Wednesday, December 31, 2008

How Succesful Is Fiscal Policy In Preventing A Recession In UK? (forecast essay)

Fiscal policy: Defined as the manipulation of government spending & level of taxation to influence the movement of AD

"Preventing a recession" indicates that UK economy could be slowing down significantly. To prevent a recession, it is necessarily for the UK government to pursue expansionary/ reflationary policy by slashing tax & increasing public spending

How does this works?

(1) Slashing direct & indirect tax. Direct tax refers to income tax & corporation tax. By paying lower income tax, individuals will have greater amount of disposable income. As such this may increase overall spending into the economy. Lower corporation tax may put companies in higher retained profits position. As such this increases their incentive to invest such as acquire modern capital goods, build factories etc. This will increase I which is one of the component of AD. Lastly, UK government can reduce VAT on goods produced. Like now, the slash in 2.5% of VAT will make goods cheaper, thereby encouraging more purchases. All these shift AD curve right & thereby reducing the possibility for recession to take place

(2) Increase public spending. When government allocate more funding for public services, such as onto schools, hospitals, infrastructures, public transport, telecommunications etc, it has a direct effect onto AD. Also this may positively affect other components of AD. Firms will gain a windfall profit when they are engaged with government’s project. More money can be reinvested into operation later. Along the way, it will create more employment thereby increasing spending into UK economy. All these shifts AD rightward, thereby preventing the possibility of recession


(1) Lags. Fiscal policy suffers from all lags. Government tends to be too ‘careful’ in announcing a shock e.g. recession has happened in the economy. The sub prime mortgage time bomb has actually happened end of last year & only now they are aggressively countering it (recognition lags). When it comes to implementation, it may take months to years. The proposal will have to go through various legal procedures, departments & including securing a planning permission (implementation lags). Once executed, it further takes some time for the effect to be seen in economy (effect lags), e.g. increase in real GDP, fall in unemployment etc. Monetary policy is seen to be more efficient as it’s free from implementation lags

(2) Crowding out effect. Increased government spending may likely lead to deficit. As such government may need to get financing by issuing bonds. Private sectors will take up those bonds & as such have lesser allocation for investment. As such we say private sectors are crowded out. Another way to look at this will be, government increase borrowing from commercial banks. With greater competing demand for money, interest rates will be bid up. As such this will reduce spending & investment, leading to lower growth in long term

(3) Tax reduction may not work. Reduction in income tax may not necessarily induce spending into the economy if the reduction is insignificant. Furthermore it depends on which category of income bracket is affected e.g. lower-middle income or high income? If it affects those on higher income, spending will not increase much given the nature of their low mpc (marginal propensity to consume—tendency to spend). However one could argue that lower tax rate may reduce cases of tax evasion

(4) Limit on government spending. UK’s national debt is ballooning from its low in 2001 (29% of GDP) to its current high of about 44% of GDP. Economists predict that these figures are actually much larger than what it seems since its calculation exclude pension liabilities in future. This is worrying given the increasing size of ageing populations. Growing public debt also pose other problem such as higher taxes onto future generations to pay back all the moneys borrowed. However some argued that this is not much of problem since UK managed to recover from greater national debt of 70% of GDP in 1970s

(5) Consumer confidence. Perhaps, consumer confidence & house prices are 2 of the most important macroeconomic indicators. If consumer’s outlook is bleak & house prices continue to fall no matter what policies pursued by the government it wouldn’t work to steer the British economy forward. Consider Japan. The government has pursued deficit spending amounting to 194% of its GDP, slash in income tax & even interest rates maintained at 0%, yet it fails to revive economic activity


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