Government and the Macro‑economy – Fiscal Policy (IGCSE 0455)
Learning Objective
- Define the key terms related to the government budget.
- Explain why governments spend and tax.
- Identify the main fiscal‑policy measures.
- Calculate the size of a budget deficit or surplus and interpret the result (AO1).
- Analyse the likely macro‑economic impact of a deficit or surplus and evaluate the arguments for and against running a deficit (AO2/AO3).
Key Definitions (Syllabus 4.2.1)
| Term | Cambridge definition |
|---|
| Government revenue |
All money received by the state, principally from taxes, duties, fees and income from state‑owned enterprises. |
| Government expenditure |
Total spending on goods and services, public‑sector wages, interest on the national debt, subsidies, welfare payments, etc. |
| Government budget |
The difference between total government revenue and total government expenditure for a given financial year. |
| Budget balance |
Revenue − Expenditure. A positive balance = surplus; a negative balance = deficit. |
| Budget deficit |
Occurs when total expenditure exceeds total revenue (expenditure > revenue). |
| Budget surplus |
Occurs when total revenue exceeds total expenditure (revenue > expenditure). |
| Fiscal policy |
The use of government spending and taxation to influence the macro‑economic objectives of growth, full employment, price stability and a fair distribution of income. |
Why Does the Government Spend? (Syllabus 4.2.2)
- Provision of public goods – defence, law‑enforcement, street lighting, security.
- Redistribution of income – welfare benefits, pensions, progressive taxation.
- Stabilisation of the economy – counter‑cyclical spending to smooth out recessions and booms.
- Promotion of long‑term growth – investment in infrastructure, education and research.
Taxation – Purposes & Classifications (Syllabus 4.2.3)
Purposes of tax
| Purpose | Explanation |
|---|
| Revenue‑raising | Finances the core functions of the state. |
| Redistribution | Reduces inequality by taking more from higher incomes (progressive taxes) and providing benefits. |
| Discouraging demerit goods | Excise duties on tobacco, alcohol, fuel, etc. |
| Encouraging merit goods | Tax reliefs for education, health, R&D. |
| Influencing aggregate demand | Changes in tax rates can raise or lower total demand. |
Classification of taxes
| Type | Definition | IGCSE examples |
|---|
| Direct |
Levied directly on individuals or organisations. |
Income tax, corporation tax, capital gains tax. |
| Indirect |
Collected by an intermediary (e.g., retailer) and passed to the government. |
VAT, excise duties, customs duties. |
| Progressive |
Rate rises as the tax base (income, profit) increases. |
Band‑based income tax. |
| Regressive |
Rate falls as the tax base increases – the poorer pay a larger proportion. |
VAT on basic goods. |
| Proportional (flat) |
Same rate for all levels of the tax base. |
Flat‑rate income tax, some payroll taxes. |
Fiscal‑policy Measures (Syllabus 4.2.5)
The syllabus expects four specific measures:
- Changes in government spending (increase or decrease).
- Changes in taxation (cut or raise tax rates).
- Borrowing / deficit‑financing (issuing bonds to fund a deficit).
- Automatic stabilisers (welfare benefits, unemployment payments, progressive taxes that automatically change with income).
These measures are described as:
- Expansionary fiscal policy – increase spending, cut taxes, or borrow more to raise aggregate demand (used in a recession).
- Contractionary fiscal policy – decrease spending, raise taxes, or run a surplus to lower aggregate demand (used when inflation is a risk).
Effects of each measure on the four macro‑economic aims
| Measure | Growth | Employment | Price stability | Income distribution |
|---|
| Increase spending |
↑ AD → ↑ output |
↑ AD → ↓ unemployment |
Risk of ↑ inflation if economy near full‑employment |
Can target disadvantaged groups (e.g., social housing) |
| Decrease spending |
↓ AD → ↓ output |
↓ AD → ↑ unemployment |
Helps contain inflation |
May hurt low‑income groups if cuts affect welfare |
| Cut taxes |
↑ disposable income → ↑ consumption → ↑ AD |
↑ AD → ↓ unemployment |
Potential inflationary pressure |
Progressive cuts can aid lower incomes; regressive cuts can widen inequality |
| Raise taxes |
↓ disposable income → ↓ consumption → ↓ AD |
↓ AD → ↑ unemployment |
Helps curb inflation |
Progressive taxes improve redistribution; regressive taxes may harm equity |
| Borrowing/deficit‑financing |
Provides extra resources for spending without immediate tax increase |
Same as increase spending – can boost employment |
Long‑term debt may raise interest rates (crowding‑out) → inflation risk |
Depends on how borrowed funds are used (investment vs consumption) |
| Automatic stabilisers |
Increase automatically in a downturn (welfare, unemployment benefits) → boost AD |
Reduce rise in unemployment |
Less likely to cause inflation because they are built‑in and temporary |
Progressive nature improves income distribution |
Calculating the Budget Deficit / Surplus
Formula (expressed in the same monetary unit, e.g. £ million)
Budget Balance = Revenue – Expenditure
- If Balance > 0 → Surplus
- If Balance < 0 → Deficit
Step‑by‑Step Procedure
- Obtain the latest figures for total government revenue and total government expenditure (usually from the national budget or national accounts).
