Chapter 5.

22 A1 new

Fiscal Policy
Fiscal policy and the budget
⚫ Fiscal policy is the use of taxation and government
spending to manage aggregate demand in order to achieve
the government’s macroeconomic aims.
⚫ The government’s annual budget is a statement of its fiscal
policy.
⚫ In the budget statement, the finance minister outlines the
government’s spending and taxation plans for the year
ahead. It might be Budget surplus plan or Budget deficit
plan.
⚫ Most governments seek to achieve a balanced budget over time.
In the short term,
⚫ A government may aim, or welcome, a budget deficit if there is
a low level of economic activity.
⚫ If there is a decline in economic growth and a rise in
unemployment, a government may decide to cut tax rates and
increase government spending.
⚫ It may also allow government spending on unemployment
benefits to rise and tax revenue to fall as an automatic result of
a slowdown in the economy.
⚫ A budget deficit that occurs due to a fall in economic activity
is known as a cyclical deficit.
⚫ A government is unlikely to be concerned about a cyclical
deficit as it will move towards a balance as economic activity
increases.
⚫ However, a government will be concerned about a
structural deficit. A structural deficit arises when a
government is committed to too much spending relative
to its tax revenue.
⚫ In this case, the deficit will not disappear when GDP
increases.
⚫ In practice, a budget deficit may contain both cyclical and
structural elements.
The difference between a government’s cyclical
and structural budget deficit.
XX expenditure line
shows a situation where
there would be no
structural deficit. This is
because at the full
employment level of real
GDP(Yfe), there is no
budget deficit.
However, in ZZ there
would be a budget deficit
at the full employment
level.
At an income of Y1 the
budget deficit is 0b. where
The national debt
⚫ National debt is connected to budget deficits and budget
surpluses. If a government has a budget deficit in one year
it will add to the country’s national debt.
⚫ In contrast, the extra revenue earned from a budget
surplus can be used to pay off part of the national debt.
⚫ The national debt tends to increase during economic
downturns as this is when government expenditure tends
to rise at a more rapid rate than tax revenue.
⚫ There may also be a tendency for a government to spend
more than its revenue even during economic booms (a
structural deficit). In addition, military conflicts can result
in significant increases to the national debt.
⚫ There are disadvantages in having a large and increasing
national debt. There is the opportunity cost of interest
payments on the national debt.
⚫ The government revenue used to pay the debt might have been
used to finance, for instance, the building of new hospitals.
⚫ A large national debt may make financial institutions, firms,
individuals and foreign governments reluctant to lend.
⚫ This is because it may cause them to have doubts about the
government’s ability to pay interest on the debt and to repay
the sum borrowed.
⚫ Borrowing a large amount may also push up the rate of
interest that has to be paid.
Indirect taxes
⚫ Indirect taxes are taxes on the sale of goods and services.
They are called indirect taxes as they are largely paid by
consumers and collected by firms that supply the
products.
⚫ It is the firms that are legally responsible for paying the
taxes to the government. Firms will try to pass on as much
of the tax as possible to consumers in the form of higher
prices.
⚫ For instance, The more inelastic the demand, the higher
the proportion of the tax that is likely to be passed on to
the consumers.
⚫ The two most common indirect taxes are VAT (value
added tax) and GST (general sales tax). Both of these taxes
are ad-valorem taxes. This means they are taxes based on
the percentage of the price of a product.
⚫ For example, the standard rate of VAT in France in 2019
was 20% and the standard rate of GST in Pakistan was 17%.
⚫ There are also specific indirect taxes. These have a set
amount of tax. Indirect taxes on particular products are
known as excise duties.
⚫ Some excise duties are sometimes referred to as sin taxes.
Sin taxes are imposed to discourage people from buying
products that are not good for their health.
⚫ For example, a number of countries, including Denmark,
France and Mexico, have imposed taxes on high-fat foods.
Direct taxes
⚫ While indirect taxes are taxes on spending, direct taxes are
taxes on income and wealth. Two examples of direct taxes
are income tax (also sometimes called personal income
tax) and corporate tax (also known as corporation tax and
corporate income tax).
⚫ Income tax is a tax on the income of individuals and
corporate tax is a tax on the profits of firms.
Indirect taxes versus direct taxes
⚫ In recent decades there has been a tendency for
governments to rely more on indirect taxes. Indirect taxes
have a number of advantages. They can be changed, if
needed, relatively quickly and easily.
