2.4.2 Fiscal policy
What does the
government tax?
How does the
government spend
the money raised
from taxes?
AS: 3.2.4 MACROECONOMIC POLICY
2.4.2 F ISCAL POLICY

Fiscal policy involves the manipulation of government spending, taxation and
the budget balance

Fiscal policy can have both macroeconomic and microeconomic functions

How fiscal policy can be used to influence aggregate demand

How fiscal policy can be used to influence aggregate supply

How government spending and taxation can affect the pattern of economic
activity

The difference between direct and indirect taxes

The difference between progressive, proportional and regressive taxes

The relationship between the budget balance and the national debt
2.4.2 F ISCAL POLICY

You should be aware of the main taxes in the UK and the main categories of
government spending, e.g. spending on defence, health, education and
welfare

You should appreciate that governments may deliberately run budget
deficits and surpluses to try to influence aggregate demand but they are not
required to understand the arguments relating to the pros and cons of
balancing the budget or attempting to limit the size of the national debt
F ISCAL P OLICY: A D EFINITION
“The manipulation of government spending,
taxation and government borrowing to
influence the level of economic activity.”
F ISCAL P OLICY
CAN HAVE BOTH MACROECONOMIC
AND MICROECONOMIC FUNCTIONS




Fiscal policy is used to achieve a wide variety of objectives
 Keep inflation on target (2%)
 Stimulate economic growth and employment during
times of recession
 Maintain a stable economic cycle that minimises “boom
and bust”
Note however, that fiscal policy can have supply side effects
too
Any change in the balance between government spending
and taxation, will impact upon the 4 macroeconomic targets
However, fiscal policy has a wide variety of goals and may
have microeconomic targets in addition to this, which can
include improving education, health and the redistribution of
income
T YPES
OF
F ISCAL P OLICY (1)
Fiscal policy is said to be “expansionary” if the government is trying to
positively stimulate economic activity.
Possible methods include:
 Cutting taxes
 A cut in income tax may give consumers more disposable income,
thus raising consumption
 A cut in corporation tax may increase available profits for firms
which may stimulate investment
 Raising government spending
 The government may increase its spending on core infrastructure
projects or increase the pay of public sector workers
 Increasing the budget deficit
 Another way of increasing spending if the government do not wish
to raise taxation is to increase borrowing
 This can be spent on a variety of projects nationally
 However, this adds to the national debt, and must be repaid with
interest
T YPES
OF
F ISCAL P OLICY (2)
Fiscal policy is said to be “contractionary” if the government is trying to constrain
aggregate demand, reduce debt or control inflation.
Possible methods include:
 Increasing taxes
 If income tax is raised this may discourage spending and reduce
consumption
 This will reduce aggregate demand and may help to bring inflation under
control
 Cutting government spending
 The government may decide to reduce expenditure on public projects or cut
key government budgets if it considers excessive government spending to
be unaffordable or perhaps inflationary
 Cutting the budget deficit
 The UK budget deficit is large and thus must be repaid with interest
 Cutting the governments long term borrowing commitments may help to
stabilise economic growth as reduced debt repayments in future can be
reinvested back into the economy
E XPANSIONARY F ISCAL P OLICY – A GGREGATE D EMAND
1) Assume the government would like to
stimulate economic growth.
Price
Level
LRAS
2) It may decide to cut taxation, which will
boost AD to AD1, as consumption rises.
3) This has the effect of increasing real
national output from Y to Y1.
P1
P
AD1
4) There will also be the added
benefit of creating
employment.
AD
Y Y1
5) However, this has come at the
expense of an increase in the price level
to P1, which may hamper the inflation
target.
FE
Real National Output
6) In addition, if additional consumption is spent on
imports, then this will worsen the balance of payments
on current account.
E XPANSIONARY F ISCAL P OLICY – A GGREGATE
1) Imagine the government would
like to stimulate the supply-side of
the economy.
LRAS
SUPPLY
2) They may cut corporation tax in
order to boost firms’ profits, which
can then be reinvested in capital
projects.
LRAS1
Price
Level
3) LRAS will shift to the right to
LRAS1.
P
P1
AD
Y
FE Y1
FE1
5) However, if AD remains unchanged, spare capacity has now
increased in size from Y-FE to Y1-FE1, indicating a waste of
economic resources.
4) Productive capacity has
now increased to FE1 and
there has been a fall in the
price level from P to P1,
helping to soften inflationary
pressure.
Real National Output
C ONTRACTIONARY F ISCAL P OLICY – A GGREGATE
D EMAND
Price
Level
1) Assume the government would like to use fiscal
policy to maintain its inflationary target of 2%,
because the economy is running up against
capacity constraints.
2) It may decide to increase taxation,
LRAS
which will cut AD to AD1, as
consumption falls.
3) This has the effect of reducing
inflationary pressure as the price level
falls from P to P1.
P
P1
AD1
Y1 Y
5) However, this has come at the expense
of a reduction in real national output from
Y to Y1, which damages economic growth.
FE
AD
4) There will also be the added
benefit of improving the balance
of payments on current account
as less income is spent on
imports.
Real National Output
6) In addition, falling consumption and lower aggregate
demand is likely to increase cyclical unemployment.
H OW GOVERNMENT SPENDING AND TAXATION CAN
AFFECT THE PATTERN OF ECONOMIC ACTIVITY

Public expenditure entails government spending to pay
for the needs of society such as health, education,
infrastructure etc.

