Question

Explain three types of government policies that can encourage economic growth.

Answer 1

Lower Income Taxes. It is argued lower income tax can boost the incentive to work and increase labour supply. It is possible, if income taxes were excessive, then cutting them may encourage people to work more. However, this argument is often exaggerated. Reducing the basic rate of income tax from 23% to 22% would have a very minimal impact on labour supply. With a tax cut, there is both an income and substitution effect. The income effect states that higher taxes make people work longer hours to achieve their target income.

Monetary Policy

Monetary policy is the most common tool for influencing economic activity. To boost AD, the Central Bank (or government) can cut interest rates. Lower interest rates reduce the cost of borrowing, encouraging investment and consumer spending. Lower interest rates also reduce the incentive to save, making spending more attractive instead. Lower interest rates will also reduce mortgage interest payments, increasing disposable income for consumers.

3. Fiscal Policy

The government can boost demand by cutting tax and increasing government spending. Lower income tax will increase disposable income and encourage consumer spending. Higher government spending will create jobs and provide an economic stimulus.

The problem with expansionary fiscal policy is that it leads to an increase in government borrowing. To finance this extra spending, the government have to borrow from the private sector. If the economy is already growing, then higher government borrowing can crowd out the private sector. Expansionary fiscal policy is also criticised by those who fear it is an excuse to permanently increase the size of the government sector.