct tax has the effect of reducing the post-tax income of those in work because for each hour of work taken the total net income is now lower. This might encourage the individual to work more hours to maintain his/her target income. Conversely, the effect might be to encourage less work since the higher tax might act as a disincentive to work. Of course many workers have little flexibility in the hours that they work. They will be contracted to work a certain number of hours, and changes in direct tax rates will not alter that. The government has introduced a lower starting rate of income tax for lower income earners. This is designed to provide an incentive for people to work extra hours and keep more of what they earn.

2. Taxation and the Pattern of Demand Changes to indirect taxes in particular can have an effect on the pattern of demand for goods and services. For example, the rising value of duty on cigarettes and alcohol is designed to cause a substitution effect among consumers and thereby reduce the demand for what are perceived as De-merit goods.

On the other side, a government financial subsidy to producers has the effect of lowering their costs of production, lowering the market price and encouraging an expansion of demand. The use of indirect taxation and subsidies is often justified on the grounds of instances of market failure.

3. Taxation and labour productivity Some economic theories argue that taxes can have a major effect on the intensity with which people work and their overall efficiency and productivity. But there is little evidence to support this view. Many factors contribute to improving productivity tax changes can play a role - but isolating the impact of tax cuts on productivity is extremely difficult. 4. Taxation and business investment decisions Lower rates of corporation tax and other business taxes can stimulate an increase in business fixed capital investment spending. If planned investment increases, the nations capital stock can rise and the capital stock per worker employed can rise. The government might also use tax allowances to stimulate increases in research and development and encourage more business start-ups. A favourable tax regime could also be attractive to inflows of foreign direct investment a stimulus to the economy that might benefit both aggregate demand and supply. The Irish economy is often touted as an example of how substantial cuts in the rate of corporation tax can act as a magnet for large amounts of inward investment. The very low rates of company tax have been influential although it is not the only factor that has underpinned the sensational rates of economic growth enjoyed by the Irish economy over the last fifteen years. Capital investment should not be seen solely in terms of the purchase of new machines. Changes to the tax system and specific areas

of government spending might also be used to stimulate investment in technology, innovation, the skills of the labour force and social infrastructure. A good example of this might be a substantial increase in real spending on the transport infrastructure. Improvements in the transport system would add directly to aggregate demand, but would also provide a boost to productivity and competitiveness. Similarly increases in capital spending in education would have feedback effects in the long term on the supply-side of the economy.

Macroeconomic effects of fiscal policy on:

1. Inflation Inflation and fiscal policy affects the level of economic activities of a country. Fiscal policy is the Government's expenditure policy that influences macroeconomic conditions. Inflation is a monetary phenomenon, which is measured by changes in Consumer Price Index (CPI). The fiscal policy influences interest rates, tax rates and government spending strategy. The fiscal policy has the power to affect the level of overall demand in the economy. The primary objective of fiscal policy is to maintain the price stability, economic growth and employment of the country. Hence an appropriate fiscal policy can help in combating rising inflation rates. 2. Growth The effect of fiscal policy on economic growth is a controversial and longstanding topic in economic theory, empirical research, and economic policymaking. Most growth models predict that taxes on investment and income have a detrimental effect on growth. These taxes affect the rate of growth through a simple, direct channel: they reduce the private returns to accumulation. But not all taxes affect the rate of growth. The most important obstacle to an empirical analyses of the effects of fiscal policy on growth is that marginal tax rates and

subsidies-which are the relevant variables according to theory- are not observable. The evidence that tax rates matter for growth is disturbingly fragile. This empirical fragility contrast sharply with the robustness of the theoretical predictions: most growth models predict that income and investment taxes are detrimental to growth.

3. Levels of Employment The majority of macroeconomic models that study the effects of government spending usually view it as Purchases of goods and services. However, the main component of government consumption is compensation to employees. In the United States the public sector wage bill represents around 60 percent of government consumption expenditures. Government employment is an important aspect of fiscal policy, but it is also a sizable element of the labour market. In the United States around 16 percent of all employees are working in the public sector. Given its relevance, it seems plausible that part of the transmission mechanism of fiscal policy occurs through the labour market. In steady state, the optimal public sector wage premium depends mainly on the differences of the labour market frictions parameters of the public sector relative to the private sector, for instance the job security. If the government sets a higher wage, it induces too many unemployed to queue for public sector jobs and raises private sector wages, thus reducing private sector job creation and increasing unemployment. Conversely, if it sets a lower wage, few unemployed want a public sector job and the government faces recruitment problems. This further dampens job creation in the private sector and amplifies the business cycle. Deviations from the optimal policy can entail significant welfare losses. If, for instance, the public sector wage does not respond to the

cycle, volatility of unemployment doubles. The level of employment and wages in the public sector are relevant, not just because of their weight in the economy or in the government budget, but also because they play an important role over the business cycle.