- Convert both figures to the same unit (e.g., £ million or £ billion).
- Apply the formula: Balance = Revenue – Expenditure.
- Interpret the sign:
- Positive → surplus; state the amount.
- Negative → deficit; state the absolute amount and note that it is a deficit.
- Write the answer in a full sentence, e.g. “The government recorded a £ 45 billion deficit in 2022/23.”
Worked Example – Deficit
| Item | Amount (£ million) |
|---|
| Total Revenue | 850,000 |
| Total Expenditure | 1,020,000 |
Balance = 850,000 – 1,020,000 = ‑170,000 £ million
Interpretation: Country A ran a **£ 170 billion deficit** in 2023/24.
Worked Example – Surplus
| Item | Amount (£ million) |
|---|
| Total Revenue | 1,150,000 |
| Total Expenditure | 1,080,000 |
Balance = 1,150,000 – 1,080,000 = +70,000 £ million
Interpretation: Country B recorded a **£ 70 billion surplus** in 2023/24.
Common Pitfalls (AO1)
- Mixing units – always convert to the same unit before calculating.
- Omitting interest payments on the national debt from total expenditure.
- Mis‑reading the sign of the balance; a negative result from “Revenue − Expenditure” means a deficit.
- Confusing “budget deficit” with “trade deficit”.
Analysis & Evaluation (AO2/AO3)
Why might a government deliberately run a deficit?
- Counter‑cyclical stimulus (Keynesian) – increased spending or tax cuts raise aggregate demand, helping lift output and employment during a recession.
- Long‑term investment – borrowing to finance infrastructure, education or research can raise future productive capacity and potential output.
- Automatic stabilisers – welfare payments and unemployment benefits rise automatically when the economy slows, creating a built‑in deficit without active policy change.
Arguments against running a deficit
- Higher public debt leads to larger interest payments, which can crowd out other spending (the “crowding‑out effect”).
- If the economy is already near full employment, extra spending may fuel inflation.
- Persistent deficits can undermine confidence in fiscal sustainability, raising borrowing costs and possibly leading to a debt crisis.
- Deficits financed by borrowing may increase the future tax burden.
How to structure an essay‑type answer
- State the relevant economic theory (Keynesian, classical, monetarist).
- Explain the mechanism (e.g., how increased government spending shifts AD right, how borrowing affects interest rates).
- Provide real‑world examples (e.g., US stimulus after 2008, UK austerity 2010‑15, Japan’s long‑term deficits).
- Weigh short‑term benefits against long‑term risks, considering the country’s existing debt level, interest‑rate environment and inflationary pressures.
- Conclude by summarising which argument appears stronger in the given context.
Practice Questions
- Calculation: Country C reported total revenue of £ 920 million and total expenditure of £ 1,050 million. Calculate the budget balance and state whether it is a deficit or a surplus.
- Reverse calculation: Country D’s budget shows a surplus of £ 45 million. If total revenue was £ 1,200 million, what was total expenditure?
- Short answer: Explain why a government might deliberately run a deficit during a recession.
- Evaluation: Discuss the advantages and disadvantages of using expansionary fiscal policy to reduce unemployment in a country that already has a high level of public debt.
Suggested Diagram
A simple bar chart comparing “Revenue” and “Expenditure” for two fictional countries – one with a deficit (expenditure bar higher) and one with a surplus (revenue bar higher). Label the vertical axis in £ billion and add the caption: “Comparing revenue and expenditure to illustrate a budget deficit and a budget surplus”.