The Government and Fiscal Policy

Transcription

1 The Government and Fiscal Policy How does the government affect us? Government provide water, electricity, sewerage, education, health services, police and defence force. Some of these are paid for directly by us, while others are paid for out of taxes. The government or public sector in South Africa consists of Central government: concerned with national issues Regional government: concerned with regional issues Local government: deals with local issues e.g. provision of sewerage, local roads, street lighting etc. Public corporations: Eskom, Transnet etc. Government interaction with households and firms Government provides households and firms with goods and services (law, health, education and housing). Government also make transfer payments to households (pensions) and firms (subsidies). To finance these goods and services, households and firms pay taxes to the government. The government also influence households and firms through regulation (laws). Government uses tax revenue to purchase the inputs required to purchase the inputs to provide public goods and services. These include labour from households and goods such as computers, equipment, uniforms and building materials from firms. This constitutes income household and firms. This shows that there are continuous flows of goods, services and income between the public sector (government) and the private sector (households and firms). Bishops Economics Department Page 1

2 Government participation in the economy Almost all economies can nowadays be classified as mixed economies in which the government, the private sector and market forces all play an important role. What is the appropriate division (or mix) between government and the market? To answer this question, a few important points need to be considered. 1. Private firms and market forces are generally more efficient than any other possible solution to the basic economic questions of What? How? and For Whom? Government should not get involved in the production of goods and services that can be produced much more efficiently by the private sector. 2. Free markets cannot function properly without government enforcement of the rules under which private households and firms make contracts. Market economies cannot function without well-defined property rights, the enforcement of contracts, and so on. 3. Markets do not always produce efficient outcomes. Markets sometimes fail and when they do, a case for government intervention arises to correct market failure. 4. Market systems produce relatively efficient outcomes but they often do not produce equitable outcomes. Governments need to intervene in order to ensure a more equitable distribution of income and wealth, which the market system cannot provide. 5. The free market system tends to fall short of achieving important macroeconomic objectives such as rapid economic growth, full employment and price stability, and that governments have to intervene in an attempt to achieve these objectives. They emphasise that market systems tend to experience business cycles, that is, phases of rapid economic growth (called upswings or booms), followed by periods of stagnation or decline (called downswings or recessions). Other economists disagree and maintain that free market systems tend to produce the best possible results, but the debate on the appropriate role of government at the macroeconomic level is an ongoing (and often heated) one. Governments around the world try to achieve macroeconomic objectives by applying macroeconomic policy such as: economic growth full employment price stability Macroeconomic policy consists of monetary, fiscal and supply-side policies. Bishops Economics Department Page 2

3 Fiscal policy and the budget Governments need to make decisions on how much to spend, what to spend it on and how to finance its expenditure. They therefore have a policy in respect of the level and composition of government spending, taxation and borrowing. This is called fiscal policy. The main instrument of fiscal policy is the budget and the main policy variables are government spending and taxation. In the budget the Minister of Finance outlines government s spending plans for the financial year, which runs from 1 April of the current calendar year to 31 March of the following calendar year, and indicates how government proposes to finance its expenditure. The size and composition of government spending and the way in which it is financed may have significant effects on important macroeconomic variables such as aggregate production income employment the price level (inflation) the distribution of income. The government often uses the budget (or fiscal policy) to stimulate economic growth and employment redistribute income control inflation address balance of payments problems. Fiscal policy is often regarded as an effective means of influencing total spending (or the aggregate demand for goods and services) in the economy. It is therefore classified as an instrument of demand management, that is, as an instrument that can be used to manage or regulate the total demand for goods and services in the economy. The other important instrument of demand management is monetary policy. These policies have to be applied in harmony, otherwise the one may counteract or negate the effects of the other. There is a close liaison between the National Treasury, which is responsible for the execution of fiscal policy, and the SARB, which applies monetary policy in South Africa. The government in a mixed economy attempts to promote economic stability. When the economy is in a recession, the tendency is therefore to apply expansionary fiscal and monetary policies to stimulate economic activity. This usually means that government spending is raised and taxes reduced (or not increased). The difference between government spending and taxation, called the budget deficit, will therefore tend to increase. In contrast, when the economy is expanding too rapidly and inflation and balance of payments problems are being experienced, the appropriate response is to apply restrictive or contractionary fiscal and monetary policies. This means that government spending has to be reduced and/or taxes have to be increased. In other words, the budget deficit has to be reduced, or a surplus has to be budgeted for. Bishops Economics Department Page 3

