Lesson Objectives
At the end of the lesson students should be able to:
Define the government budget. Reasons for government spending: The main areas
of government spending. Reasons for taxation: reasons for and effects of spending in
these areas. Taxation as the main source of government revenue and the reasons for
levying taxation. Classification of taxes: progressive, regressive, proportional; and
direct, indirect.
Principles of taxation: The qualities of a good tax. Impact of taxation: on consumers,
producers, government and economy as a whole.
Definition of fiscal policy. Fiscal policy measures: The tax and spending changes, in
the form of fiscal policy, that cause budget balance or imbalance. Including
calculations of the size of a budget deficit or surplus.
Effects of fiscal policy on government on macroeconomic aims. How fiscal policy
measures may enable the government to achieve its macroeconomic aims. Note:
aggregate demand and aggregate supply are not required.
• ‘Class Activities’ and ‘Multiple Choice Questions with Answers.’
The government budget
The Government budget is its financial plan for a year.
It is presented each year either as:
Balanced budget: Revenue (TR) = Expenditure (GS)
Deficit budget: Revenue (TR) < Expenditure (GS) or
Surplus budget: which Revenue (TR) > Expenditure (GS)
A Government needs to borrow in order to finance a
budget deficit. This increases the public sector debt.
Reasons for government spending
Government Spending (GS) - Public expenditure - make up significant portion
of Aggregate (Total) Demand in an economy. There are three parts:
1. Current Expenditures: daily payments for running government and
public sector e.g. wages & salaries of public employees such as teachers,
police, parliamentarians, armed forces, judges, dentists etc. It also includes
payments for goods/services such as medicines for government hospitals.
2. Capital Expenditures: are investments in infrastructure and capital
equipment e.g. rail projects; new hospitals, schools, new aircraft carriers.
3. Transfer Payments: unemployment benefits, disability payments, subsidies
to producers and consumers, etc. they do not contribute to GDP as income.
Note: cross chect with the Qs 1-12 or14? From your study of
‘Fiscal, Monetary and Supply - side policies,’ in the
white boxes horizontally or vertically, with the correct
keyword(s), representing each clue statement. [Hint:
Do quick searches through the entire slides and your
textbook.]
Reference:
Complete
economics for
Cambridge
IGCSE & O
Level. Brian
Titley, Dan
Moynihan 3rd
ed. Pp.317
6
Clue statements
1. A supply-side measure that involves the return or removal of complex, old or even
unnecessary regulations. (12)
2. Term used to describe fiscal policy when it involves increasing public spending and/or
cutting taxes in an effort to boost total demand in the economy. (12)
3. A type of tax levied on expenditures on goods or services that is collected by producers
but usually passed on to consumers by raising market prices. (8, 3)
4. A government plans to spend $37 billion but expects to raise $39 billion in taxes over the
coming year. What type of imbalance will there be in its budget?. (7)
5. A government demand-side policy that involves changing the interest rate or supply of
money in an economy to manage the overall level of economic activity. (8, 6)
6. The balance on the budget when a government plans to spend more than it expects to
receive from tax revenues over the next year. (7)
7. A government will set out its plans and forecasts for public expenditure and revenues for
the year ahead in this each year. (3, 6)
8. Term used to describe a ‘tightening’ of monetary policy when interest rates are
raised in an effort to reduce borrowing and the rate at which total demand is rising in
the economy. (14)
9. A type of tax designed to take proportionally more in tax from a higher income than
a low income. (11, 3)
10. Term used to describe a collection of policy measures designed to expand the total
supply of goods and services in the economy. (6-4, 6)
11. The instrument of this government policy are public expenditures and taxes. (6, 6)
12. A type of tax that takes proportionally less in tax from a high income than a low
income. Indirect taxes have this characteristics. (10, 3)
13. A monetary policy action designed to boost the quantity of money held by banks
in an economic recession so that they increase their lending. It involves the central
bank giving cash to banks in return for their financial assets. (12, 6)
14. The assessed value of income, wealth or expenditure on which taxes are levied by
a government (3, 4)
The main areas
of government spending
Public expenditure is an important tool that
governments use to achieve their economic
objectives. Government pending includes:
1. the expenses of national or local governments
2. to fund national services like
a) health,
b) infrastructure,
c) welfare benefits, or
d) education e) security.