⚫ They are cheaper to collect than direct taxes as firms do
part of the administrative work. They can also be used to
discourage the purchase of particular products.
⚫ The main advantage claimed for indirect taxes is that they do
not discourage effort, innovation and saving.
⚫ Higher direct taxes may put off some people from joining the
labour force, may stop some people working overtime and may
encourage some people to cut the standard hours they work.
⚫ This is because the disposable income people earn for each
hour they work will be reduced.
⚫ Direct taxes may act as a disincentive to save as they mean that
income can be taxed twice – once when it is earned and again
when interest is received on any part that is saved.
⚫ High direct taxes may stop firms introducing new methods and
products if they think their post-tax income will be too low.
⚫ However, a rise in direct taxes will not necessarily have a
disincentive effect. Some workers may decide to work
more hours to maintain their level of disposable income.
⚫ High direct taxes may encourage tax avoidance and tax
evasion.
⚫ Greater reliance on indirect taxes may make income less
evenly distributed. This is because indirect taxes are
regressive taxes.
Progressive, regressive and proportional taxes
⚫ Direct taxes are usually progressive. A progressive tax is
one that takes a higher percentage of a person or firm’s
income as that income rises.
⚫ Initial $8000 is tax free amount. In this system, people
earning $20 000 pay $3000 in tax (25% of $12 000). This
is 15% of their income.
⚫ People earning $40 000 pay $11 000 ($3000 + 40% of $20
000 = $8000). This is 27.5% of their income.
⚫ Those who earn $70 000 pay 32.5% of their income
($3000 + $8000 + $15 000 (50% of $30 000) = $26 000).
⚫ So as income rises, a higher percentage is paid in tax.
⚫ In contrast, in the case of a regressive tax, a smaller
percentage of income is taken as income rises. This means
that such a tax takes a higher percentage of the income of
people on low incomes.
⚫ A proportional tax is a fixed percentage tax, for example a
20% income tax. The tax rate does not change as income
changes. In recent years, a number of countries, including
Estonia and Russia, have introduced a flat rate tax system.
⚫ A ‘pure’ version of this system would be one tax rate,
⚫ For example an income tax rate of 15%, a corporate tax rate
of 15% and a sales tax rate of 15%. Such a tax system is
simple to understand and administer, but is regressive.
Marginal and average rates of taxation
⚫ The marginal rate of taxation (mrt) is the proportion of
extra income taken in tax.
⚫ For example, if a person earns an extra £100 and £30 is
taken in tax, the marginal tax rate is £30/£100 = 0.3. This
can also be expressed as 30%.
⚫ In contrast, the average rate of taxation (art) is the
proportion of a person’s total income that is taken in tax. If
a person earns £50 000 and pays £10 000 in tax, the
average tax rate is 0.2 or 20%.
⚫ In the case of a progressive tax, the marginal tax rate is
higher than the average tax rate. The proportion of tax
people would pay on extra income would be greater than
the proportion they pay on the total amount they earn.
⚫ In contrast, in the case of a regressive tax, the marginal tax
rate is lower than the average tax rate.
⚫ The relationship is also different in the case of a
proportional tax. In this case, the marginal tax rate equals
the average tax rate.
The reasons for taxation
⚫ Taxes are imposed for a number of reasons. One is to raise
revenue to finance government spending on merit goods,
such as education, and public goods, such as defences.
⚫ The government also imposes taxes to influence aggregate
demand.
⚫ If the government wants to reduce aggregate demand it
will raise tax rates and/or increase the tax base vice versa.
⚫ A government could, in theory, finance its spending just by
printing money. However, such an approach would be
very inflationary
⚫ A progressive income tax may be used to distribute
income more evenly. Such a tax narrows the gap between
the disposable income of rich people and people on low
incomes.
⚫ The gap could be further narrowed by the government
using some of the tax taken from rich people to provide
cash benefits to those on low incomes.
⚫ Taxes are imposed to discourage the consumption of
certain imported products.
⚫ A government may be concerned that the country is
spending more on imports than it is earning from selling
exports.
⚫ Taxes may also be imposed on demerit goods in order to
improve people’s health and the environment.
22.4 Government spending
⚫ Government spending can be divided into spending on
transfer payments (not counted in measures of national
income), current spending and capital spending.
⚫ Government spending on transfer payments (welfare
payments to certain groups of people) includes spending
on unemployment benefits, state pensions and interest
payments on the national debt.
