Fiscal policy refers to the government’s tax and spending policies. Looser fiscal policies refer to more expansionary fiscal measures, with tax cuts being a key fiscal measure that may successfully increase economic growth in the Eurozone. Income tax reductions for lower-income earners should successfully boost consumption within the economy. This is because lower earners have a larger marginal propensity to consume compared to higher-income earners. This means that for every extra pound in disposable income, a larger proportion of that pound will be spent on consumer goods and services. This has the effect of a greater multiplier effect throughout the economy, as the initial injection of money that comes with tax reductions is multiplied to produce a larger increase in Aggregate Demand that occurred compared with the initial tax cuts. As a result, economic growth spurs from income tax reductions for lower-income individuals, as a large increase in consumption leads to Aggregate Demand shifting outwards, thereby producing economic growth, with a multiplier effect occurring throughout the economy spurring an even greater increase in Aggregate Demand, economic growth and prosperity.
This doesn’t mean that taxes shouldn’t be cut for higher-income earners. This is because higher-earning individuals are more likely to invest their increased disposable income in equities, bonds and other alternative investments such as private equity. This leads to more capital for institutional groups and private investment firms, resulting in more investment throughout the economy, thereby boosting aggregate demand and economic growth. At the same time, tax cuts for higher-income individuals increase consumption through rising animal spirits. This is because of the asset price inflation that occurs in equity and real estate markets following tax cuts for higher earners, due to the investment by these institutional groups. In 2013, a year after the reduction of the top marginal tax rate from 50% to 45% by Osborne, the average house price in the UK started to increase for the first time in five years. Increased consumer confidence that comes with asset price inflation should result in increased consumption, leading to economic growth through an outward shift in Aggregate Demand.
With this said, it could be argued that looser fiscal policies through income tax cuts could result in a fall in investment due to the crowding-out effect. This is because tax cuts should result in a fall in tax revenues, thereby increasing the budget deficit – the difference between tax revenues and government expenditure. This would reduce the confidence of investors that Eurozone governments can repay their debt. As a result, they demand higher interest rates on government bonds. This would make it more expensive for firms to borrow money, thereby reducing investment within the economy, resulting in a fall in Aggregate Demand. However, tax cuts can result in such economic growth that results in increased tax revenues, thereby resulting in no budget deficit and no crowding effect. Following the Osborne tax cuts of 2012, tax revenues from those paying the top tax rate increased from £38 billion in 2012-13 to £46 billion in 2013-14. This is due to the large increase in economic growth that accompanied these tax reductions, thereby rendering looser fiscal policy that is tax cuts a success.
Supply-side reforms refer to policies that aim to increase the long-run aggregate supply of the economy. One such supply-side reform that would be effective in promoting economic growth in the Eurozone is to abolish the minimum wage for under-21s. This is because the Eurozone has high levels of youth unemployment. For example, Spain had a youth unemployment rate of over 50% in 2013. This is since firms find it very expensive to hire young workers, as their labour output doesn’t justify their salary of the minimum wage due to the lower quality and quantity of output. This is unsurprising, as youth workers often lack the experience and proper skills that many jobs require. As a result, abolishing the minimum wage for the younger citizens as a supply-side reform would make it profitable for firms to hire younger workers, thereby reducing the chronically high levels of youth unemployment across the continent as the demand for labour increases. As the unemployment rate falls within Eurozone economies, the productive potential of the economy will vastly increase, thereby producing long-run economic growth.
However, some claim that due to the monopsony power of large firms within the Eurozone, abolishing the minimum wage for younger workers will lead to falling living standards due to low wages. This is because when there are only a few firms demanding labour within a region, they can pay low wages without the threat of being outcompeted by other firms offering higher salaries. With this said, this conclusion ignores the sheer number of small businesses that would appear because of abolishing the minimum wage for these younger workers. This is because employee remuneration comprises a far larger part of the budget of small businesses compared to larger firms and thus reduced labour costs will promote the creation of small businesses as more businesses can afford to pay lower wages. This would raise competition, thereby reducing the monopsony power of larger firms in the area – all the while promoting more employment opportunities through more firms able to hire workers, increasing long-run aggregate supply and economic growth.
Ultimately, targeted loose fiscal measures coupled with supply-side reforms should be effective in promoting economic growth in the Eurozone. Income tax cuts for high and low earners should do well in increasing aggregate demand through greater consumption and investment, whilst simultaneously increasing tax revenues through greater economic growth and activity. At the same time, reforming the minimum wage will stem the excess supply of labour that has plagued the Eurozone for years, promoting the creation of small businesses all the while increasing youth employment, thereby increasing long-run economic growth.