Government and the Macro‑economy – Fiscal Policy
Objective: Reasons for Taxation (IGCSE 0455 – Section 4.2)
1. What is Fiscal Policy?
- Fiscal policy is the use of government‑spending and taxation to influence the macro‑economy.
- The two levers are:
- Taxes – change disposable income, production costs and the price of imports.
- Government spending (G) – directly adds to aggregate demand and can target specific sectors.
- This note concentrates on the taxation side, because the reasons for taxation are a distinct part of the syllabus.
2. The Five Macro‑economic Aims (Cambridge)
- Economic growth (increase in real GDP)
- Full employment (low unemployment)
- Price stability (low inflation)
- Balance of payments equilibrium
- Redistribution of income and sustainable development
Each reason for taxation can be linked to one or more of these aims (see Section 5).
3. Key Definitions
- Tax – a compulsory payment to the government, without a direct return of a specific good or service.
- Taxation – the whole system of levying, collecting and managing taxes.
- Fiscal policy – the combined use of taxes and government spending to achieve macro‑economic objectives.
- Government budget – a plan showing expected expenditure (G) and expected revenue (R) for a financial year.
- Budget deficit – when expenditure > revenue.
Formula: Deficit = G – R - Budget surplus – when revenue > expenditure.
Formula: Surplus = R – G
4. Classification of Taxes
| Classification | How it works | Typical IGCSE example |
|---|
| Progressive | Rate rises as the tax‑base (income, profit) rises. | Personal income‑tax bands (0 %, 20 %, 40 %). |
| Regressive | Rate falls as the tax‑base rises; low‑income earners pay a larger share. | Excise duty on cigarettes (same amount for rich and poor). |
| Proportional (Flat‑rate) | Same percentage applied to every level of the tax‑base. | Corporate tax at a flat 20 %. |
| Direct | Levied directly on the income or wealth of individuals/firms. | Income tax, corporation tax. |
| Indirect | Collected by an intermediary when a good or service is bought. | VAT, excise duties. |
5. Main Reasons for Taxation (Six Required Items)
- Raising revenue for public expenditure
- Finances health, education, defence, infrastructure, welfare, etc.
- Supports the aims of growth, employment and price stability by providing the resources for public investment.
- Formula:
Tax Revenue = Tax Rate × Tax Base
- Discouraging consumption of demerit (sin) goods
- Higher price → lower quantity demanded for goods that cause social harm.
- Typical sin taxes: excise duties on cigarettes, alcohol, sugary drinks.
- Links to the aim of redistribution & sustainability (health improvement, reduced external costs).
- Reducing imports (protective taxation)
- Tariffs raise the price of foreign goods, making domestic alternatives relatively cheaper.
- Helps infant industries and can improve the balance of payments.
- Directly addresses the aim of balance‑of‑payments equilibrium.
- Redistributing income
- Progressive taxes collect a larger share from higher‑income households.
- Revenue can be used for transfers, subsidies or public services that benefit low‑income groups.
- Serves the macro‑economic aim of redistribution of income.
- Influencing total (aggregate) demand
- Tax changes alter disposable income → consumption (C) and investment (I).
- Lower income tax → higher disposable income → AD shifts right.
- Higher tax → AD shifts left, potentially curbing inflation.
- AD formula:
AD = C + I + G + (X – M) - Relates to the aims of growth, employment and price stability.
- Encouraging environmental sustainability
- Green taxes internalise the external cost of pollution (negative externalities).
- Examples: carbon tax per tonne of CO₂, plastic‑bag levy, fuel excise.
- Supports the aim of sustainable development and can also affect AD.
6. Impact of a Tax Change on Economic Agents
| Agent | Effect of a Tax Increase | Effect of a Tax Decrease |
|---|
| Consumers (households) | Lower disposable income → less consumption. | Higher disposable income → more consumption. |
| Workers (labour supply) | Higher marginal tax on wages may reduce the incentive to work extra hours. | Lower marginal tax may encourage greater labour‑supply. |
| Firms | Higher production costs (e.g., corporation tax, excise) → lower output or higher prices. | Lower costs → higher profit, possible expansion and investment. |
| Government | Higher tax receipts → larger surplus or smaller deficit. | Lower receipts → need to borrow or cut spending. |
| Whole economy (Aggregate Demand) | Reduced AD → recessionary pressure, lower inflation. | Increased AD → expansionary pressure, possible inflation. |
7. Tax Incidence and Elasticities
- Tax incidence – who actually bears the economic burden of a tax (consumers vs. producers).
- When demand is price‑inelastic (low PED), consumers absorb most of the tax.
- When supply is price‑inelastic (low PES), producers absorb most of the tax.
- If both demand and supply are elastic, the burden is shared more evenly.
Example: A 10 % excise duty on cigarettes. Demand for cigarettes is relatively inelastic, so the price rise is largely passed on to smokers – the consumer bears most of the tax.
8. Simple Revenue‑raising Calculations (IGCSE style)
For any given tax:
Tax Revenue = Tax Rate × Tax Base
The tax base is the total amount subject to the tax (e.g., total wages for income tax, total value of sales for VAT).
Illustrative calculation – VAT
- Standard VAT rate = 20 %.
- Taxable sales in a month = £500 000.
- VAT revenue = 0.20 × 500 000 = £100 000.
9. Summary Table – Tax Types, Classification & Primary Purposes
| Tax Type | Classification | Direct / Indirect | Primary Purpose(s) | Typical IGCSE Example |
|---|
| Personal Income Tax | Progressive | Direct | Raise revenue, redistribute income | Banded rates – 0 %, 20 %, 40 % |
| Corporate Tax | Proportional (flat) | Direct | Raise revenue | 20 % on company profits |
| Excise Duty (sin tax) | Regressive | Indirect | Discourage demerit goods, raise revenue | £0.50 per pack of cigarettes |
| Import Duty (tariff) | Regressive (applied to value) | Indirect | Reduce imports, protect domestic industry | 10 % duty on imported steel |
| Value‑Added Tax (VAT) | Proportional | Indirect | Raise revenue, influence demand | Standard 20 % rate on most goods/services |
| Carbon Tax / Environmental Levy | Proportional (per tonne) | Indirect (often on fuel) | Encourage environmental sustainability, internalise externalities | £25 per tonne of CO₂ emitted |
10. Diagram Suggestion (Revision)
Figure: The effect of a tax cut on aggregate demand – AD shifts right from AD₁ to AD₂ as disposable income rises, holding G, X and M constant.
Key Points to Remember
- Fiscal policy uses taxes and government spending to achieve five macro‑economic aims.
- Taxation is both a source of revenue and a policy tool.
- The six statutory reasons for taxation are:
- Raise revenue
- Discourage demerit goods
- Reduce imports
- Redistribute income
- Influence aggregate demand
- Encourage environmental sustainability
- Classification (progressive, regressive, proportional, direct, indirect) explains how different groups are affected.
- Tax incidence depends on the price‑elasticities of demand and supply.
- Changes in tax rates affect disposable income, labour supply, firm costs, government receipts and, ultimately, aggregate demand.
- Progressive taxes aid redistribution; regressive taxes can increase inequality.
- Green taxes correct market failures caused by negative externalities and support sustainable development.