JUNE 2011 Q1 B Essay

Evaluate the case for cutting public expenditure rather than raising taxes as a means of reducing fiscal deficits. (30)
A fiscal deficit is when the government spends more than it receives in tax revenue.
There are many benefits of cutting expenditure rather than increasing taxes. Firstly this will avoid any tax evasion and avoidance. This is because when taxes are increased a smaller amount of income is retained giving people the incentive to declare lower incomes to the HMRC so that they fall into a lower tax bracket. Moreover people may take incomes as a share option. This is because capital gains tax is at a flat rate of 18% therefore much lower that income tax allowing people to retain more of their incomes and enjoy better living standards. This will result in a reduction in the government’s tax revenue as people are paying less tax, which will lead to further increases in the deficits.

Secondly high taxes create disincentives to work and this can be analysed through income and substitution effects. The substitute for work is leisure time and when taxes increase the opportunity cost for leisure time decreases, also people will have to work longer hours to earn the same post tax income causing disincentives as it reduces living standards as people must work longer and harder for the same incomes. This will create disincentives to work and so lead to a reduction in the labour force meaning less people in jobs and so less people paying income tax. Also as people earn less this way consumption in the economy falls therefore reducing the governments VAT recipts and corporate tax revenues and businesses make lower profits. This will lead to increases in the fiscal deficits as the government earns less and may be spending more in forms of social protection i.e. unemployment benefits.
These factors can be shown using the laffer curve, as tax rates increase tax revenues will fall.
Thirdly there are further advantages of cutting expenditure rather than increasing taxes. One is that it reduces the dangers of crowding out the private sector. When the government spends or runs a large deficit much of the spending is financed through borrowing which is done through the issue of government bonds. To make these bonds more attractive the government will offer a higher rate of interest on these bonds. In addition government bonds are seen to be much more safe than private sector investments especially when the government has a AAA credit rating. Therefore when the government offers bonds investors provide their money to the government reducing the potential investment for the private sector. Moreover if the government borrows through the banks then the increased demand for repayable loans will increase pushing up the interest rates and so increasing costs of borrowing for the private sector and further reducing investment ability. So by cutting expenditure this is avoided enabling the private sector to invest more and provide longer term economic growth and increasing future tax returns.
Fourthly many economists argue that the public sector in countries such as the UK is too big. As the public sector is less profit-centric their allocation of resources is less efficient and they are known to be less productive and efficient than the private sector therefore by reducing public expenditure there will be less waste and inefficiency in the economy moreover resources will be more efficiently allocated greater output and so economic growth enabling the economy’s ability to finance the fiscal deficits more easily as the deficit to GDP ratio will be reduced. Also as the economy grows further employment rises, increasing income tax revenue. Higher consumer confidence will also translate into higher consumption and so greater VAT receipts, corporate tax revenues as profits increase helping to reduce the deficit.
However in evaluation there are also a few drawbacks of cutting public expenditure. Firstly this will lead to a reduction in the

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