Reasons for Taxation
1. To correct market failure: through subsidizing the
production of merit goods, taxing demerit goods to
provide essential goods and services.
2. Promote equity: the wealthy are taxed to reduce
income inequality.
3. Support key industries: in a global economy, which
help them remain competitive.
Classification of Taxes
Taxes constitute the main source of government revenue.
Direct taxes: are taxes levied by government on individual incomes and
corporate profits. e.g. Income tax, corporation tax, capital gains tax,
national insurance contributions, inheritance tax
Indirect taxes: are imposed on spending. The less a consumer spends the
less indirect tax they pay. e.g. Value Added Tax, taxes on demerit goods,
excise duties, fuel, etc.
Tax systems
are classified into progressive, regressive or proportional tax.
Progressive: As income rises, a larger percentage of income is paid in tax
In the diagram, when personal income rises from Y to Y2, the tax rate rises
from TR to TR2.
Regressive: As income rises, a smaller percentage of income is
paid in tax. In the diagram, when personal income rises from Y to
Y2, the tax rate falls from TR2 to TR.
All indirect taxes are regressive. In the USA, Nigeria, Federal
income tax is progressive but almost all State taxes are regressive.
Proportional: As income rises, the same percentage of income is
paid in tax. In the diagram, when personal income rises from Y to
Y2, the tax rate remains constant at 15%. In 2022, Bolivia used
this system with a proportional tax rate of 13%.
TR2
TR2
TR
TR
Y
Y2
Y
TR = 15%
Y
Y2
Y2
Principles of Taxation
A good tax system must have following qualities to be acceptable.
1. Simple: taxpayers know what, when, where and how to pay tax.
2. Fair (equity): taxes should reflect a taxpayer’s ability to pay e.g.
progressive taxation.
3. Convenient: easy to collect, pay, and provide choice for
tax payers. e.g. monthly payments spread over 12 months or tax
deducted by the employer each month from source.
4. Efficient: It should be cost effective not wasteful.
5. Fit for purpose: with no unintended side effects e.g., disincentives
to workers.
6. Flexible: easy to adjust/change as the economy.
The Impact of Taxation
Direct & indirect taxes have influence on a range of economic variables.
Bigger tax changes, have more effects on households, firms and the economy.
Effects Of Tax Rate Changes
1. Incentive to work: The higher the tax rate, the lower the incentive for the
unemployed to seek work - or for workers to work overtime.
2. Government tax revenues: Generally, the higher the tax rates the higher
the level of government revenues. However, tax rates can increase, to a
point where workers work less leading to lower incomes and less
government tax revenue.
3. Tax avoidance: More people will actively avoid paying or move their
incomes elsewhere.
4. Income redistribution: A progressive tax system reduces income inequality
by taxing higher income earners more in order to provide benefits for lower
income earners. The benefits of progressive tax can be lost through
imposing multiple regressive indirect taxes.
5. Economic growth: Tax could reduce aggregate demand, firms and households
disposable income, Productivity and employment and vice versa.
6. Inflation: Increasing Indirect tax rates increase agitations for higher wages,
and costs of production possibly leading to cost-push inflation.
7. The trade balance (X-M): Increase in taxes can reduce disposable income,
reduce the level of imports and improve the trade balance.
8. Business relocation: can occur if corporation tax rises relative to other
countries. Also, direct foreign investment could fall.
Fiscal Policy
Fiscal Policy is the use of government expenditure and taxation
to influence total / aggregate demand in the economy.
Expansionary fiscal policy: will increase economic growth
through lower taxes or higher government spending.
Contractionary fiscal policy: will reduce economic activities,
growth, and reduce inflation through higher taxes and/or lower
government spending.
Fiscal Policy is used yearly through the Government Budget.
The Effects of Fiscal Policy on Government
Macroeconomic Aims
The effects of fiscal policy on an economy, are better understood
by calculating the Gross Domestic Product (GDP).
GDP = household consumption (C) + firms investment (I) +
government spending (G) + exports (X) - imports (M)
GDP (Total demand) = C + I + G + (X - M)
It is easy to see that changes to fiscal policy can influence any or
several of these components.
Examples of The Impact of Contractionary Fiscal Policy
Example 1 The Government increases income tax levels.
Effect on the economy: Consumers pay more tax, discretionary
income reduces, consumption reduces, total demand reduces.
