Objectives of the Lesson ¢ \ Define Budget and Fiscal Policy Analyse the reasons for Government spending and levying taxes Discuss the effect of fiscal policy on government macro-economic aims Describe the differenttypes of taxes ] 3.) Explain the principles of taxation Analyse the impact of t __ ) Calculate the size ofa budgetdeficitand surplus Analyse the effect of fiscal policy measures on the budget positionFISCAL POLICY Fiscal policy is the use of taxation and governmentexpenditure strategies to influence the level of economic activity and macroeconomic objectives such as employment, economic growth and the control of inflation. For example, taxation can be used to redistribute income and wealth to benefit less wealthy members of society. Government spending can be used to improve standards of living, such as building schools, hospitals and transportation networks. ‘ax revenues Government spending Income ta Heath care Corporation tax Education etre eS EPP pene Import taves Roads state benefitsTHE BUDGET Budget shows the relationship between governmentrevenue and the government spending. A governmentwill prepare a budgeteach year setting out its plan and forecasts for public spending and public revenues. Ifthe government manages to balance its revenues and its spending, then a balanced budgetis said to exist. However, ifthe government spends more than it collects from its revenues then a budget deficit exists. And if there is more government revenue than is spent, the govemmenthas a budgetsurplus. In the long run, governments strive to balance their budgets. Thisis partly because increasing government revenues by raising taxes is highly unpopular, while government borrowing to fund a budget deficitis hugely expensive due to the amount of interest owed on such loans.ACTIVITY Budget or bodge it The figuresin the table present the budget forecasts forthe government of a small fictitious ‘country forthe three different years. te Z Tele CCM mle te Year1 Year 2 ala Total Public expenditure($ millions) 250 278 310 Total Public Revenue ($ millions) 270 278 284 2 2 ? Balance on Budget ($ millions) Calculate the budget balance for each year. In which year did the government budget for (a) deficit (b) a surplus and (c )a balanced budget?GOVERNMENT REVENUE In addition to the tax revenues, a governmentmay also receive other public revenue including: Interest payments on governmentloans - private sector or overseas governments. Rents from publicly owned buildings and land rentedto the private sector. ‘Admission charges for public museums and national monuments Revenues from government agencies and state owned enterprise — from the sale of goods and services. Proceeds fromthe sale of government owned industries or privatization or any publicly owned assets.GOVERNMENT SPENDING DEFINITION: Government spending refers to money spent by the public sector on the acquisition of goods and provision of services such as education, healthcare, social protection and defense. REASONS FOR GOVERNMENT SPENDING To reduce market failure: Govemmenis spend on public goodssuch as street lighting and merit goods such as education, health care as this will not be financed or provided by the private sector To invest in social and economic infrastructure: Spending on roads, railvays network, schools and other public building to support growth, human and economic development in their economies. To support agriculture and other key industries: Providing financial assistance or subsidies to firms reduces their cost of production To promote equityireduce inequalities: Government provide benefits and products to vulnerable groups and the unemployed in the form of state pensions to retired people, subsidised housing for the poor, free education to children and so on. To manage the macro economy: Using public expenditure to control total demand to achieve economic growth, reduce unempioyment, and avoid high and unstable periods of price inflation. To pay interest on national debt: If 2 government fias borrowed in the past to finance a gap belween its spending and its tax revenue, it will have to pay interest on loans.Vocabulary Builder The amount of money a governmentneeds each year to finance any short fall of public revenues below total public expenditure is called the public sector borrowing requirements. Government debt can be internal debt (owned to private individuals, firms and banking system within its economy) and external debt(owned to overseas bank, residents or international organizations such as World bank or IMF —international Monetary fund. Each year a govemmenttakes a loan to finance its borrowing requirements and every year in which a government borrows more money it will add to its total stock of debt. The total amount of money borrowed by the public sector of a country overtime that has yet to be repaid is called the National Debtor Public Sector Debt.Relation Between National Debt and GDP A comparison between a national debt of an economy to its GDP(National Income) tells us about the ability of an economy to manage and repay its debt. As a national debt of a country rises as proportion of its GDP, the burden of paying debts increases. This burden increases if the stock of national debt increases at a faster rate than GDP. However, rising public debt and rising interest payments need not be a bad thing as long as the national income or GDP of a country rises faster than the total debts.REASONS FOR LEVYING TAXES 1. Taxes raise revenue to fund public expenditure: Taxes are the main way of raising money 10 finance public sector spending. 