Fiscal Policy

Fiscal Policy

• Fiscal policy is the taxation and spending decisions of a government
  • The government can control tax rates, the types of taxes, what it taxes, and the amount, timing and composition of government spending.
• The main aim of fiscal policy is to influence AD, either via increasing gov. spending or by reducing taxes.
  • Increasing government spending would increase AD, e.g. buying computers for schools (this could also have a multiplier effect, increasing AD further)
  • Cutting taxes will also increase AD, e.g. if income tax was cut, consumers would have more disposable income, which would thus increase consumption.
• Reflationary policies are measured designed to increase AD, whereas deflationary are designed to reduce it.
• Changes in gov. spending and taxation aren’t just to influence AD
  • They can also be to promote the consumption of merit goods, changing the distribution of income, and altering incentives.

The Nature of Fiscal Policy

• A government may implement policies which try and match AD to AS, so both inflation and unemployment are avoided
• If private sector demand is too high, the government may seek to reduce AD, whereas if it’s too low, it may seek to reduce it.
  • This is known as acting ‘counter cyclically’ – the government is trying to create greater economic stability by offsetting changes in private sector spending
• To achieve this move of AD, a government can use either discretionary fiscal policies, or allow automatic stabilisers to operate
  • Discretionary fiscal policy is deliberate changes in government spending and taxation that is designed to influence aggregate demand
  • Automatic stabilisers are forms of government spending and taxation that change automatically to offset fluctuations in economic activity
    • For example, government spending on job seeker’s allowance falls when unemployment falls
    • The government spending on automatic stabilisers are linked to the economic cycle.
  • A number of governments are now setting themselves ‘fiscal policy rules’, and these are designed to determine the nature of what policies can be introduced, as well as to create greater certainty and stability.
    • Example of a rule, known as the ‘golden rule’, states that over the economic cycle, the government should only borrow to pay for investment spending.

Types of Taxes

• There are progressive taxes and regressive taxes
  • Progressive tax is a tax that takes a higher percentage from the income of the rich
  • Regressive tax is a tax that takes a greater percentage from the income of the poor
• Income tax is a direct and progressive tax – as a person’s income rises, so does the actual amount of money they pay in tax, as well as the percentage they have to pay.
• VAT is an indirect and regressive tax
• Other taxes include:
  • Excise Duty – indirect tax imposed on specific products, e.g. alcohol and tobacco
  • Capital Gains Tax – a tax on the increase of value of items such as shares, paintings, etc.
  • Corporation Tax – a tax on the profits of firms
  • Inheritance Tax – a tax on the transfers of wealth above a certain amount

Government Spending

• Government spending can be divided into:
  • Capital expenditure – e.g. spending on hospitals, schools, roads, etc.
  • Current spending – teachers’ pay, running of public transport, etc.
  • Transfer payments – money transferred from taxpayers to recipients of the benefits
  • Debt interest payments – payments made to the holders of government debt

The Budget

• The budget report contains information on the budget position in the past year, and predictions for future years, as well as spending reviews and tax changes.
• The budget position shows the relationship between government spending and tax revenue
  • A budget deficit is when spending exceeds revenue
  • There are also balanced and surplus budgets
• Budget deficit and surpluses may occur due to cyclical factors, such as recessions
  • In a recession, tax revenue is likely to fall (due to increased unemployment), and government spending on JSA is likely to rise, due to automatic stabilisers.
  • The government may also us discretionary fiscal policy to increase AD
  • As a result, a budget deficit is likely to occur.