⚫ Current government spending is spending on goods and
services used to provide state-financed services. It covers
the operating costs the spending on the wages of teachers
employed in state schools, salary of govt. officials and the
medicines used in state hospitals.
⚫ Capital government spending is spending on capital
goods used in the public sector. It includes spending on
building state schools and hospitals.
Government exhaustive and non-exhaustive
spending.
⚫ Exhaustive government spending covers current and
capital spending. It is spending which uses resources and is
counted in aggregate demand and GDP.
⚫ Non-exhaustive government spending is spending on
transfer payments. The people who receive the payments
make the decision about how to use the resources.
Reasons for government spending
⚫ The reasons for government spending are linked with
taxation. Governments spend in order to influence
aggregate demand and so the level of economic activity.
⚫ If private sector spending is too low, a government may
decide to inject more spending into the economy. It will
aim for a budget deficit, spending more than it raises in
taxation.
⚫ Likewise, a government may use its spending to increase
aggregate supply. Government spending on education,
healthcare and infrastructure can raise an economy’s
productive potential.
⚫ Unemployment benefits provide an income for those who
have lost their jobs and run the risk of falling into poverty.
⚫ Governments also spend on merit and public goods in
order to overcome market failure.
⚫ As GDP rises, there is likely to be pressure on the
government to spend more on merit and public goods.
⚫ In practice, governments may also spend to win political
popularity so that they can stay in power.
⚫ Government spending in a number of countries regularly
rises just before an election.
⚫ Governments may also be influenced by pressure groups
that encourage them to spend more on, for instance, the
environment, MNCs.
Types of fiscal policy
⚫ It is the use of taxation and government spending to
manage aggregate demand in order to achieve the govt’s
macro economic aims.
⚫ Expansionary or reflationary fiscal policy is designed to
increase aggregate demand. This can be achieved by a govt
spending and/or cutting tax rates.
⚫ In contrast, Contractionary or deflationary fiscal policy is
intended to lower agg demand . Here the govt will reduce
its spending and /or increase tax rates.
⚫ Deliberate changes in govt spending and taxation can be
referred to as discretionary fiscal policy.
Automatic stabilizers
⚫ Automatic stabilizers are forms of govt spending and
taxation that change, without any deliberate government
action, to offset fluctuations in GDP.
⚫ For example, during recession, govt spending on
unemployment benefits automatically rises because there
are more unemployed people.
⚫ Tax revenue from corporate tax, income tax and indirect
tax will fall automatically as profits, income and
expenditure decline.
⚫ This can be shown in the figure below:
The given diagram shows
how tax revenue and government expenditure change
automatically as GDP changes.
⚫ Initially, the economy is operating below full employment
at Y with a significant gap between government spending
and taxation. As GDP rises, government spending on
benefits falls while tax revenue rises with more people in
employment and so receiving more income.
The impact of expansionary and contractionary
fiscal policy on the macro economy
⚫ Governments may use contractionary fiscal policy tools to
reduce demand-pull inflation.
⚫ Income tax rates may be increased, and the tax base may
be changed.
⚫ Governments may cut their own spending.
⚫ Higher taxes and lower government spending may reduce
aggregate demand.
⚫ However, raising income tax to reduce demand-pull
inflation may not go as planned because workers may seek
higher wages to maintain their disposable income.
⚫ If their wage claims are granted, firms’ costs of production
may increase. Higher costs can generate cost-push
inflation.
⚫ Higher income tax rates may also create disincentive
effects. Some workers may respond to a reduction in
disposable income by leaving the labour force.
⚫ Other workers may emigrate to countries with lower tax
rates. This will reduce the economy’s productive capacity
and so reduce aggregate supply.
⚫ Expansionary fiscal policy may be used to increase the
country’s output and to raise employment.
⚫ If a country has high cyclical unemployment, the
government is likely to try to increase aggregate demand.

⚫ It might seek to achieve this by cutting direct and indirect

Figure 22.10
shows higher
aggregate
demand raising
the country’s
output from Y
to Y1.
⚫ The success of expansionary fiscal policy tools in
stimulating economic growth and reducing
unemployment will depend on a number of factors.
⚫ For instance, expansionary fiscal policy may not be very
effective if households and firms are worried about the
future.
⚫ In this case, they may save most of any extra disposable
income they receive as a result of lower taxes and higher
government spending.
⚫ There is also the risk that the government may inject too
much spending into the economy, causing demand-pull
inflation.