Government and the Macro‑economy – Fiscal Policy
1. Fiscal Policy – Definition & Aims (Syllabus 4.2.4)
Definition (as stated in the Cambridge IGCSE syllabus):
Fiscal policy is the use of government spending and taxation as a form of government macro‑economic intervention to influence the level of aggregate demand (AD) in the economy.
Four macro‑economic aims that fiscal policy seeks to achieve (exact wording from the syllabus):
- Economic growth
- Low (cyclical) unemployment
- Price stability (control of inflation)
- Equitable distribution of income
2. Government Budget – Deficit / Surplus (Syllabus 4.2.1)
The government budget compares total public expenditure (G) with total revenue (R).
Budget = Spending – Revenue
- Budget surplus: Revenue > Spending – the government saves money.
- Budget deficit: Spending > Revenue – the government must borrow to cover the shortfall.
Numerical example (useful for AO1 calculations):
If a government spends £200 bn (G) and raises £150 bn in taxes and other revenues (R), then
Budget = £200 bn – £150 bn = £50 bn deficit.
3. Taxation – Purposes & Classifications (Syllabus 4.2.3)
Purposes of taxation (five main reasons):
- To raise revenue for public services.
- To discourage consumption of demerit goods (e.g., tobacco, alcohol).
- To reduce imports (through tariffs) and protect domestic industry.
- To redistribute income and reduce inequality.
- To influence aggregate demand (stimulate or restrain spending).
Classifications of taxes:
- Direct taxes – paid directly to the government (e.g., income tax, corporation tax). Usually progressive because the rate rises with income.
- Indirect taxes – levied on goods and services (e.g., VAT, excise duties). Usually proportional or regressive.
Why are indirect taxes usually regressive? They take a larger proportion of the income of low‑paying households because such households spend a higher share of their income on taxed consumption goods.
Rate structures:
- Progressive – higher rates on higher incomes.
- Regressive – lower rates on higher incomes (e.g., flat‑rate consumption taxes).
- Proportional (flat) – same rate for everyone.
4. Fiscal Policy as a Macro‑policy Tool
Fiscal policy is one of the three main macro‑policy tools used by governments:
- Fiscal policy – government spending and taxation.
- Monetary policy – central‑bank control of interest rates and the money supply.
- Supply‑side policy – measures that affect the productive capacity of the economy (e.g., deregulation, investment in infrastructure). (Mentioned for completeness – not covered in detail in this chapter.)
5. How Fiscal Policy Works (AO1)
The basic identity for aggregate demand is:
$$\Delta AD = \Delta G + \Delta C + \Delta I - \Delta T$$
- ΔG – change in government spending.
- ΔC – change in consumption, which depends on disposable income (after‑tax income).
- ΔI – change in private investment.
- ΔT – change in taxes; a rise reduces disposable income, a fall increases it.
6. Fiscal‑policy Instruments (AO2)
| Instrument |
Expansionary Effect |
Contractionary Effect |
| Government spending (G) |
Increase G → AD rises → higher output & employment. |
Decrease G → AD falls → lower output & employment. |
| Direct taxes (e.g., income tax) |
Cut taxes → disposable income ↑ → consumption ↑ → AD rises. |
Raise taxes → disposable income ↓ → consumption ↓ → AD falls. |
| Indirect taxes (e.g., VAT, excise duties) |
Cut taxes → prices of taxed goods fall → consumption ↑ → AD rises. |
Raise taxes → prices rise → consumption ↓ → AD falls. |
| Government borrowing (to finance a deficit) |
Borrowing can fund extra G or tax cuts → expansionary, but may push up interest rates and crowd out private investment. |
Reduced borrowing or debt repayment frees resources for the private sector; however, if it requires cutting G or raising taxes, the net effect can be contractionary. |
7. Effects of Fiscal Policy on the Four Macro‑economic Aims (AO2)
| Aim |
Expansionary Policy |
Contractionary Policy |
| Economic growth |
↑ AD → ↑ GDP → higher growth rate. |
↓ AD → ↓ GDP → lower growth rate. |
| Low (cyclical) unemployment |
Higher output → firms need more labour → ↓ cyclical unemployment. |
Lower output → reduced labour demand → ↑ cyclical unemployment. |
| Price stability |
Risk of demand‑pull inflation if AD rises faster than the economy’s productive capacity (LRAS). |
Reduces inflationary pressure by pulling AD back towards LRAS. |
| Equitable distribution of income |
Targeted tax cuts for low‑income groups or increased welfare spending can reduce inequality. |
Higher progressive taxes or cuts to welfare can increase inequality unless carefully designed. |
8. Types of Fiscal Stance (AO1)
- Expansionary fiscal policy – used in a recession; involves increasing G or cutting taxes to boost AD.
- Contractionary fiscal policy – used when the economy is overheating or inflation is high; involves decreasing G or raising taxes to reduce AD.
9. Limitations of Fiscal Policy (AO2)
- Time lags – recognition lag, decision‑making lag, and implementation lag can delay the impact of policy.
- Political constraints – governments may be reluctant to cut popular programmes or raise taxes, especially before elections.
- Crowding‑out effect – large government borrowing can push up interest rates, making private investment more expensive and partially offsetting the expansionary impact.
- External‑sector impact – persistent deficits can lead to a depreciation of the exchange rate, affect the balance of payments, and alter the competitiveness of domestic firms.
10. Link to Economic Growth & Unemployment (Syllabus 4.5‑4.7)
- Expansionary fiscal policy raises AD, which can increase real GDP and lower cyclical unemployment in the short run.
- If the expansion is financed by heavy borrowing, crowding‑out may reduce private investment, weakening the growth boost.
- Fiscal policy primarily tackles **cyclical** unemployment; it does not directly address structural unemployment (skill mismatches, geographic factors).
- When AD rises faster than LRAS, the economy may experience demand‑pull inflation, threatening price stability.
11. Suggested Diagram
Draw an AD–AS diagram showing:
- A right‑ward shift of the AD curve after an expansionary fiscal policy (higher G or lower taxes).
- A left‑ward shift of the AD curve after a contractionary fiscal policy (lower G or higher taxes).
- Label the short‑run equilibrium points and note the possible movement of the price level (inflation) and output (GDP).