2. Taxes are used to manage the macro economy: Gontractionary fiscal policy invoWves raising taxes fo reduce aggregate demand and therefore inflationary pressures in an economy, Whereas, cutting taxes during an economic recession can help boost aggregate demand and therefore output and employment 3. Taxes can reduce inequalities in income: High incomes can be taxed more than lower ones to Teduce the inequalities between incomes afer tax as inequality in income may mean that ‘some people might experience poverty. A significant gap may also cause social unrest as a poor may feel a sense of social injustice 4 Taxes can discourage spending on imported goods: A tax or tariff on the prices of goods purchased from overseas can encourage the use of local goods. This will reduce a balance of payments deficit and boost oulput and employment 5. Taxes can discourage the consumption and production of harmful goods: These are product s that the government considers more harmful to consumers than they realize for example, taxes are used to raise the prices of cigarettes and alcohol so that demand for them contracts. 6. Taxes can be used to protect the environment. Increased taxes an productive activities or products that create pollution will reduce the profits of firms and can deter the consumption of goods,QUALITIES OF A GOOD TAX 1. Equity. This means fairness in the sense that tax payer with similar characteristics such as same level of profit or income should be charged same. It also means taxing people or firms’ according to their abilty to pay. 2. Certainty: A tax should be easy to understand and people and firm should be able to calculate the amount of tax required to be paid by them. 3, Convenience: The process of paying the tax should be simple and easy for people and firm to pay. 4, Economyladministrative efficiency: Taxes should be cheap and easy to collect. The cost of collecting the tax should be considerably less than the revenue it generates. 5 Elexbility: ft should be possible to change the tax if economic activty changes or government aims change 6 Efficiency: Atax should improve the performance of markets or at least, not significantly reduce the efficiency of markets. For instance, an extra one off tax (windfall tax) Is imposed an firms eaming super natural profits to reduce the costs they charge cn customers 7. Non. distortionary: Taxes should nat affect or distort sensible economic behavior For example _ high taxes on profits and incomes might discourage enterprise or people from workingNATURE OF TAXATION Taxes are progressive, proportional ar regressive Progressive tax system: A progressive tax is one which takes a higher proportion ofthe income, as taxable income rises. This means people or firms with higher income or profits pay higher taxes than those on lower income. Government use progressive tax to reduce the inequality in income after tax ‘Annual income § Sotacrate Tax Paid 100 10 500 20 10 100 0 400NATURE OF TAXATION Taxes are progressive, proportional ar regressive Regressive tax system: In regressive tax system, the percentage paid in tax falls as income rises. it may be considered unfair to people or firms with low incomes be cause a much larger fraction of their income is taken as tax although they will in tot al pay lessthan those on higher incomes, ‘Annwal reone § 109) 500 1000NATURE OF TAXATION ‘Taxes are progressive, proportional or regressive. Proportional tax/Flattax system: In proportionaltax, a fixed percentage ofttax is charged at all the levels ofincome. ‘Annual income $ 300 500 1000Activity Tax Systems Look at the following graph Tax Rate 4. Which of the lines, 4,2 of 3 represents a tax that is: ‘a. Progressive b. Regressive. proportional, IncomeActivity Tax Systems 2. Now look at the three tax systems below. Calculate the percentage oftax paid on each income and state whether the systems are progressive, regressive or proportional. fee feos ee) Annual income — $ Tax Paid Annual income $TaxPaid Annualincome $ Tax Paid $5,000 $1,500 $10,000 $1,000 $8,000 $3,200 $15,000 $4,500 $16,000 $2,400 $12,000 $3,600 $25,000 $7,500 $30,000 $6,600 $20,000 $4,000TYPES OF TAXES DIRECT TAXES: Direct laxes are taken direciy from individuals or fms income. They are called direct taxes because the people or firms responsible for paying the tax have to bear the burden of the tax, Direct tax includes Income tax: This isthe tax on income that individual receives from their employment and investment income. Individuals are given a tax allowance, which is an amount of income which is free of tax. income above this level is referred to as taxable income Employer payroll taxes: Other payroll taxes lke social security coninibution (welfare benefits and old age pensions) are often based on an individual's eamings but maybe payable from an employer's own funds as well as by an employee. Payroll taxes that have to be paid by an employer's own funds are offen called employment taxes because they increase the cost of employing workers, Corporation Tax: ‘Corporation tax’ is levied on the profits of limited companies or corporations. and may also be called ‘profit tax’ if applied on the profits of unincorporated businesses (sole traders and partnership). Capital Gains tax: This 18 the tax on the profits made an assets when they are sold at a higher price than what they were bought for. When 2 capital gaintax is imposed some alowances are made for instance, for the length of time someone held an asset-the longer someone holds the asset the lower the tax the person pays Wealth tax: Wealth taxes can include taxes on the value of residential and commercial land or property. Weatth tax can also include inheritance taxes on the transfer of wealth from one person to another upon their deathTYPES OF TAXES DIRECT TAXES ADVANTAGES High revenue yield: Directtaxes have a high yield of revenue as comparedito their costof collection. The total amount of money collected can be estimated with reasonable accuracy. Reduce inequalities in income: The progressive nature of may direct taxes reduces the inequalities in income. Ability to pay: a directis usually basedon a person's of firm's ability to pay the tax. 1 DISADVANTAGES Can reduce work incentive: Some people prefer to remain unemployed ifhigh taxes