Discuss ‘looser fiscal policy’ and ‘supply-side reforms’ that may be used by governments of Eurozone countries to increase economic growth

Edexcel A-Level Economics Paper 1 June 2017 Extract

Discuss ‘looser fiscal policy’ and ‘supply-side reforms’ (Extract A, lines 20 and 21) that may be used by governments of Eurozone countries to increase economic growth. (15 marks)

Looser fiscal policy refers to expansionary fiscal policy, which is when the government increases spending or reduces taxes in order to stimulate economic growth. One example of this would be if the government decided to reduce income taxes. As income taxes are reduced, people can enjoy more disposable income. This should lead to an increase in consumer spending (C), which leads to an increase in aggregate demand (AD) as C is a component of AD. Additionally, as consumer spending increases, this stimulates investment which is when firms spend on capital goods like self checkout machines or other machinery. Firms like Lidl are more likely to invest in additional capital based on animal spirits or when they anticipate an increase in economic growth. They do this so they can increase their capacity and fulfil all future demand. As investment (I) is another component of aggregate demand, aggregate demand increases further, which is a multiplier effect. The diagram below shows real gdp increasing from y1 to y3 as a result of lower income taxes. 

However, this might be damaging to the Eurozone overall as lower taxes will worsen the budget deficit which is the difference between government spending and tax revenue in a given year. Higher budget deficits each year accumulate as national debt, which is dangerous. High levels of debt carry a huge opportunity cost as the government must pay back more principal debt but also interest. For example, the UK government paid close to £100m in interest alone, which could have been spent on public services had debt and interest been lower. 

Supply-side reforms can enable more potential economic growth, which is when the productive potential increases in the economy. This allows the economy to continue to grow in the future without causing inflation. One example of a supply-side policy might be to reduce corporation taxes, which is also a fiscal policy at the same time, as it involves changing tax rates. Lower corporation taxes mean that firms can retain more of their profits, which incentivises more businesses to set up, but also enables them to invest more in capital. As firms employ more capital, they can become increase productivity, which leads to an increase in the potential level of economic growth. This can be seen by an increase in long-run aggregate supply.

However, one disadvantage with supply-side reforms like this is a time lag. This means that there will be a lengthy period between when, in this case, corporation taxes are reduced, to the time when the economy actually grows. In this case, lower corporation taxes will not immediately guarantee that more firms are setting up and investing more. This is down to other factors such as animal spirits, which is affected mainly by business confidence and the rate of economic growth. Even with other supply-side reforms, the time lag could be even greater. Another example is infrastructure spending on projects like HS2 in the UK, which has already taken over ten years and is incomplete.

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