Government and the Macro‑economy – Fiscal Policy
1. What is fiscal policy?
- Fiscal policy is the use of government spending (G) and taxation (T) to influence the level of aggregate demand (AD) in an economy.
- It is the main tool by which a government tries to achieve the macro‑economic aims set out in the national policy framework.
2. The government budget
- Budget balance = G – T
- • Budget deficit: G > T (the government spends more than it raises in tax revenue).
- • Budget surplus: T > G (tax revenue exceeds government spending).
- • Public debt: the accumulated total of past deficits (the stock of borrowing).
Worked example – deficit
- G = £120 bn, T = £100 bn
- Budget balance = £120 bn – £100 bn = £20 bn deficit
- If the deficit is financed by borrowing, public debt rises by £20 bn.
Worked example – surplus
- G = £80 bn, T = £100 bn
- Budget balance = £80 bn – £100 bn = £20 bn surplus
- A surplus can be used to repay existing debt or to increase the government’s cash reserves.
3. Why does the government spend?
- Provide public goods and services (e.g., roads, education, defence) that the market would under‑provide.
- Correct market failure (e.g., subsidies for research, regulation of externalities).
- Redistribute income (e.g., welfare benefits, progressive taxation).
- Stimulate economic growth (e.g., infrastructure investment, support for new industries).
4. Taxation – purposes & classifications
Purposes of taxation
- Raise revenue for public spending.
- Manage aggregate demand (demand‑side objective).
- Redistribute income and wealth.
- Influence behaviour (e.g., environmental taxes, sin taxes).
Classifications
| Classification | Definition | Examples |
|---|
| Direct vs. Indirect | Direct taxes are paid straight to the government (income tax). Indirect taxes are levied on goods and services (VAT, excise). | Income tax, corporation tax | VAT, fuel duty |
| Progressive, Proportional, Regressive | Progressive – tax rate rises as income rises. Proportional – same rate for all incomes. Regressive – rate falls as income rises. | Income tax (progressive), flat‑rate tax (proportional), VAT on basic goods (regressive) |
5. Fiscal‑policy measures (changes in G and T)
| Instrument | Expansionary example | Contractionary example | Four‑step impact chain |
|---|
| Government spending (G) | Increase spending on road building, schools, defence. | Reduce spending on defence or cut back on public sector wages. | ΔG → higher income for contractors & workers → ↑ consumption (C) → AD shifts right → ↑ real GDP. |
| Direct taxes (income tax, corporation tax) | Cut income tax by 5 % or lower corporation tax by 2 %. | Raise income tax by 5 % or increase corporation tax by 2 %. | ΔT (↓) → disposable income ↑ → consumption ↑ → AD shifts right. ΔT (↑) → disposable income ↓ → consumption ↓ → AD shifts left. |
| Indirect taxes (VAT, excise duties) | Reduce VAT on fuel from 20 % to 15 %. | Increase VAT on luxury goods from 20 % to 25 %. | ΔVAT (↓) → price of taxed goods falls → real purchasing power ↑ → consumption ↑ → AD shifts right. ΔVAT (↑) → opposite effect. |
6. Types of fiscal policy
- Expansionary fiscal policy: Used when the economy is operating below its potential (recessionary gap). Involves increasing G or cutting taxes.
- Contractionary fiscal policy: Used when the economy is overheating (inflationary gap). Involves decreasing G or raising taxes.
7. Effects of fiscal policy on the macro‑economic aims
| Macro‑economic aim | How fiscal policy can help | Possible conflict with another aim |
|---|
| Economic growth (increase in real GDP) | Expansionary measures raise AD → higher output. | May increase the price level → inflation. |
| Low unemployment (move towards full employment) | Higher G or lower taxes raise AD → more jobs. | Higher AD can also raise inflation. |
| Price stability (low, stable inflation) | Contractionary measures reduce AD → downward pressure on prices. | Can lower output and raise unemployment. |
| External balance (sustainable current‑account balance) | Contractionary stance reduces import demand; expansionary stance increases it. | Policies that boost growth may widen the trade deficit. |
| Equitable distribution of income | Progressive taxes and targeted welfare spending reduce inequality. | Higher taxes on high incomes may discourage investment and affect growth. |
8. The fiscal multiplier
The multiplier shows how a change in autonomous spending (ΔG or ΔT) leads to a larger change in equilibrium output.