Impact on macroeconomic aims:
• Economic growth slows down.
• Inflation eases up.
• Unemployment may increase, output may fall and fewer workers
are required.
• Current account may improve with less income, imports may fall.
Example 2 The Government freezes or reduces public sector
workers pay.
Effect on the economy: Wages stagnate or reduce, consumer
confidence falls, consumption decreases, total demand falls.
Impact on macroeconomic aims:
• Economic growth slows down
• Inflation eases
• Unemployment may increase as output is falling
• Current Account Improves (with less income, imports may fall).
Example 3 The Government cuts its spending in the Budget.
Effect on the economy: Less demand for goods and services, less
income for firms, output and profits decrease, total demand falls.
Impact on macroeconomic aims:
• Economic growth slows down Inflation eases.
• Unemployment may increase as output is falling.
• Current Account Improves (with less income, imports may fall)
• Less corporation tax available for redistribution.
Examples of The Impact of Expansionary Fiscal Policy
Example 1 The Government decreases corporation tax.
Effect on the economy: Firms net profits increase, investment by
firms increases, total demand increases.
Impact on macroeconomic aims:
• Economic growth increases.
• Inflation rises.
• Unemployment may decrease as output is rising which requires
more workers.
• Current account - unsure. Exports may rise due to new
investments in the economy, but imports may rise due to higher
income generated by the investment.
Example 2 The Government increases unemployment benefits
Effect on the economy: Household income increases,
consumption increases, total demand increases.
Impact on macroeconomic aims:
• Economic growth increases
• Inflation rises
• Unemployment may decrease as output is rising, calling for
more workers (although increased unemployment benefits may
be disincentive to some people to seek jobs)
• Current Account unlikely to change as this policy helps the
poorest and imports are unlikely to increase.
• Redistribution of income has increased and there is more
equity in society.
Strengths of Fiscal Policy
Spendings can be targeted on specific industries.
• Its effects are quicker when compared with monetary policy.
• Income redistributed through taxation.
• Taxation reduces negative externalities through increased
consumption of merit/public goods.
• Short term government spending can lead to an increase in the
aggregate supply.
Example: Building a new airport immediately increases government
spending and total demand, but when it is built, the potential output
will have increased (Production Possibility Curve has shifted outward).
Weaknesses of Fiscal Policy
• Policies can shift significantly when new governments comes in.
• Long term infrastructure projects may be abandoned.
• Increased government spending can create budget deficits.
• Repaying this debt may lead to austerity on future generations.
• Conflicts between objectives, e.g. Cutting taxes to increase
economic growth may cause inflation
1 A government uses different supply-side policy measures to improve
economic performance. Which policy measure would not satisfy one of the
government’s macroeconomic aims?
A changing the tax system which leads to more tax evasion
B encouraging foreign investment which improves the balance of payments
C privatising state industries which increases economic growth
D retraining redundant workers which lowers unemployment
2 The US government introduces tariffs on steel
imported from China. This increases the price of
imported Chinese steel.
Whose income would be likely to increase as a
direct result?
3 What is an example of a fiscal policy measure?
A increasing the exchange rate
B reducing the power of trade unions
C reducing the rate of corporation tax
D setting a lower interest rate
4 What is a likely cause of economic growth?
A decreased employment
B decreased investment
C decreased productivity
D decreased taxation
5 Which topic is not included in microeconomics?
A consumer demand
B economies of scale
C forms of competition
D inflation
6 The table shows some economic indicators. Which increase in the first
indicator is most likely to lead to an increase in the second indicator?
1 Australia’s foreign exchange rate fluctuates. The value of Australia’s
exports is regularly greater than the value of its imports. Australia is
Papua New Guinea’s main trading partner. In 2019, the government of
Papua New Guinea increased income tax to reduce its inflation rate. It
used other policy measures to increase its economic growth rate.
(a) Analyse how an increase in income tax can affect a country’s inflation
rate.
[6]
2 There was a significant increase in the money supply in Angola in 2019.
The National Bank of Angola was concerned that this would keep
inflation above 17% and harm Angola’s producers.
The Angolan government had concentrated on reducing unemployment,
which had fallen from 10% in 2010 to 7% in 2019.
(a) Discuss whether or not inflation will harm producers.
[8]