We can distinguish between:

Current expenditure – short-term spending on day to day
running of the country e.g. wages, consumables etc.

Capital expenditure – long-term spending on assets e.g.
hospitals, schools, roads, infrastructure etc.

Transfer payments are a redistribution of income for which
no good or service is provided in return e.g. benefit
payments
H OW GOVERNMENT SPENDING AND TAXATION CAN
AFFECT THE PATTERN OF ECONOMIC ACTIVITY

What was the effect
of undervaluing the
Royal Mail?
The government pay for their spending through a variety
of taxes, borrowing, income received form the provision
of goods and services and selling off state assets:

Taxation includes income, corporation and value added

The public sector net cash requirement is the finance
required to pay for a budget deficit – the difference
between expenditure and income

Government provide a variety of goods and services that
have to be paid for by the consumer e.g. prescriptions for
drugs

Governments sell off state assets and privatise businesses
e.g. the Royal Mail
H OW GOVERNMENT SPENDING AND TAXATION CAN
AFFECT THE PATTERN OF ECONOMIC ACTIVITY
UK Budget
2014

The role of the government has grown in many economies

This has lead to increased public expenditure

Spending tends to rise significantly as government transfer
payments increase e.g. unemployment benefits

The government may increase spending in time of a
recession in order to kick-start the economy and increase
demand, benefitting from the multiplier effect

In periods of healthy growth the government will tend to
reduce spending and repay borrowing
H OW GOVERNMENT SPENDING AND TAXATION CAN
AFFECT THE PATTERN OF ECONOMIC ACTIVITY

Bloated
government.
Projected
government
expenditure –
international.

The type of government in power in different economies
will have an impact on public expenditure:

Left-leaning governments tend to increase public spending
in order to look after the needs of society

Right-leaning governments tend to reduce public spending
and believe that markets should be left to fend for
themselves
The impact of the global recession has had a significant
impact on forecast spending as many nations look to
reduce debt and slim down the public sector
H OW GOVERNMENT SPENDING AND TAXATION CAN
AFFECT THE PATTERN OF ECONOMIC ACTIVITY

As an economy grows the pattern of public expenditure
will change:

Government will seek to provide what are deemed to be
necessities to society such as, education, health care and
housing

Transfer payments will increase as governments ensure that
there is no absolute poverty within the economy

Spending on infrastructure is deemed to be essential if
firms and markets are to operate effectively
D IRECT

Direct tax is imposed on the income of individuals or profits of businesses

This type of tax is paid directly to the government

Examples include:
 Income tax
 Corporation tax
 Inheritance tax
 National Insurance contributions

Indirect tax is imposed on goods or services

This increases the price of that good or service

Examples include:
 Value Added Tax
 Excise duty
 Customs duty
Corporation
tax levy.
Income tax
allowance.
VAT.
AND INDIRECT TAXATION
China cuts
import tax.
D IFFERENCES IN TAX S TRUCTURE

The tax structure shows how the government raise taxation as a
proportion of peoples income:

Government policy redistributes income from richer to poorer
members of society

A progressive tax will increase the proportion of tax as workers
earn more, a regressive tax the opposite. A proportional tax will
mean that all workers will pay the same percentage of their
income as tax

The extent of this redistribution depends on the government of
the day

Governments also try to create a tax friendly environment to
attract foreign businesses to set up in their country and to stop
domestic businesses from leaving

As firms operate in a global economy it has become easier to
avoid paying taxes in high tax economies
D IFFERENCES IN TAX S TRUCTURE

There are a range of tax systems in use around the world

Income, corporation and consumer tax rates have fallen on a
global basis:


In particular, we have seen a significant fall in corporation
tax
The global financial crisis has had a significant impact on the
tax structure in different countries:

Some nations have increased tax in order to pay for
government investment that was used to counter
recession, whilst others have needed to repay debt

However, many economies have reduced taxes in order to
attract multinational firms and to stimulate demand
D IFFERENCES IN TAX S TRUCTURE
Which country has
the highest tax rate?

High tax economies tend to have a larger public sector as the
state uses the government revenue to pay for public
expenditure

This means that EU states such as France, Italy and Spain will
pay more, particularly in labour taxes, to fund state run
organisations

There are a variety of reasons for this that include social,
political and historical factors

Where trade unions have greater power the public sector is
likely to be larger and paid for by higher taxes

Where multinationals have greater power they are able to
use their influence to lower tax rates with the threat of
leaving the domestic market or transferring tax payments to
low tax economies
G OVERNMENT B UDGET (F ISCAL )
DEFICIT AND
SURPLUS
UK budget
deficit
compared
with Europe.

