Cambridge (CIE) IGCSE Your notes
Economics
4.2 Fiscal Policy
Contents
The Government Budget
Taxation
Fiscal Policy Measures
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The Government Budget
Your notes
Key government budget terms
Government budget
A statement of the government’s planned revenue (mainly from taxation) and
expenditure (spending) over a specific period, usually one year
Shows the government’s fiscal policy intentions
Government budget deficit
Occurs when government expenditure exceeds government revenue in a given
period
Indicates that the government must borrow to finance the shortfall
For example, UK public sector net borrowing in 2023/24 was around £120 billion
Government budget surplus
Occurs when government revenue exceeds government expenditure in a given
period.
May be used to repay debt or saved for future spending
For example, Norway often runs budget surpluses due to high oil revenues
Fiscal policy
The use of government spending and taxation to influence the economy
It can be:
Expansionary – increasing spending or reducing taxes to stimulate growth
Contractionary – reducing spending or increasing taxes to slow inflation
Calculating the surplus or deficit
The budget balance is calculated using the following formula:
Budget balance = Government revenue − Government expenditure
If budget balance > 0 → surplus
If budget balance < 0 → deficit
Worked Example
Government revenue = $800 billion
Government expenditure = $900 billion
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Calculate the budget balance and determine if it in surplus or deficit
Step 1: Substitute the values into the formula Your notes
Budget balance = $ 800b – $ 900b
Step 2: Calculate the answer and state if it is a surplus or deficit
= – $ 100 billion
= deficit
Reasons for government spending
Public expenditure (government spending) represents a significant portion of the total
(aggregate) demand in many economies
Spending happens for the following reasons:
1. Provision of public goods
Goods that the market would not supply effectively due to the free rider problem
E.g. national defence, street lighting, flood barriers
2. Provision of merit goods
Goods/services that would be under-consumed without government intervention
E.g. education, healthcare, vaccination programmes
3. Welfare and social protection
Direct financial support to vulnerable groups to improve living standards
E.g. unemployment benefits, pensions, disability support
4. Infrastructure investment
Building and maintaining transport, energy, water and digital networks
Supports business activity and long-term productivity growth
5. Debt interest payments
Servicing existing government borrowing
Prevents default and maintains credibility in financial markets
6. Environmental protection projects
Funding for conservation, pollution control, and climate change adaptation
Reasons for taxation
Nearly every economy in the world is a mixed economy and has varying degrees of
government intervention
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One of the main forms of government intervention is taxation and there are many
reasons why it is necessary
Your notes
A diagram showing several reasons for government taxation in mixed economic systems
Correct market failure
In many markets there is a less than optimal allocation of resources from society's
point of view
The government aims to subsidise merit goods and tax demerit goods to
address this market failure
Earn government revenue
Governments need money to provide essential services and public and merit
goods
Revenue to fund this is raised through taxation
Promote equity
The wealthy are taxed to provide funds that can be utilised in reducing the
opportunity gap between the rich and poor
Support firms
In a global economy, governments choose to support key industries so as to help
them remain competitive and taxation provides the funds to do this
Support poorer households
Poverty has multiple impacts on both the individual and the economy
Intervention seeks to redistribute income (tax the rich and give to the poor) so
as to reduce the impact of poverty
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Taxation
Your notes
The classification of taxes
The main source of government revenue is taxation
Direct taxes are taxes imposed on income and profits
They are paid directly to the government by the individual or firm
E.g., income tax, corporation tax, capital gains tax, national insurance
contributions and inheritance tax
Indirect taxes are imposed on spending
The less a consumer spends, the less indirect tax they pay
Examples of indirect tax include Value Added Tax (19% VAT rate in the European
Union in 2022), taxes on demerit goods and excise duties on fuel
Progressive, regressive and proportional tax
systems
Tax systems can be classified as progressive, regressive or proportional
Most countries have a mix of progressive (direct taxation) and regressive (indirect
taxation) taxes in place
Progressive tax system
As income rises, a larger percentage of income is paid in tax
In the diagram, when personal income rises from Y1 to Y2, the tax rate rises from T1 to T2
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Regressive tax system
Your notes
Regressive taxation
As income rises, a smaller percentage of income is paid in tax
In the diagram, when personal income rises from Y1 to Y2, the tax rate falls from T1 to T2
All indirect taxes are regressive
In the USA, Federal income tax is progressive but almost all State taxes are regressive
(the bottom 20% of income earners pay as much as 6x the % of their income than the
top 20%)
Proportional tax system
A proportional tax system
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As income rises, the same percentage of income is paid in tax
In the diagram, when personal income rises from Y1 to Y2, the tax rate remains constant Your notes
at 20%
In 2022, Bolivia was using this system with a proportional tax rate of 13%
Examiner Tips and Tricks
MCQ frequently test your knowledge of the different tax systems by presenting you
with a table and asking you to identify the type of tax system illustrated
Identify the type of tax system illustrated below:
Weekly Income ($) 100 150 200 250
Weekly Tax ($) 20 30 40 50
It is a proportional tax system with a constant tax rate of 20%
The impact of taxation
Impact on consumers
Higher prices
Indirect taxes increase the price of goods and services, reducing consumers’
purchasing power
Reduced consumption
Higher prices may cause people to buy less, especially for non-essential goods
Behaviour changes
High taxes on harmful goods (e.g. cigarettes) can discourage consumption
Lower disposable income
Direct taxes (e.g. income tax) reduce the amount of income consumers can spend
or save
Impact on workers
Lower take-home pay
Income tax reduces the amount workers keep from their wages
Reduced incentive to work
Higher taxes may discourage overtime or seeking higher-paid jobs
Impact on employment
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If firms cut costs to pay higher taxes, jobs may be lost or wage growth may slow
Impact on producers/firms Your notes
Higher costs of production
Indirect taxes (e.g. VAT) make production more expensive
Reduced sales
Higher prices can lower demand, especially for price-sensitive goods
Lower profits
Increased costs and reduced sales can reduce profitability
Business decisions
Firms may relocate to countries with lower taxes or invest less in expansion
Impact on the government
Revenue generation
Taxation is the main source of government income for funding public services (e.g.
