Monday, 16 May 2011

Economics: Fiscal Policy

Fiscal policy: achieve economic goals by adjusting government revenue and expenditure
Tax: principle of taxation includes:
1)       Equity / ability-to-pay: tax accords to their abilities of pay like taxable income. So those taxes should be proportional or progressive.
2)       Certainty: The tax payer should know clearly about the amount of tax/payment methods.
3)       Convenience: The process of paying tax should not impose extra cost to tax payers.
4)       Economy: The administrative cost of collecting tax should be minimized and smaller than tax collected. For example in HK employers have to report employee’s salaries/pensions to reduce cost of calculating tax and avoid tax evasion.
Classification of tax: the two classification method
1)       Direct tax: taxpayer can’t shift the tax burden to others, usually tax levied on wealth.
2)       Indirect tax: taxpayer can shift the tax burden to others, usually tax levied on goods/services.
Formulae about calculating tax:
Taxable income = Total income – tax allowance
Avg. tax rate = total tax / total taxable income
Marginal tax rate = additional tax/additional income.
1)       Progressive tax: tax rate increase with taxable income; graph of tax-taxable income is concave. Examples: salaries tax in HK (first $40k: 2%, next $40k: 7%, next $40k: 12%, Reminder: 17%)
2)       Proportional tax: tax rate is constant; graph of tax-taxable income is a straight line. Examples: profit tax and property tax in HK.
3)       Progressive tax: tax rate increase with taxable income; graph of tax-taxable income is concave. Examples: Air passenger departure tax and tax on luxury goods (since tax is given per goods, independent of the taxable income)
Tax in HK
1)       Direct tax: Salaries tax, property tax and profit tax
2)       Indirect tax: stamp duty; bets and sweeps tax; general rates and duties
Effects on P and Y by fiscal policy:
The concerns include stabilizing price level (like lower P during inflation), employment level (like eliminating deflationary output gap to reduce unemployment problem), stimulating economic performance (Yf) and narrowing income inequality.
1)       By direct tax: direct tax / disposable income / C/I / AD /. So we can eliminate deflationary output gap by cutting direct taxes (inflation occurred), or eliminating inflationary output gap by raising direct taxes (deflation occurred).
2)       By government expenditure: G/ AD /, so we can control AD by government expenditure as well.
3)       By [general] indirect tax like general sales tax: tax / MC / SRAS /. We can eliminate deflationary output gap by cutting direct taxes (but deflation occurred), or eliminating inflationary output gap by raising direct taxes (inflation occurred).
4)       To increase Yr we reduce specified direct taxes or increase government expenditure that aims to increase in LRAS. For example we can increase government expenditure in education that increases AD and LRAS together, then Yf is increased (with no significant change in P).
5)       Eliminate a demand-pull inflation by raising direct tax and eliminate cost-push inflation by cut indirect tax, in order to stabilize P.
6)       Increase the progressivity of direct tax to narrow income inequality.
Advantage of direct tax:
1)       Effects on price level: direct tax P so it relieves inflationary pressure, but indirect tax P, so it puts inflationary pressure in the economy.
2)       Direct tax narrows income inequality since it’s usually proportional/progressive, but indirect tax widens the income inequality since it’s usually regressive.
Advantage of indirect tax:
1)       More stable income to government since it’s less relating to taxable income, so as the economic prospects.
2)       Less disincentive effect on work/investment than direct tax since indirect tax don’t reduce their income from work directly.
3)       Less tax avoidance/evasion since it’s “packed” in the goods or services.
Government expenditure in fiscal budget refers to transfer payment + government departmental expenditure (consumption expenditure G + investment expenditure I). Currently most government expenditure is spent on education sector.
Budget: statement of estimation in government revenue and expenditure. For example, surplus budget implies estimated revenue > estimated expenditure.
Fiscal: the actual government revenue/expenditure, like fiscal balance means actual revenue = actual expenditure and fiscal deficit is actual revenue < actual expenditure.
Expansionary fiscal policy aims to raise Y in short run by increasing government expenditure or reducing revenue.
Contractionary fiscal policy aims to reduce Y in short run by reducing government expenditure or increasing revenue.
Another classification refers to recurrent expenditure (regular, like salaries) and capital expenditure (like infrastructure)
The net effect by increasing the same amount of government expenditure and revenue is expansionary under the assumption of existence of saving habit.
When an amount of tax X is collected, the disposable income in the economy dropped less than $X since they have taken part of their savings for the tax. So the AD is reduced by less than $X. When all of this revenues is used as expenditure, SRAS increased by $X. So SRAS shifts more than AD and it’s slightly expansionary.
As a result, balanced and deficit budget is expansionary while surplus budget can be expansionary, neutral or contractionary.
Public sector can be used to measure the proportional of government expenditure:
Public sector = government expenditure / GDP * 100%.

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