Formula used in the syllabus
\$\Delta Y \;=\; \frac{1}{1-\text{MPC}\,(1-t)}\;\Delta A\$
- ΔY = change in real GDP
- MPC = marginal propensity to consume
- t = average tax rate (as a decimal)
- ΔA = change in autonomous spending (ΔG or –ΔT)
Numerical example
- MPC = 0.8, t = 0.25
- Multiplier k = \( \dfrac{1}{1-0.8(1-0.25)} = \dfrac{1}{1-0.8\times0.75}= \dfrac{1}{0.40}=2.5\)
- A £10 bn increase in government spending → ΔY = 2.5 × £10 bn = £25 bn increase in GDP.
9. Automatic stabilisers
Built‑in fiscal mechanisms that operate without a new government decision.
- Progressive income tax – tax revenue rises automatically as incomes rise, reducing disposable income and AD.
- Unemployment benefit payments – increase automatically when unemployment rises, supporting household consumption.
- Corporate profit tax – falls when profits fall, leaving firms with more after‑tax income.
10. Discretionary fiscal measures
- Deliberate changes announced by the government, usually in the annual budget.
- Examples:
- £5 bn stimulus package for new infrastructure.
- Temporary 3 % cut in VAT on restaurant meals.
- New tax credit for low‑income families.
11. Fiscal‑policy lags
- Recognition lag – time taken to recognise that the economy needs intervention.
- Decision lag – time taken to decide on the appropriate fiscal response.
- Implementation lag – time needed to pass legislation, allocate funds or change tax codes.
- Effect lag – time before the change actually influences AD and macro‑economic outcomes.
12. Interaction with public debt and the wider economy
- Crowding‑out: Large borrowing can raise interest rates, reducing private investment.
- Debt sustainability: Debt‑to‑GDP ratio = (Public debt ÷ Real GDP) × 100 %. A high ratio may limit future fiscal space.
- Debt financing vs. tax financing:
- Debt spreads the cost over time but adds to public debt.
- Tax financing raises revenue immediately but can lower consumption and investment.
13. Evaluation of fiscal policy
Advantages
- Direct impact on AD through changes in G and T.
- Automatic stabilisers provide continuous counter‑cyclical support without new legislation.
- Targeted spending can raise long‑term growth potential (e.g., infrastructure, education).
- Can be used to achieve distributional objectives (progressive taxes, welfare programmes).
Disadvantages / Limitations
- Time lags may cause policy to be pro‑cyclical if the effect arrives after the economy has already turned.
- High deficits increase public debt; excessive debt can raise interest rates and crowd out private investment.
- Political pressures may lead to inappropriate timing, size, or composition of measures.
- Effectiveness depends on the size of the multiplier – smaller when the economy has little idle capacity or when consumers save rather than spend.
- Risk of conflict between aims (e.g., expansionary policy boosts growth and employment but may raise inflation or worsen the current‑account deficit).
Factors influencing the effectiveness of fiscal policy
- Size of the multiplier – larger when there are unemployed resources and when the tax system is not highly progressive.
- State of the economy – recessionary gaps respond better to expansionary policy; inflationary gaps respond to contractionary policy.
- Coordination with monetary policy – an expansionary fiscal stance is more powerful if the central bank keeps interest rates low.
- Credibility and expectations – if households expect future tax rises to pay for current deficits, they may save (Ricardian equivalence).
- External sector – in open economies a large part of an expansionary stimulus can leak abroad via imports.
14. Suggested diagrams for the exam
- AD–AS diagram showing a right‑ward shift of AD after an expansionary fiscal policy and a left‑ward shift after a contractionary policy.
- Fiscal multiplier diagram: initial change in G or T → induced change in consumption → final change in equilibrium output.
- Budget diagram: bars for G, T, deficit/surplus and the resulting change in public debt.
- Lags flow‑chart: Recognition → Decision → Implementation → Effect.