A fiscal deficit is when a government’s total expenditures exceed the tax revenues that it generates. A budget deficit can be cut by either reducing public expenditure or raising taxes. In this essay, I am going to analyse the benefits and costs of increasing tax rates to reduce fiscal deficits instead of cutting government expenditure.
First of all, if the government decides to cut current public expenditure, it will lead to a reduced quantity and quality of public goods and service. For example, closing NHS direct call centres down which results in lower living standard. Moreover as the spending in sectors such as healthcare and education is cut, these services may need to redundant staff to stay within their new budgets. For instance if the NHS’s budget is cut they will lay-off additional staff. Those public sector workers may find it difficult to find a new job in private sector if they are not competitive enough to compete with other people in the labour market, leading to higher unemployment conflicting with the government macroeconomic objective of low unemployment rate. Also higher unemployment will mean less income tax revenue, lower VAT receipts, higher welfare payments, as well as lower standards of living.
If the government is to cut capital expenditure this is the type of expenditure that expands LRAS. It might not cause serious problems in short run, however in long run less spending on for example education and healthcare will result in a less educated and skilled workforce and a less healthy workforce. The negative effects of inadequate skilled human capital in the long run include lower productivity which makes the economy less competitive internationally compared with for example Germany. It in turn leads to deterioration on balance of payment, economic stagnant growth and inflationary pressure as labour costs increase.
Thirdly, government spending is an injection into the circular flow of income. A decrease in the government spending will incur negative wealth effect and therefore lead to weaker economic growth. In addition, the government spending is one of the components of aggregate demand, consequently, lower GDP. In a demand-deficient recession, consumption and investment tend to decrease due to lower income and revenue, the (X-M) component tends to level off or worsen in short run, which makes government spending an essential device to stimulate the economy. Therefore a decrease in the government spending will cause an even deeper recession and a larger budget deficit.
Last but not least, a decrease in government spending could mean worse income distribution compared with increasing progressive tax. This is because transfer payment forms almost a third of the governments budgets and so by cutting expenditure it is very likely that it will also be cut making the poor poorer and widening the gap. On the other hand, taxes could be increased progressively by for example increasing marginal income taxes so that the people with high income pay more than the poor narrowing the gap between.
However, there are also some drawbacks associated with raising taxes. Tax is a form of leakage from the circular flow of income leading to negative multiplier effect. If the government increases income tax rates, it might create disincentives to work. It is because when income tax increases, the opportunity cost for leisure time decreases; and people will have to work longer hours to earn the same disposable income. Some people may therefore prefer claiming Jobseekers’ Allowance instead of working. If the corporation tax is to be increased, there will be disincentive for firms to locate in the UK, leading to less investment and corporation tax revenues. Additionally, an increase in the National Insurance may discourage firms taking more employers as the NI is paid per employee.
Secondly, if the government raises higher income by increasing indirect taxes for example VAT, it may also have problems. It shifts the SRAS curve to the left as the cost of production increases. And it may therefore push up the price level and reduce the level of output. Moreover, indirect taxes are regressive taxes, which impose a greater burden relative to the incomes on the poor than on the rich.
Thirdly, as the public sector is basically non-profit, their allocation of resources believed to be less efficient than the profit-making private sector firms. Therefore reducing public expenditure may lead to greater efficiency and productivity by for example removing unnecessary layer of management hence more effective communication and better service provided by the public sector.
Last but not least, the choices between the two possible ways and their effects depend on the macroeconomic situation- for example the unemployment rate and the size of the public sector. If the size of the public sector is small, the adjustment on government spending might not be very large and the effect on budget deficit wouldn’t be significant. If the unemployment rate is high, for example 26% general rate and 50% youth rate in Spain, making it very hard to raise taxes.
Apparently, both reducing government spending and increasing tax rates will lead to a lower AD, but they will have different other effects. Therefore the choice between this two may depend on macroeconomic situation and what the government is focusing on achieving.