Economics (0455) | Fiscal policy

👋 Welcome to the World of Fiscal Policy!

Hey there, IGCSE Economics student! This chapter is all about how the government uses its main financial tools to steer the national economy. Think of the government as the manager of a giant household budget—Fiscal Policy is the set of choices they make about how much money to collect and how much money to spend.

Understanding Fiscal Policy (along with Monetary and Supply-Side policies) is crucial because it directly influences everything from job availability to the cost of living.

Let's dive in!

1. Defining Fiscal Policy (4.3.7)

What exactly is Fiscal Policy?

Fiscal Policy refers to the use of Taxation (T) and Government Expenditure (G) to influence the economy. It is controlled by the government (the Ministry of Finance or Treasury).

Analogy: If the economy is a car, Fiscal Policy is the government deciding whether to press the accelerator (spend more, tax less) or the brakes (spend less, tax more).

The Two Main Tools of Fiscal Policy

There are only two levers the government can pull:

• Government Spending (G): Money spent by the government on public services (like schools, hospitals, roads, defense) and welfare benefits.
• Taxation (T): Money collected by the government from individuals (income tax) and firms (corporation tax, indirect taxes).

Key Takeaway: Fiscal policy is all about G and T.

2. The Government Budget and Budget Balance (4.3.1, 4.3.8)

Every year, the government creates a plan detailing its expected revenue (T) and expected expenditure (G). This plan is called the Government Budget.

Types of Budget Balance

By comparing G and T, we determine the budget balance:

1. Budget Balance (or Balanced Budget): When Government Spending (G) is equal to Taxation (T).

   \( G = T \)

2. Budget Surplus: When Taxation (T) is greater than Government Spending (G). The government is collecting more than it is spending.

   \( T > G \)

   The government has extra funds which can be used to pay off national debt.
3. Budget Deficit: When Government Spending (G) is greater than Taxation (T). The government is spending more than it is collecting.

   \( G > T \)

   The government must borrow money (national debt) to cover this shortfall.

Calculating the Size of the Budget Deficit or Surplus (4.3.8)

The size of the deficit or surplus is calculated by finding the difference between total revenue and total expenditure.

$$ \text{Budget Deficit or Surplus} = \text{Total Taxation (T)} - \text{Total Government Spending (G)} $$

• If the result is positive, it's a Surplus.
• If the result is negative, it's a Deficit.

Example: If a government collects $500 billion in taxes (T) and spends $550 billion (G):
$$ 500 \text{ billion} - 550 \text{ billion} = -50 \text{ billion} $$ The government has a Budget Deficit of $50 billion.

⚠️ Common Mistake Alert!

Students sometimes confuse a Trade Deficit (imports > exports) with a Budget Deficit (spending > revenue). Remember, the budget relates only to the government's internal finances (G and T).

3. Types of Fiscal Policy Measures (4.3.8)

Governments use fiscal measures to manipulate the budget balance in order to achieve their macroeconomic aims. The two main policy stances are expansionary and contractionary.

3.1 Expansionary Fiscal Policy (Loose Policy)

This is used when the economy is slow, facing a recession or high unemployment. The goal is to increase economic activity.

• Measures:
  • Increase Government Spending (G): E.g., funding infrastructure projects like new railways or paying higher unemployment benefits.
  • Decrease Taxation (T): E.g., cutting income tax or corporation tax, leaving consumers and firms with more money to spend and invest.
• Result on the Budget: Usually leads to a larger Budget Deficit (or reduces an existing surplus).
• Effect on the Economy: Increases total spending in the economy, boosting production and creating jobs.

3.2 Contractionary Fiscal Policy (Tight Policy)

This is used when the economy is growing too fast, leading to high inflation. The goal is to slow down economic activity.

• Measures:
  • Decrease Government Spending (G): E.g., cutting funding for public services or slowing down public works projects.
  • Increase Taxation (T): E.g., raising income tax, forcing consumers and firms to spend less.
• Result on the Budget: Usually leads to a smaller Budget Deficit or creates a Budget Surplus.
• Effect on the Economy: Reduces total spending, easing pressure on prices and slowing down inflation.

4. Effects of Fiscal Policy on Macroeconomic Aims (4.3.9)

The success of fiscal policy is judged by how well it helps the government achieve its five main macroeconomic aims.

4.1 Economic Growth and Full Employment/Low Unemployment

How Fiscal Policy helps:

An Expansionary Fiscal Policy is highly effective here:

• When G increases (e.g., building a new motorway), this creates demand for labour and raw materials, leading to higher GDP (Economic Growth).
• When T decreases, consumers have more disposable income and firms have more profits to reinvest, also increasing demand and leading to greater production and consequently, lower Unemployment.

4.2 Stable Prices/Low Inflation

How Fiscal Policy helps:

If the economy is overheating and prices are rising too quickly (demand-pull inflation):

• The government can use Contractionary Fiscal Policy.
• Raising taxes (T) removes money from the economy, lowering overall demand and thus reducing the upward pressure on prices.
• Cutting government spending (G) also reduces demand.

4.3 Balance of Payments (BoP) Stability

How Fiscal Policy affects BoP:

The relationship here is tricky, often creating a policy conflict (4.2.2).

• If the government uses Expansionary Policy to boost growth, people have higher incomes.
• When incomes rise, people tend to buy more goods, including imported goods (i.e., foreign products).
• An increase in imports will likely worsen the Current Account Balance, potentially leading to a larger BoP deficit.

Did you know? Countries facing a BoP deficit often try to reduce government spending (Contractionary Policy) to reduce the demand for imports.

4.4 Redistribution of Income

Fiscal policy is the primary tool for redistributing income and reducing inequality.

• Taxation (T): Using a progressive tax system (where the rich pay a higher percentage of income in tax) takes proportionally more from the wealthy.
• Government Spending (G): Spending on social welfare (like unemployment benefits, housing assistance, and public education/healthcare) transfers money and resources directly to lower-income families.

5. Summary of Fiscal Policy Impact

Fiscal policy is a powerful tool because it directly influences aggregate demand through the government's own spending decisions and its power to change private sector spending via taxation.

Key Takeaway: Fiscal policy is essential for macroeconomic management, dealing directly with unemployment, growth, and income inequality, but governments must constantly navigate conflicts between these aims.