Paper 3 question on government indebtedness, taxation, GDP, circular flow
Paper 3 sample question
IB Economics Paper 3 includes two compulsory questions. This is a sample Paper 3 question. The time allowed for Paper 3 is 105 minutes, so students should spend 52.5 minutes on each question.
This Paper 3 style question is on government indebtedness, taxation, GDP, and circular flow of income.
Question paper
AnswersGovernment debt in France
On December 4, the French government, which had only been in power for three months, collapsed. Prime Minister Michelle Barnier's government was called to a vote of no confidence when Barnier tried to push through a social security financing plan without a parliamentary vote. [Paragraph 1]
A central issue behind the French government's difficulties is the size of its budget deficit. France’s deficit has been revised up 2024 to 6.1% of GDP from 4.4%. The social security bill proposed by the Barnier government would add to the country’s indebtedness. Like so many countries, France's budgetary position was weakened by the COVID-19 pandemic, with its national debt 111% of GDP in 2024. Indeed, its national debt has remained well over 100% of GDP since 2020. [Paragraph 2]
France’s debt problem can be viewed in three ways. During his first term as president, Emmanuel Macron pushed through a cut in corporate tax on company profits from 33.3% to 25% and abolished France’s wealth tax. While this temporarily boosted economic growth, it was not sustained, reducing the country’s tax revenues. [Paragraph 3]
Next, the sheer scale of the cost to the French government of supporting businesses and households through the pandemic added a significant percentage to the country’s budget deficit and national debt, and the government could not manage its debt downwards when the pandemic finished. [Paragraph 4]
Finally, the cost to the French government of servicing its debt has increased. The markets are concerned about the high level of government debt and are charging an interest premium because of this. Moody’s, the credit ratings agency, has downgraded France’s economic outlook from “stable” to “negative”, which has worried domestic and international investors who buy French government bonds. [Paragraph 5]
These debt problems are a significant challenge for any French administration that emerges from the collapse of the current government. The government's fiscal constraints are likely to negatively affect economic growth and the economic well-being of French households going forward. [Paragraph 6]
One option for the French government to reduce its debt is to increase taxes, but critics of any tax increase point to the negative effect this might have on French economic growth. There are also worries that any attempt to increase VAT will adversely affect French consumers and add to inflation. Many commentators are worried that any significant increase in taxation could reduce the country’s growth rate in the short and long run. [Paragraph 7]
Table 1 shows the French real GDP and GDP deflator for 2021 - 2024. The figures are representative rather than actual data.
Year | GDP deflator | Real GDP Bn $ |
2021 | 95 | 2,966.28 |
2022 | 98 | 2,784.56 |
2023 | 99 | 3,031.32 |
2024 | 100 | 3,048.36 |
Questions
a. (i) Explain two ways an increase in the French government's indebtedness will affect its debt servicing. [4] [Paragraph 2]
Debt servicing is the money the French government has to repay because of the debt it owes. This is made up of the following:
- Loan interest payable borrowed funds
- Repayment of the outstanding amount that has to be repaid on loans the government has.
(ii) Calculate France's nominal GDP in 2021, 2022, 2023 and 2024.[2]
Year | Nominal GDP Bn $ | GDP deflator | Real GDP Bn $ |
2021 | 2,817.97 | 95 | 2,966.28 |
2022 | 2,728.87 | 98 | 2,784.56 |
2023 | 3,001.01 | 99 | 3,031.32 |
2024 | 3,048.36 | 100 | 3,048.36 |
(iii) Calculate the value of France's national debt and budget deficit in 2024. [2] [Paragraph 2]
- Budget deficit: 0.061 x $3,048.36Bn = $185.95Bn
- National debt: 1.11 x $3,048.36Bn = $3,383.68Bn
France's forecasted economic growth rate in 2025 is 0.6%, and its budget deficit is forecast to be $211.60 billion.
(iv) Calculate France's forecasted real GDP in 2025. [2]
$3,048.36Bn x 1.006 = $3,066.65Bn
(v) Calculate France's forecasted budget deficit as a percentage of GDP. [2]
$211.60Bn / $3,066.65Bn = 6.9%
(vi) Using a circular flow of income diagram, explain the impact a decrease in French government expenditure might have on the country's real GDP. [4]
If the French government decreases its expenditure this will reduce the value of injections into the French circular flow of income. This is shown in the French economy's circular flow of income diagram. The reduced value of injections into the French economy will decrease the income, output and expenditure flows of France's circular income flow, reducing the French real GDP.
(vii) Using an aggregate demand and supply diagram, explain the impact an increase in French taxation on firms and households might have on the country's real GDP. [4]
An increase in French taxation of firms, such as a tax on business profits, might decrease investment. An increase in tax on households, such as an income tax, would reduce consumption. A decrease in consumption and investment would lead to a fall in France's aggregate demand, which is shown in the diagram where AD shifts to AD1. This leads to a decrease in France's real GDP from Y to Y1 and price level from P to P1.
b. Recommend a policy the French government might use to reduce its budget deficit. [10]
Possible policy options for the French government to reduce its budget deficit:
- Decreasing French government spending
- Increasing taxation in France
- Using expansionary fiscal policy to increase French economic growth and decrease its budget deficit
- Using expansionary monetary policy to increase French economic growth and decrease its budget deficit.
Sample policy
The French government could use a policy of increasing taxation to reduce its budget deficit by increasing direct tax on households through income tax and indirect tax through VAT. This could raise the revenue needed to reduce the French government's budget deficit. (‘One option for the French government to reduce its debt is to increase tax.’)
The French government could also increase business taxes, such as a tax on profits, to raise revenue and reduce its budget deficit.
Evaluation
A problem of increasing income tax on households to reduce the French budget deficit is the impact it might have on French aggregate demand if there is a fall in consumption expenditure because a tax increase will decrease household disposable income. If aggregate demand falls in France, this could reduce the country’s economic growth rate, which could decrease French tax revenue and make the government's budget deficit worse. (‘Critics of any tax increase point to the negative effect this might have on French economic growth’.)
An increase in income tax could reduce labour productivity if workers feel demotivated by the tax increase. A progressive income tax might lead to tax avoidance from high-income individuals, and some of them might leave France, which reduces the number of skilled workers.
Any increase in indirect tax in France would mean higher prices for French consumers, which could add to the nation’s rate of inflation. ('Attempt to increase VAT will adversely affect French consumers’.)
A tax on business profits would mean French businesses would have less funds to spend on Investment. This could decrease the country's economic growth in the short run as reduced investment decreases aggregate demand. Less investment in France could also reduce the country’s long-term growth prospects as business productivity is adversely affected. (‘Many commentators are worried that any significant increase in taxation could reduce the country’s growth rate in the short and long run.)
Total [30]