Economics (9708) | Fiscal policy

Welcome to the World of Fiscal Policy!

Hello future economist! This chapter is all about how governments use their money – where they get it from (taxes) and where they spend it (services) – to influence the entire economy. This is called Fiscal Policy.

Don't worry if macroeconomics seems abstract. Fiscal policy is happening right now in your country, affecting prices, jobs, and public services. Understanding it gives you the power to analyze real-world government decisions!

1. The Government Budget: Income and Expenditure

Every household has a budget, and so does the government. The Government Budget is simply the financial statement showing the government's planned revenue (mostly taxes) and its planned expenditure (spending) over a specific time period (usually a year).

1.1 Key Budget Definitions

• Government Revenue (T): The income collected by the government, primarily through taxation (T).
• Government Expenditure (G): The total money spent by the government (G).

Budget Outcomes: Deficit, Surplus, and Balance

The relationship between G and T determines the budget outcome:

• Budget Surplus: This happens when government revenue is greater than expenditure.
  Formula: \(T > G\)
• Budget Deficit: This happens when government expenditure is greater than revenue.
  Formula: \(G > T\)
• Balanced Budget: This happens when revenue equals expenditure.
  Formula: \(G = T\)

Analogy: If you earn $100 (T) and spend $80 (G), you have a $20 surplus. If you spend $120 (G), you have a $20 deficit.

1.2 The National Debt

When a government runs a budget deficit, it has to borrow money to cover the shortfall. This accumulation of past borrowing is called the National Debt.

• National Debt is the total amount of money owed by the central government to domestic and foreign lenders.

Important Distinction:

Budget Deficit is a flow concept (it happens over one year).
National Debt is a stock concept (it is the accumulated total over many years).

Did you know? Many developed countries regularly run budget deficits, meaning their national debt grows almost every year!

2. The Tools of Fiscal Policy: Taxation (T)

Taxation is the main source of government revenue and is a crucial lever for policy.

2.1 Types of Taxes

Taxes are categorized based on who is legally required to pay them and how they relate to the price of a good.

1. Direct Taxes: Levied directly on income, wealth, or profit. The burden cannot easily be shifted.
   Examples: Income tax, corporation tax, inheritance tax.
2. Indirect Taxes: Levied on spending (goods and services). The burden can be shifted, often resulting in higher prices for consumers.
   Examples: Value Added Tax (VAT), Sales Tax, Excises on fuel or tobacco.

2.2 Tax Structures (How the Rate Changes with Income)

This is crucial for understanding equity (fairness) and redistribution.

• Progressive Tax: The proportion of income paid in tax increases as income increases.
  Example: Most income tax systems, where higher earners face a higher percentage tax rate. (This promotes vertical equity—the idea that those who can afford to pay more should).
• Regressive Tax: The proportion of income paid in tax decreases as income increases.
  Example: Indirect taxes like VAT. Although everyone pays the same tax rate (e.g., 10%) on a product, this tax takes up a much larger percentage of a poor person’s income than a rich person’s income.
• Proportional Tax (Flat Tax): The proportion of income paid in tax remains constant, regardless of the level of income.
  Example: A flat 20% tax on all income.

2.3 Tax Rates: Marginal vs. Average

You must know the difference between these two rates, especially for progressive systems:

1. Average Rate of Taxation (ART): The percentage of total income paid in tax.

   \(\text{ART} = \frac{\text{Total Tax Paid}}{\text{Total Income}} \times 100\)

2. Marginal Rate of Taxation (MRT): The percentage of extra income paid in tax. This is the rate applied to the next unit of currency you earn.

   \(\text{MRT} = \frac{\text{Change in Tax Paid}}{\text{Change in Income}} \times 100\)

Memory Aid: Think of a multi-lane swimming pool. Your Average speed is your speed across the whole pool. Your Marginal speed is how fast you swim the very next stroke.

3. The Tools of Fiscal Policy: Government Spending (G)

Government spending is the other side of fiscal policy. It can be used to directly increase aggregate demand or improve long-term productive capacity.

3.1 Types of Government Spending

1. Current Spending: Spending on goods and services consumed immediately or within the current year (day-to-day running).
   Examples: Public sector wages (teachers, police), medicines for hospitals, utilities.
2. Capital Spending (Investment): Spending on goods that will be used over a long period, increasing the productive capacity of the economy.
   Examples: Building new schools, highways (infrastructure), purchasing new military equipment.

