4.5.4a Policies and responses to external shocks

Policy Instruments

1. Fiscal and monetary policy work mainly on the demand side, supply-side policies on productive capacity, and direct controls by rule rather than incentive.
   1. Most governments combine several instruments, since each has different strengths, time lags and side effects.

Reducing Deficits and Debt

1. Governments cut fiscal deficits by raising taxes or cutting spending, known as fiscal consolidation.
2. Faster growth also helps, since it raises tax revenue and lowers the debt-to-GDP ratio.
   1. Tightening too fast in a downturn can cut demand and slow growth, so it may be self-defeating.

Reducing Poverty and Inequality

1. Progressive taxation takes a larger share from higher earners, narrowing the post-tax income gap.
2. Transfer payments and a national minimum or living wage lift incomes at the bottom.
3. State provision of health and education raises the real living standards of the poorest.
   1. Supply-side measures such as training can raise the earning power of low-paid workers.

Interest Rates and the Money Supply

1. A central bank cuts its policy rate, say from $5\%$ to $4\%$, to boost borrowing, spending and investment.
   1. Higher rates and tighter money slow demand to control inflation.

International Competitiveness

1. Supply-side policies raise productivity and lower unit costs, improving competitiveness.
2. A lower exchange rate makes exports cheaper and imports dearer.
   1. Lower business taxes and better infrastructure can also attract investment and raise competitiveness.

Responding to External Shocks

1. Expansionary fiscal and monetary policy can support demand after a negative demand shock.
2. A supply shock that raises costs is harder, since supporting demand can worsen inflation.
   1. Exchange rate movements and direct controls can also cushion a shock, though each has costs.

Can policy offset an external supply shock?

1. It can help because targeted measures, such as fuel subsidies or supply-side support, ease the cost pressure and cushion output and jobs.
2. But a supply shock creates a genuine trade-off: loosening policy to protect output tends to worsen inflation, while tightening to curb inflation deepens the fall in output.
3. Policy also acts with time lags and governments cannot control the shock itself, so the response is often partial and mistimed.
   1. On balance it depends on the type of shock, the economy's spare capacity and how well policy is targeted and timed.

4.5.4b Controlling global companies and policy problems

Controlling Global Companies

1. Governments try to control transnationals to protect tax revenue, workers, consumers and the environment.
   1. But a transnational's global reach limits how far any one government can control it.

Regulating Transfer Pricing

1. By setting internal prices to shift profit from a country taxing profits at $25\%$ into one taxing at $12.5\%$, a firm can cut its overall tax bill.
2. Governments regulate this by requiring an arm's-length price, the price unrelated firms would charge, and by sharing tax information across borders.
   1. The OECD and tax authorities such as HMRC coordinate rules to limit profit shifting.

Limits to Government Control

1. A transnational can relocate production or profits to a country with lighter rules or lower taxes.
2. Firms may lobby governments and threaten to withdraw investment and jobs.
   1. Enforcement is costly and difficult when a firm operates across many legal systems.

Problems Facing Policymakers

1. Policy relies on inaccurate information, since it depends on estimates and later-revised data, so it can misjudge the state of the economy.
2. Risks and uncertainties mean the size and timing of a policy's effect are hard to predict.
3. Governments cannot control external shocks such as oil price spikes or global crises.
   1. Time lags mean a policy may take effect only once conditions have already changed.

Can governments control global companies?

1. It works to a degree because arm's-length transfer-pricing rules, information sharing and a global minimum tax narrow the room for profit shifting.
2. But transnationals can relocate profits and production, lobby hard and threaten to pull investment and jobs, so a single government has limited leverage.
3. Control is strongest when countries coordinate, as with the OECD deal, and weakest when they compete to offer the lightest rules and lowest taxes.
   1. On balance it depends on international cooperation, the firm's mobility and the government's willingness to bear the cost of enforcement.