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The raising of tax has never been a good idea or good news in all economies. This is because it not only makes the government increasingly unpopular but it also wanes the confidence on investors and consumers, depresses economic growth and takes money needed within the productive economies. However, despite the above scenario, the government still remains under pressure to either raise tax revenue or reduce expenditure or both. The big challenge is how to approach this without affecting the average middle class citizen.  A number of suggestions have been projected as effective in addressing deficit by increasing the amount of government revenue while at the same ensuring mass support for the government's financial policy. These have been popularly advanced because they fit the political order of the day.

The three most widely advanced strategies of raising tax revenues while at the same time have been pointed out as working together with the private sector, increasing fines levied on poor decisions in the society and expansion of existing taxes. While these may be seen as attempts to reduce the increasing deficit levels, they may fail to make notable impact. This is because the rate at which the deficit level has skyrocketed demands more than a gloss over economic strategy. The government desires to have a strategy that has the capacity to generate more revenues while at the same time maintaining the level of confidence in its citizens. These include shifts in both fiscal and monetary policies on government spending.

However, within all these attempts to underline available strategies to the government in addressing this case scenario, a number of points must be outlined. These include both the fiscal and monetary policies of the government. Until quite recently fiscal policy was mainly used to manage aggregate demand and in so doing manipulate the economy in an upwards (reflate) or downwards (deflate) direction. This was often referred to as Keynesian economics.

If a government wanted to increase aggregate demand it would increase its own spending and probably cut taxes. This would inject a boost of spending into the economy and absorb more resources, especially labour. The opposite, namely a reduction in spending and/or an increase in taxes would reduce demand within the economy and cause it to slowdown - probably reducing inflationary pressure. To maintain 'a balance' within the economy 'fine tuning' took place, which meant that taxes and spending has to be altered to suit economic conditions and objectives. The impact of a reflationary policy on national income can be seen below with the boost in aggregate demand leading to a higher level of output (assuming there were spare resources available to absorb the increased demand).

Despite this entire seemingly open avenue, the fiscal policy is no longer the principal policy open to government to influence economic activity. It is part of a blend of monetary, fiscal and supply-side policies that are designed to produce a sustainable level of economic growth without stimulating inflation or sudden increases in unemployment (Page, 1983). Part of the decline in the popularity of fiscal policy was the fear that excessive government borrowing would cause interest rates to rise. The 'appetite' for money by government would reduce the funds available for other borrowers and the price of money (interest rates) would rise. This would cause a 'crowding out' of consumption, as consumers could not afford credit charges and investment, as business could not afford overdraft and loan charges. Together they would cause a slowdown, or under achievement within the economy.

The next important area that the government has the opportunity to explore is a shift in its monetary policy. This is based on the understanding that the fiscal policy is no longer the principal policy used by government to influence economic activity and thus monetary policy is now the major way in which government controls inflationary pressures and fiscal policy is subject to rigorous controls. The UK government now have three yearly reviews of public spending and how this will be financed.

Monetary policy is the use of interest rates and money supply changes to manage the overall level of demand in the economy and therefore help achieve the economic objectives we have set out in previous sections (Persson & Tabellini, 1994). Monetary policy therefore can control inflation, help produce growth, keep employment rates high and maintain price stability.

The responsibility for monetary policy rests with the Bank of England's Monetary Policy Committee (MPC) (Beetsma, 2004). This has been the case since 1997 when the incoming Labour government gave the Bank of England operational independence. The Bank of England is set an inflation target by the government (currently 2.5% for RPIX) and they set short-term interest rates to ensure that they achieve this target. Interest rates are set monthly, though the decisions are based on their forecasts for inflation. They believe that it takes 18 months to 2 years for the full effect of any interest rate changes to work right through the economy.

However, within this cacophony, the government still has changes in executing a sudden shift in its monetary policy. This is because of the knowledge that interest rate changes will affect aggregate demand. For example, if interest rates rise, the impact on aggregate demand will be:

  • Consumption - if interest rates are increased then consumers will find that their disposable income is lower (because debt repayments and mortgage repayments will be higher) and they will be less likely to borrow as it is more expensive. This will negatively impact on their levels of consumption. Higher interest rates also make saving more attractive than consuming.
  • Investment - higher interest rates will make investment less attractive as the returns are relatively lower.
  • Government expenditure - government also borrow large amounts of money and if interest rates rise then they will face higher 'debt servicing' costs (higher interest payments).
  • Exports and imports - an increase in interest rates may lead to a rise in the exchange rate and this will make exports less price competitive. Exports may fall and imports may rise.

Furthermore, monetary policy is now PRE-EMPTIVE - changes are designed to affect inflation and other economic variables 18-24 months into future. So, if the MPC fear rising prices in eighteen months time they change rates upwards, say 0.25% now and watch for signs of slowdown in inflationary pressures.

The MPC is accountable to parliament and if they fail to stay within 1% either side of the target (currently 2.0%) then the Governor of the Bank has to write an open letter (available to the media and public) to the Chancellor and explain why this has happened and what the Bank are doing to correct it. The challenge is that failure to institute working policy to correct the rates may have profound impacts on inflationary pressures that have the capacity to influence other critical sectors of the economy.  It can be seen that the government walks a tight rope it its efforts to institute policies capable of addressing the increasing levels of deficit.

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