3.2 Reasons for Government Spending

• Provision of Public Goods: Providing services like defense or street lighting that the free market won't supply efficiently.
• Merit Goods: Providing or subsidizing goods like education and healthcare to ensure access and prevent under-consumption.
• Economic Development: Investing in infrastructure (capital spending) to boost potential growth.
• Redistribution: Using transfer payments (benefits, pensions) to reduce income inequality.

4. Expansionary vs. Contractionary Fiscal Policy

Fiscal policy is used to manage Aggregate Demand (AD), which is why it is often called a Demand-Side Policy. The policy chosen depends on the current macroeconomic objective (e.g., fighting recession or fighting inflation).

4.1 Expansionary Fiscal Policy

This policy aims to increase Aggregate Demand (AD shifts right). It is typically used during a recession or a period of slow economic growth (when unemployment is high).

• Tools Used:
  • Increase Government Spending (G ↑)
  • Decrease Taxation (T ↓)
• Outcome (Ceteris Paribus): This shifts AD to the right. \(AD = C + I + G + (X – M)\). An increase in G directly increases AD, while a decrease in T increases disposable income (boosting C and possibly I).

Analogy: Expansionary policy is like pressing the accelerator pedal to speed up the economy.

4.2 Contractionary (or Deflationary) Fiscal Policy

This policy aims to decrease Aggregate Demand (AD shifts left). It is typically used to fight high inflation (an overheating economy).

• Tools Used:
  • Decrease Government Spending (G ↓)
  • Increase Taxation (T ↑)
• Outcome (Ceteris Paribus): This shifts AD to the left. Higher T reduces disposable income (reducing C and I), and lower G directly reduces AD.

Analogy: Contractionary policy is like pressing the brake pedal to slow down the economy.

5. AD/AS Analysis of Fiscal Policy Impact (5.2.7)

The core of analyzing fiscal policy is showing its impact on the economy's equilibrium: Real Output (Y), the Price Level (P), and Employment.

(In the exam, you should always illustrate these changes using a clearly labelled AD/AS diagram.)

5.1 Impact of Expansionary Fiscal Policy

Let's assume the economy is currently in a recession (operating well below full capacity).

1. Policy Action: Government increases G or decreases T.
2. Result: AD curve shifts right (from \(AD_1\) to \(AD_2\)).
3. Effect on Indicators:
   • Real Output (Y) increases (economic growth).
   • Price Level (P) increases (some inflation).
   • Employment increases (unemployment falls).

Important Caveat: The Shape of AS Matters!

If the economy is already near full employment (i.e., the AS curve is steep), an expansionary policy will mostly cause inflation (P ↑↑ ) with little increase in real output (Y ↑ ). Resources are scarce, so increasing demand mainly bids up prices.

5.2 Impact of Contractionary Fiscal Policy

Let's assume the economy is currently suffering from high demand-pull inflation.

1. Policy Action: Government decreases G or increases T.
2. Result: AD curve shifts left (from \(AD_1\) to \(AD_2\)).
3. Effect on Indicators:
   • Real Output (Y) decreases (economic slowdown).
   • Price Level (P) decreases (inflation falls).
   • Employment decreases (unemployment may rise).

Policy Conflict: Notice the conflict here! While contractionary policy fixes inflation, it often leads to higher unemployment and slower economic growth. Governments face tough choices when deciding which macroeconomic objective to prioritize.

6. Summary of Strengths and Weaknesses (Evaluation)

When you evaluate fiscal policy, consider how effective it is and what limits its success.

6.1 Strengths of Fiscal Policy

• Direct Impact: Changes in G (especially capital spending) can directly target specific sectors or regions, promoting development and structural change.
• Effectiveness in Recession: Increasing G can be very effective in pulling an economy out of a deep recession when private sector confidence (C and I) is very low.
• Equity: Progressive taxation and targeted transfer payments are powerful tools for redistributing income.

6.2 Weaknesses and Limitations

• Time Lags: Implementing changes (like approving a new tax law or starting a large infrastructure project) takes a long time. The policy might hit the economy too late.
• Crowding Out: If the government finances a deficit by borrowing, it may drive up interest rates, reducing (crowding out) private investment (I).
• Political Constraints: Cutting popular spending programs (G) or increasing taxes (T) is politically unpopular, making contractionary policy difficult to implement when needed.
• Incentive Effects: High marginal rates of taxation (MRT) in a progressive system might discourage people from working harder, leading to potential efficiency losses (a concept related to the Laffer Curve, which you may study further at A2).