Fiscal policy
The government budget
- Government budget - the government's planned revenue and expenditure over a period, usually one year.
- Government budget deficit - the amount by which government expenditure exceeds government revenue over a period.
- Government budget surplus - the amount by which government revenue exceeds government expenditure over a period.
| Budget position | Calculation |
|---|
| Deficit | government spending - government revenue |
| Surplus | government revenue - government spending |
Worked budget example
A government receives $82 billion in revenue and spends $95 billion.
- Compare spending with revenue. Spending is larger, so the budget is in deficit.
- Calculate the size. $95bn - $82bn = $13bn budget deficit.
Government spending
Governments spend because markets alone may not provide enough essential services, infrastructure or protection for vulnerable groups. Spending also changes total demand and the economy's future productive capacity.
| Main area | Reason for spending | Likely effects |
|---|
| Education and training | Improve skills and access to opportunity. | Higher productivity and employability; benefits take time and depend on quality. |
| Healthcare | Improve health and provide services people may be unable to afford. | Longer, healthier lives and fewer working days lost; high opportunity cost for the budget. |
| Infrastructure | Provide transport, energy, water and digital networks. | Lower business costs and connect markets; projects may be slow, expensive or poorly chosen. |
| Defence, policing and justice | Protect people, property and legal rights. | Greater security and confidence; resources cannot then be used elsewhere. |
| State benefits | Support unemployed, elderly, sick or low-income households. | Reduces hardship and supports spending; generous or badly designed schemes may weaken work incentives. |
| Environmental protection | Reduce pollution and protect shared resources. | Improves health and sustainability; enforcement and monitoring cost money. |
| Debt interest | Meet the cost of past government borrowing. | Maintains lender confidence but leaves less revenue for current services. |
Taxation
- Tax - a compulsory payment to the government by individuals or organisations.
- Raise revenue: finance public services, benefits, infrastructure and debt interest
- Discourage demerit goods: raise the price of products such as cigarettes so consumption may fall
- Reduce imports: tax imported goods so they become more expensive relative to domestic products
- Redistribute income: collect more from higher-income groups and finance benefits or services for lower-income groups
- Influence total demand: higher taxes reduce disposable income and spending; lower taxes can increase them
- Support sustainability: tax pollution, carbon emissions or resource use so harmful activity becomes more costly
Classifying taxes
- Direct tax - a tax charged directly on the income or wealth of a person or organisation, such as income tax or corporation tax.
- Indirect tax - a tax placed on spending on goods and services, such as a sales tax or excise duty.
- Progressive tax - a tax for which the proportion of income paid rises as income rises.
- Proportional tax - a tax for which the same proportion of income is paid at every income level.
- Regressive tax - a tax for which the proportion of income paid falls as income rises.
| Classification | Example | Key point |
|---|
| Direct | Income tax | The legal taxpayer pays the government directly. |
| Indirect | Tax on petrol | The tax is collected through the seller and can raise the market price. |
| Progressive | Income tax with higher rates on higher bands | Higher-income earners pay a larger share of income. |
| Proportional | A single 15% income-tax rate | Everyone pays the same share, although the cash amount differs. |
| Regressive | A fixed indirect tax on an essential product | The same cash tax takes a larger share of a low income. |
Classification warning: Direct/indirect describes what is taxed and how it is collected. Progressive/ proportional/regressive describes the tax burden as income changes. A tax can belong to one category from each pair.
| Quality | Meaning | Why it matters |
|---|
| Equity / fairness | People in similar positions are treated similarly, while ability to pay may also be considered. | Improves acceptance and can support redistribution. |
| Certainty | The amount, timing and method of payment are clear. | Households and firms can plan and arbitrary treatment is reduced. |
| Convenience | The tax is collected at a practical time and in a practical way. | Makes compliance easier for taxpayers. |
| Economy | Administrative and compliance costs are low relative to the revenue raised. | Prevents collection from wasting a large share of receipts. |
| Flexibility | Rates or coverage can be changed when economic conditions or government aims change. | Allows policy to respond to inflation, recession or new priorities. |
Impacts of taxation
| Group | Possible effects of higher taxation |
|---|
| Consumers | Lower disposable income or higher prices reduce purchasing power; consumption of taxed products may fall. |
| Workers | Lower reward from extra work may reduce work incentives, but tax-funded education, healthcare and infrastructure can improve welfare and productivity. |
| Producers / firms | Profit and funds for investment may fall; indirect tax can reduce demand. Firms may also benefit from public services and infrastructure financed by tax. |
| Government | Revenue may rise, allowing more spending or a smaller deficit. If tax rates are very high or activity falls sharply, the revenue increase may be smaller than expected. |
| Economy | Total demand and inflationary pressure may fall. Progressive tax and benefits can reduce inequality, but weak incentives may slow growth. |
Fiscal policy: measures and effects
- Fiscal policy - changes in government spending and taxation designed to influence the economy and achieve macroeconomic aims.
- Expansionary fiscal policy - higher government spending and/or lower taxes intended to increase total demand.
- Contractionary fiscal policy - lower government spending and/or higher taxes intended to reduce total demand.
| Policy change | Transmission chain | Main aims helped | Possible limitation |
|---|
| Higher spending or lower taxes | Disposable income or direct government demand rises -> spending rises -> firms sell more -> output and employment may rise. | Growth and lower unemployment; possibly less poverty. | May raise inflation, imports and the budget deficit, especially when capacity is limited. |
| Lower spending or higher taxes | Total spending falls -> firms face weaker demand -> price pressure falls. | Lower inflation and possibly improved balance of payments stability. | May reduce growth and employment; spending cuts can harm services or productive capacity. |
The effect depends on size, timing, consumer and firm confidence, how much spare capacity exists, and what the government spends on. Infrastructure or education can strengthen both current demand and future productive capacity, whereas wasteful spending may do little.