Economics (9640) | Fiscal policy

Welcome to the Macroeconomic Policy Toolkit: Fiscal Policy!

Hi there! This chapter is all about one of the most powerful tools a government has to manage the economy: Fiscal Policy. Think of it as the government's financial steering wheel. By changing how much it spends and how much it collects in taxes, the government can try to steer the entire nation towards its economic goals—like making sure everyone has a job and the economy is growing steadily.

Don't worry if budgets and taxes sound dry; we’ll break down exactly how these tools work to influence aggregate demand and supply. Let's get started!

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1. Defining Fiscal Policy: The Government's Budget

What is Fiscal Policy?

Fiscal policy involves the manipulation of two main governmental levers: Government Spending (G) and Taxation (T), primarily to influence the level of aggregate demand (AD) in the economy. It also affects the balance of the government’s budget.

Analogy: Imagine your country is a large household. Fiscal policy is how the household decides how much money (Taxes) to bring in and how much to spend (Government Spending). The difference determines whether the household saves or borrows.

The Tools of Fiscal Policy

• Government Spending (G): This includes public expenditure on everything from healthcare, education, defence, and infrastructure (roads, railways). Government spending is a direct component of Aggregate Demand (AD).
• Taxation (T): This is money collected from individuals and firms (businesses). Taxes act as a withdrawal from the circular flow of income, reducing the disposable income of households and the profits of firms, thereby reducing private consumption and investment.

The Budget Balance

The budget balance is simply the difference between government spending (G) and government receipts (T) over a period, usually one year.

• Budget Deficit: Occurs when G > T (Spending exceeds taxes). The government must borrow money, which increases the national debt.
• Budget Surplus: Occurs when T > G (Taxes exceed spending). The government can use the surplus to pay down its national debt.

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2. The Functions of Fiscal Policy: Macro and Micro Roles

Fiscal policy is versatile; it serves two distinct masters:

A. Macroeconomic Functions (Targeting the Whole Economy)

The primary macroeconomic function is to influence Aggregate Demand (AD) to achieve key objectives:

• Economic Growth: By increasing G or reducing T.
• Minimising Unemployment: By boosting AD to reduce demand-deficient (cyclical) unemployment.
• Price Stability (Inflation Control): By reducing G or increasing T to cool down an overheating economy.

B. Microeconomic Functions (Targeting Specific Sectors)

Fiscal policy also affects how resources are allocated and income is distributed:

• Allocation of Resources: Taxes can discourage certain activities (e.g., high taxes on fuel or carbon emissions to discourage pollution). Subsidies (a form of G) can encourage beneficial activities (e.g., funding education).
• Pattern of Economic Activity: Government spending decisions shift demand towards specific industries. Example: If the government spends billions on building a new high-speed rail network, the construction sector sees a huge rise in activity.
• Equitable Distribution of Income: Using progressive taxes and transfer payments (like welfare benefits) to redistribute income from the rich to the poor.

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3. Fiscal Policy and Aggregate Demand (Demand-Side)

Governments use fiscal policy to manage short-term fluctuations in the economic cycle.

A. Expansionary Fiscal Policy (To Fight Recession)

This policy aims to increase Aggregate Demand (AD). It is used when the economy is experiencing a negative output gap (e.g., during a recession).

How it works:

1. Increase Government Spending (G): Government invests in infrastructure projects or increases funding for public services. Since G is a component of AD, AD shifts right.
2. Decrease Taxation (T): The government cuts income tax or corporation tax. This increases disposable income (C) and/or profits for investment (I). C and I are components of AD, so AD shifts right.

Effect: AD increases, leading to higher Real GDP and lower unemployment. (This effect is often boosted by the multiplier process, which you learned about earlier!)

B. Contractionary (Deflationary) Fiscal Policy (To Fight Inflation)

This policy aims to decrease Aggregate Demand (AD). It is used when the economy is overheating and experiencing inflationary pressures (a positive output gap).

How it works:

1. Decrease Government Spending (G): Cuts to public services or delays in planned projects. AD shifts left.
2. Increase Taxation (T): The government raises income tax or indirect taxes (like VAT). This decreases disposable income (C) and investment (I). AD shifts left.