A budget deficit occurs when a government receives less
income through tax receipts and other government revenue
than it spends

This will lead to increased government debt that will have to
paid off in future years

A budget surplus occurs when a government receives more
income through tax receipts and other government revenue
than it has to pay out in its spending plans

This will allow the government to reduce its debt burden and
therefore reduce interest payments

The national debt is the total amount of money owed by the
government
Current UK
national debt.
A
Osborne’s aim to
run a permanent
budget surplus.
Brown’s aim to run
a permanent
budget balance.
BALANCED GOVERNMENT BUDGET AND THE
NATIONAL DEBT

A balanced government budget is one where government
revenue is equal to government expenditure

This means that there is not:

A budget surplus, where revenue is greater than expenditure

A budget deficit, where expenditure is greater than revenue

A budget surplus will enable the government to pay off
some of it’s debt, a budget deficit will increase it

Governments will often borrow during the bad times e.g.
the 2008 recession and pay back during the good times e.g.
a boom
Do you think that a balanced
budget is controversial?
Should we always have one?
Why?
The Chancellor of the Exchequer
outlines the governments future
spending plans in March each year.
It is at this time that key
announcements regarding tax and
spending are made.
Look at the summary of the 2013 UK budget outlined by George
Osborne, Chancellor of the Exchequer.
Do you think that his polices will positively impact on the UK’s
ability to meet its macroeconomic objectives?
F ISCAL P OLICY
IN THE
UK
Look at the
summary of
planned
government
revenue and
spending in the
UK in 2013/14.
What might you
change and why?
Source:
The Guardian
I S F ISCAL P OLICY
GOOD AT IMPROVING MACRO ECONOMIC TARGETS ?


Economic Growth

Expansionary policy alone won’t increase the long-run growth rate, but
will act as a short-run stimulus to economic growth

However, fiscal stimulus through tax cuts and increasing government
spending may be employed to help lift a country out of recession,
therefore smoothing out fluctuations in the economic cycle

Keynesian economists favour this approach and might consider
increasing the governments budget deficit in the short-run - a necessary
requirement to put an economy back on target in terms of economic
growth
Unemployment

Higher government spending should lead to higher levels of employment
if there are good polices to support training programmes and back to
work schemes

The use of fiscal policy to improve employment statistics is a vital part of
economic policy

Tax credit and welfare changes are on-going – keep up to date with
these!
...C ONTINUED

Inflation





Fiscal policy is a fairly blunt instrument with which to seek to control the
price level
In theory, expansionary policy will boost AD and create inflationary
pressure, whilst contractionary policy will do the opposite
In reality, it is very difficult to ‘fine tune’ the economy towards a 2%
inflation target using broad instruments such as taxation and government
spending
In any case, the causes of inflation are varied and come from many sources
which fiscal policy cannot control e.g. increasing raw material costs from
abroad
Balance of Payments on Current Account


The UK has a high propensity to import, so expansionary policy tends to
limit our ability to achieve this target
However, the government could employ expenditure-switching policies by
e.g. taxing foreign imports to make domestic goods more attractive
To what extent is Larry Summers correct to say “UK economic policy illogical”?
T RADE O FFS

As is now perhaps clear, fiscal policy has
some built in trade-offs


E.g. 1

Expansionary policy  higher output + lower
U

BUT at expense of high inflation
E.g. 2

Tight fiscal policy control inflation

BUT may increase U and damage GDP
SO,
IS
F ISCAL P OLICY
EFFECTIVE ?
It depends!
 The size of the change in government spending and/or
taxation will vary the impact it has
 The effectiveness, efficiency and timing of changes will also
influence policy effectiveness
 The size of the multiplier will influence the size of changes
in AD
 How close to full employment the economy is


Expansionary policy will have different effects if there is
significant spare capacity compared to if it is close to full
employment
Time – It takes time for the full effect of tax cuts or
spending increases to have the desired effect on the
economy
M ULTIPLE C HOICE 1


Fiscal policy involves changes in both
a) the budget balance and the balance of payments
b) interest rates and the supply of credit
c) the money supply and the exchange rate
d) government spending and tax revenue
Can you explain your answer?
M ULTIPLE C HOICE 2


Which one of the following is an example of
expansionary fiscal policy?
a) A reduction in interest rates
b) An increase in the budget deficit
c) An increase in the money supply
d) An increase in tax rates
Can you explain your answer?
M ULTIPLE C HOICE 3


All other things being equal, a substantial cut in the
rate of income tax in the short run is most likely to
reduce
a) inflation
b) unemployment
c) spending on imports
d) the government budget deficit
Can you explain your answer?
M ULTIPLE C HOICE 4


Which one of the following is the best example of fiscal policy
having a direct supply-side effect?
a) An increase in the money supply leading to greater output
b) A reduction in income tax boosting consumption and the
supply of consumer credit from banks
c) A reduction in interest rates boosting investment and the
productive potential of the economy
d) Government expenditure on retraining schemes increasing
factor mobility
Can you explain your answer?