healthcare, education)
Economic control
Taxes can discourage harmful consumption (e.g. sugar tax) or reduce imports (e.g.
tariffs)
Redistribution of income
Progressive taxes (higher rates for higher earners) can reduce income inequality
Impact on the economy
Reduced spending and investment
High taxes can slow economic growth if they reduce consumption and business
activity
Inflationary pressures
Indirect taxes can raise prices, contributing to inflation
Improved public services
Tax revenue allows the government to invest in infrastructure, education and
healthcare, which can boost productivity in the long term
Balancing effects
The overall impact depends on tax rates, how revenue is used and the state of the
economy
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Fiscal Policy Measures
Your notes
Understanding fiscal policy
Fiscal policy involves the use of government spending and taxation (revenue) to
influence total (aggregate) demand in the economy
Fiscal policy is usually presented annually by the government through the Government
Budget
Fiscal policy can be expansionary in order to generate further economic growth
Fiscal policy can be contractionary in order to slow down economic growth or
reduce inflation
Fiscal policy measures
When using fiscal policy, the government can change two main elements:
Changes in taxes
Reducing taxes increases consumers’ disposable income and may encourage higher
spending
Increasing taxes reduces disposable income, lowering spending and potentially
slowing inflation
Changes in government spending
Increasing spending boosts demand for goods and services, creating jobs and
encouraging growth
Decreasing spending reduces total (aggregate) demand, which can slow inflation but
may lead to higher unemployment
The effects of fiscal policy on
macroeconomic aims
To understand the effects of fiscal policy on an economy, it is useful to know how total
demand (gross domestic product) is calculated
Total (aggregate) demand = household consumption (C) + firms' investment (I) +
government spending (G) + exports (X) - imports (M)
AD = C + I + G + (X − M)
From this, it is logical that changes to fiscal policy can influence any of these
components – and often several of them at once
Expansionary fiscal policy
Lower taxes and/or higher government spending
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Increases total (aggregate) demand in the economy, encouraging higher output
and employment
Your notes
Useful during a recession to boost economic growth and reduce unemployment
May risk higher inflation if total (aggregate) demand grows too quickly
Can be directed towards sustainable growth by funding renewable energy, public
transport, and green infrastructure
Contractionary fiscal policy
Higher taxes and/or lower government spending
Reduces demand in the economy, helping to control inflation
Useful when the economy is overheating or inflation is high
May slow growth and increase unemployment if used for too long
Can support environmental sustainability by reducing subsidies for polluting industries
and increasing taxes on harmful activities (e.g. carbon taxes)
Link to macroeconomic aims
Macroeconomic aim How fiscal policy can help achieve it
Economic growth Increase government spending on projects and cut taxes to
encourage spending and investment
Lower inflation Raise taxes or reduce spending to lower total demand and
reduce price pressures
Lower unemployment Fund job creation schemes and infrastructure projects,
lower taxes to stimulate hiring
Healthy balance of Tax imports (tariffs) to reduce demand for foreign goods
payments and support domestic industries
Fairer income Use progressive taxes and targeted government spending
distribution to reduce inequality
Sustainability Fund renewable energy, protect natural resources and use
environmental taxes to encourage greener behaviour
Examiner Tips and Tricks
When discussing sustainability in fiscal policy, focus on long-term benefits. For
example: “Government investment in renewable energy creates jobs now while
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reducing future environmental costs"
Examples of fiscal policy Your notes
Contractionary fiscal policy
Example 1 The government increases income tax levels
Effect on the economy Consumers pay more tax → discretionary income reduces
→ consumption reduces → total demand reduces
Impact on Economic growth slows down
macroeconomic aims
Inflation eases
Unemployment may increase as output is falling and fewer
workers are required
Current Account Improves (with less income, imports may
fall)
Example 2 The government freezes/reduces public sector workers pay
Effect on the economy Wages stagnate or reduce → Consumer confidence falls
→ consumption decreases → total demand decreases
Impact on Economic growth slows down
macroeconomic aims
Inflation eases
Unemployment may increase as output is falling
Current Account improves (with less income, imports may
fall)
Example 3 The government cuts public spending in its budget
Effect on the economy Less demand for goods/services → less income for firms
→ output and profits decrease → total demand decreases
Impact on Economic growth slows down
macroeconomic aims
Inflation eases
Unemployment may increase as output is falling
Current Account improves (with less income, imports may
fall)
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Less corporation tax available for redistribution
Sustainability may worsen due to lower green subsidies Your notes
being available
Expansionary fiscal policy
Example 1 The government decreases corporation tax
Effect on the Firms' net profits increase → investment by firms increases →
economy total demand increases
Impact on Economic growth increases
macroeconomic
aims Inflation rises
Unemployment may decrease as output is rising, which
requires more workers
Current Account – Unsure – Exports may rise due to new
investments in the economy, but imports may rise due to
higher income generated by the investment
Example 2 The government increases unemployment benefits
Effect on the Household income increases → consumption increases →
economy total demand increases
Impact on Economic growth increases
macroeconomic
aims Inflation rises
Unemployment may decrease as output is rising, which
requires more workers (although increased unemployment
benefits may discourage some people from entering the
labour market)
The Current Account is unlikely to change, as this policy helps
the poorest and imports are unlikely to increase
Redistribution of income has increased and there is more
equity in society
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