Effect: AD decreases, which slows down growth and helps reduce inflation, though it may lead to higher unemployment.

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4. Fiscal Policy and Aggregate Supply (Supply-Side)

Fiscal policies aren't just for the short run; they can also be designed to shift the Long-Run Aggregate Supply (LRAS) curve outward, increasing the economy's productive potential.

How taxation and spending can influence AS:

Government Spending (G) that boosts LRAS:

• Investment in Infrastructure: Building better roads, ports, and communications lowers the costs of production for firms and improves factor mobility (e.g., workers can get to work faster).
• Investment in Human Capital: Spending on education and training increases the skills and productivity of the labour force.
• Investment in R&D: Government funding for research and innovation helps develop new technology.

Taxation (T) that boosts LRAS:

• Lower Income Tax: By reducing the tax rate, the government can increase the incentive for people to work longer, harder, or enter the workforce. This boosts the quantity and quality of labour.
• Lower Corporation Tax: Reducing taxes on business profits encourages firms to retain profits and invest in new capital, increasing the capital stock.

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5. Understanding Different Types of Taxes

Taxation is essential for funding government spending and influencing behaviour, but not all taxes are created equal. We classify taxes in two main ways:

A. Direct and Indirect Taxes

1. Direct Taxes

These are taxes levied directly on income, wealth, or profit.

• Examples: Income Tax (on wages), Corporation Tax (on company profits), Capital Gains Tax.
• Impact: They directly reduce the amount of money economic agents have before they spend it.

2. Indirect Taxes

These are taxes levied on spending or economic activity.

• Examples: Value Added Tax (VAT), Excise Duties (on tobacco, alcohol, fuel).
• Impact: They increase the price consumers pay, often used to discourage the consumption of demerit goods (like smoking).

B. Tax Structures (Based on Income Proportion)

These classifications describe how the burden of the tax relates to a person's income level:

1. Progressive Taxes

The proportion of income paid in tax increases as income increases. These taxes help reduce income inequality.

• Example: A typical income tax system where higher earners move into higher tax brackets.
• Think of it: The poor pay a small percentage; the rich pay a large percentage.

2. Regressive Taxes

The proportion of income paid in tax decreases as income increases. These taxes tend to worsen income inequality.

• Example: Indirect taxes like VAT. A 10% VAT on bread is a much larger proportion of a poor person's income than a rich person's income.
• Common Mistake: A regressive tax doesn't mean the poor pay more money, it means the poor pay a higher percentage of their income than the rich do.

3. Proportional Taxes (Flat Taxes)

The proportion of income paid in tax remains constant regardless of income level.

• Example: If everyone pays exactly 20% of their income in tax, regardless of how high or low that income is.

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6. The Budget Balance: Cyclical vs. Structural Influences

When analyzing the budget balance (G vs T), economists must distinguish between factors that are temporary (cyclical) and those that are permanent (structural).

A. Cyclical Influences on the Budget

These are automatic changes to G and T that happen naturally as the economy moves through the business cycle (the ebb and flow of growth).

• During a Recession: Income falls, so tax receipts (T) automatically fall. Unemployment rises, so government spending on welfare benefits (G) automatically rises. This creates a cyclical deficit.
• During a Boom: Income rises, so tax receipts (T) automatically rise. Unemployment falls, so G on benefits falls. This often creates a cyclical surplus.

Important: These changes are automatic; they happen without the government actively changing policy rules.

B. Structural Influences on the Budget

This is the deficit or surplus that would remain even if the economy was operating exactly at its normal capacity (full employment).

• A structural deficit means the government's spending plans are fundamentally higher than its tax revenue at the economy's long-term potential output.
• A structural deficit requires the government to take deliberate action (e.g., permanently raising tax rates or permanently cutting spending) to fix it.

Did you know? If an economy is in a recession and running a large budget deficit, only the part of the deficit due to *structural* factors is a long-term problem. The *cyclical* part will disappear when the economy recovers.

The Relationship Between Budget Balance and National Debt

When a government runs a budget deficit, it has to borrow money, usually by issuing bonds (government IOUs). This borrowing adds to the total accumulated national debt. Persistent deficits lead to rising national debt, which means the government must spend more money on interest payments—a significant cost for the future.