reduce the return from ‘employment. Similarly, people in work may reduce their productive effort to seek promotion because the more they earn the more the tax need to be paid Can reduce enterprise incentive: Corporation tax on profits can feduce the incentive for entrepreneurs to start up new firms or expand existing ones. ‘Tax Evasion: High tax rates in creases the chances of avoiding taxes and finding loopholes in tax lawsTYPES OF TAXES Indirect taxes/Expenditure or Outlay taxes: indirect taxes are taxes taken only indirectly from incomes when they are spent on goods and services; this means that indirect taxes are added to the price of goods and services. An indirect tax may be a fixed percentage of a price or value or it may bea fixed amount An indirect tax wall normally be imposed on producers but they ll ass on as much of the burden of the tax as possible to consumers through high prices, Indirect taxes include Advalorem tax (Value added taxiSales tax): Ad valorem taxes are imposed as a percentage of the selling once of goods and services or on sales revenue. Sales taxis usualy lemed on finished products whereas VAT is imposedon sem.-finished products and materials bought by producers. VAT is therefore added at every stage of production. Firms usually get back the VAT paid by them on the sale ofits output, Excise Duties: these are taxes charged on specific goods such as alcohol, petrol and tobacco Import Tantts/Custom cues: These are taxes on the value of imported goods. Tarif may be Used to raise the price of certain imported products to protact the domestic frms from overseas compettion. However, domestic firms that rely on imported raw material to use in production wal face increased cost. User Charges: these are taxes or charges linked to the use of specific good or actities. For example a TV licenseTYPES OF TAXES INDIRECT TAXES ADVANTAGES Cost effective: Indirect taxes are relatively cheap and easy to collect The administratve burden of collecting the tax lies mainly with the manufacturers, wholesalers, retailers and with importers. Expand the tax base: Indirect taxes are paid by everyone whether old or young, employed or unemployed alike when they buy the goods or semces Can be used to target specttic products and activities: Indirect taxes can be used to achieve Specific government targets e.g, Taxes on oil can help to reserve a non-renewable resoutce and also help to reduce poltition Flexible" it is often quicker and easierfor a {Government to alter tax rates for VAT and excise duties than to make changes to direct taxes DISADVANTAGES ‘They are inflationary: Raising indirect taxes increases the price of the product and reduce the teal income of the consumer. As the result the demand wil fal They are rearessive: Indirect taxes tend fo be regressive in nature. That is, their burden as a proportion of income is ofeater on low salaried people than on high salaried people Revenues are less certain and predictable: It can be diificut for a ‘government to predict accurately how much consumers will spend on goods and services Encourage tax evasion: High tariffs on imported goods may encourage illegal smuggling of goods.IMPACT OF INDIRECT TAXATION 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 demandit is producers who bear most ofthe tax. This is because they know that they cannot pass on much ofthe tax to consumers as move would bring down the sales significantly. Elasticity of supply also influences the incidence oftaxation. The more inelastic supply is, the more the tax borne by the supplier. In contrast, if supply is elastic, more of the tax will be borne by consumers.Important Terms ‘Tax Burden: The tax burden relates to the amount of tax paid by people or firms as a proportion of their incomes. Itis sometimes expressedas a percentage of the country’s total income. ‘Tax Base: The tax baseis the source of tax revenue that is what is taxed. A wide tax base means that a large range of items and people are taxed. Tax Evasion: Taxes are compulsory payments backed by law. Non — payments of tax, or tax evasion is a punishable offence. Tax avoidance: Some taxes may be avoided legally. For example, taxes on cigarettes can be avoided by not smoking. Hypothecated tax: A tax on a specific good or activity used to raise revenue fora specific purpose, such as paying tax for road or public transport improvements, is called a hypothecatedtax.Important Terms Flat Taxes: A pure flat tax systeminvoives income tax, corporation tax and VAT being setat the same rate with no exceptions. Its advantages include they are simple to administer for governments and firms, there is less incentive to evade paying tax and more incentive for workers and entrepreneurs to eam and produce more. However, concems have been expressed about the regressive nature of flat taxes although in practice, all existing flat taxes have set the uniform rate above a tax free level ofincome. Average and Marginal tax rate: The average tax rate is the total amount oftax paid by a person divided by their total income. Whereas, marginal tax rate is the rate of tax paid on additional slice of income. Aperson could therefore pay many different marginal rates of taxes on their income. By adding up the amount of tax paid on each additional slice of income the average tax rate can be calculatedImportant Terms National debt: The total amount of money borrowed by the public sector of a country overtime that has yet to be repaid. Public sector borrowing requirement: the amount of money the public sectorin an economy needs in order to balance its spending. Local and National taxe Most taxes are levied by the national governmentto pay for public expenditures and to control the macro economy. But some countries allow local governments to levy their own taxes to raise revenue fromlocal residents and businesses. Local taxes are used to pay for local services such as education, fire services etc.