4 Government spending Government spending (G) is an important component of total spending in the economy. The government s involvement in economic activity is often measured by the share of government spending in total spending in the economy. The growth in government spending during the post-war period is not unique to South Africa. Most other countries have had a similar experience. There are a number of possible explanations for this trend, including the following Political and other shocks: In the 1970s and 1980s, South Africa s involvement in wars in Namibia, Angola and Mozambique caused sharp increases in our defence expenditure. The Apartheid era also gave rise to increases in spending on law and order, education and other services. Redistribution of income: Democratisation shifted the balance of power towards the lowerincome groups, and accordingly much more attention is being given nowadays than in the past to redistribution measures. Population growth and urbanisation: Rapid population growth in South Africa has resulted in large increases in the demand for public goods and services like education and health services. Governments also need to spend more on infrastructure (roads, sewerage, electricity, etc), housing and the maintenance of law and order due to urbanisation. The high incidence of HIV/AIDS also contributes in various ways to rising government expenditure. Bishops Economics Department Page 4

5 Note, in particular, the decline in the share of defence spending and the increase in the share of spending on social services. Financing of government expenditure Government spending has to be financed in one way or another. There are basically three ways of financing government spending: income from property, taxes and borrowing. Government has certain property which yields income. This includes interest and dividend income derived from government s full or partial ownership of enterprises such as Eskom, Telkom and Transnet, profit earned from government production and the sale of agricultural, forestry and fishing products, rent (for example in the form of mining rights), and other license fees and user charges. But income from property is a relatively insignificant source of revenue for government. Taxation, however, is not sufficient to finance all government spending. The difference between government spending and current revenue is called the budget deficit. This deficit is financed by borrowing. The government can borrow in the domestic and international capital markets or it can borrow from the central bank. Government can also borrow from the central bank. This type of financing increases the quantity of money in the economy and is potentially inflationary. It is therefore called inflationary financing and is avoided as far as possible. Like any other borrower, government has to pay interest on borrowed funds, and as its debt increases, its interest burden also increases. In South Africa, for example, the interest on public debt reached 20 per cent of current spending by general government in Bishops Economics Department Page 5

6 Taxation Taxes are compulsory payments to government and are the largest source of government revenue. In 2010 taxes constituted 97,7 per cent of total budget revenue in South Africa. Criteria for a good tax 1. Neutrality Taxation can also act as a disincentive to the owners of the factors of production. For example, workers might decide to work less if they are taxed at high marginal rates of personal income tax. These costs of taxation have to be kept as low as possible. 2. Equity The tax burden should be spread as fairly as possible among the various taxpayers. If a tax system is generally perceived to be equitable, taxpayers might be quite willing to pay high taxes. In order to decide what is fair and determine who should pay the most tax, we need to look at two principles The ability to pay principle The ability to pay principle means that people should pay according to their ability. For example, in the case of an income tax the ability to pay is determined by the level of income. There are two notions of equity in this regard Horizontal equity requires that people in the same position (ie two taxpayers who have the same income) should be taxed equally. Vertical equity requires that people in different positions should be taxed differently. Rich people should therefore pay more tax than poor people. The benefit principle According to the benefit principle, the recipients of the benefits generated by a particular government expenditure should pay for the goods or services concerned. In this case, taxation is viewed as a charge or levy that has to be paid for goods and services provided by government the more you receive, the more you have to pay. 3. Administrative simplicity Taxpayers have to keep records and complete tax returns or pay accountants to do it for them. These costs are called compliance costs. Government also has to employ people to write tax laws, design tax forms, collect taxes and assess tax returns. These costs are called administration costs. A good tax (or tax system) is one that keeps the compliance and administration costs as low as possible. Bishops Economics Department Page 6

7 Different types of tax Direct and indirect taxes Taxes are classified into two major categories: direct and indirect taxes. Direct taxes (taxes on income and wealth) These taxes are levied on persons, more specifically the income or wealth of individuals and organisations such as companies. Examples include personal income tax company tax estate duty Indirect taxes (taxes on goods, services, products and production) These taxes are levied on transactions (eg the purchase of goods and services) and are usually paid by those who consume the goods and services in question. Examples include VAT customs duties excise duties General taxes and selective taxes VAT is a general tax since it is levied on most goods and services. Excise duties are selective taxes which are levied on specific goods only. In South Africa, excise duty is levied on tobacco and alcohol (these duties are commonly referred to as sin taxes ), fuel and a few luxury goods. Progressive, proportional and regressive taxes The distinction between progressive, proportional and regressive taxes is based on the ratio of tax paid to taxable income (ie the average tax rate). Progressive tax Progressive tax: when the ratio of tax paid to taxable income increases as taxable income increases. This means that people with high incomes pay a larger percentage of their income in tax than people with low incomes. Personal income tax in South Africa is an example of a progressive tax. Proportional tax Proportional tax: the ratio of tax paid to taxable income is the same at all levels of income. Bishops Economics Department Page 7

8 In other words, the average tax rate is the same for all taxpayers. The basic company tax in South Africa is an example of a proportional tax because it is levied as a fixed percentage of company profits. Regressive tax Regressive tax: the ratio between tax paid and taxable income decreases as taxable income increases (or rises as taxable income falls). A regressive tax takes a larger percentage of the income of low-income individuals and groups than of those with higher incomes. Indirect taxes (eg VAT) are often regressive. The three main taxes in South Africa are 1. Personal income tax 2. Company tax 3. VAT 1. Personal income tax Personal income tax is the most important single source of tax revenue. Taxable income is obtained by deducting personal and other allowances from an individual s total income (see table below). Tax tables (like the one below) are then used to determine how much tax should be paid. For each tax bracket there is a minimum amount of tax and a tax rate that is applied to each rand by which taxable income exceeds the starting point of the bracket. This rate is called the marginal tax rate. Marginal tax rate: the rate at which each additional rand of income is taxed. Bishops Economics Department Page 8

9 Average tax rate: the ratio between the amount of tax paid and taxable income - also called the effective tax rate. Personal income tax in South Africa is a progressive tax. As taxable income increases, the proportion of taxable income that is paid in taxes increases. In other words, the average tax rate increases as income increases. Why does the average tax rate increase? It increases because the marginal tax rate increases. If each successive rand (or income interval) is taxed at a higher rate than the previous one, the average tax rate must increase. Capital gains tax (CGT) was introduced in the 2001/ 2002 financial year. Capital gains tax: a tax levied on the gains resulting from the sale of assets such as shares and fixed property. CGT was introduced primarily to protect the integrity of the personal income tax base and to ensure horizontal equity. 2. Company tax Companies are separate legal entities and are taxed independently from their shareholders and other individuals. Once the taxable income has been established, all profits are taxed at a uniform rate - a proportional tax rate, thus the average tax rate is equal to the marginal tax rate. 3. Value-added tax (VAT) Value-added tax (VAT) the most important source of indirect tax in South Africa. It is second only to personal income tax (a direct tax) as a source of tax revenue in South Africa. VAT is an important and effective source of revenue for government but it is a regressive tax. Most goods and services are taxed at the same standard rate. However, since low-income consumers spend a greater proportion of their income on goods which carry VAT than highincome consumers (who save part of their income), the ratio between tax paid and income is greater for low-income households than for high-income households. In other words, the tax burden increases as income decreases (or falls as income rises). Politically it is therefore difficult for government to increase VAT, particularly in a country like South Africa, which has a vast number of poor households. Bishops Economics Department Page 9