Chapter 23

Fiscal Policy
Government Budget
➢ A statement of the government’s planned revenue (mainly from
taxation) and expenditure (spending) over a specific period,
usually one yea.
➢ Shows the government’s fiscal policy intentions

➢ The Government Budget (Fiscal policy) is presented each year as

a balanced budget, a budget deficit, or a budget surplus.

✓ A balanced budget means that,

government revenue = government expenditure
✓ A budget deficit means that,
government revenue < government expenditure
✓ A budget surplus means that,
government revenue > government expenditure

➢ A budget deficit has to be financed through public sector borrowing. This borrowing gets
added to the public debt.

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

Question
Answer
• Government revenue = $800 billion

• Government expenditure = $900 billion

Calculate the budget balance and determine if it in surplus or deficit.

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The reasons for government spending
Reason Easy Explanation

1. Influence economic More government spending increases total demand in the economy
activity → businesses produce more → economy grows.

2. Reduce market Private businesses won't provide things like street lights or defence
failure (public goods) or enough schools and hospitals (merit goods). So the
government provides them.

3. Use the multiplier Extra government spending leads to even more total spending.
effect Example: 20m→becomes20m→becomes100m as people keep
spending what they earn.

4. Promote fairness Government helps the poor, elderly, and unemployed with pensions,
(equity) housing subsidies, and free education.

Direct financial support to vulnerable groups to improve living

standards.

5. Pay interest on If the government borrowed money before, it must pay interest on
national debt that loan, just like you do on a credit card.

Prevents default and maintains credibility in financial markets.

6. Encourage Government pays for things like solar panel subsidies and home
environmental insulation to protect the environment.
sustainability
Funding for conservation, pollution control, and climate change
adaptation.

What is the multiplier effect?

The multiplier effect occurs when an initial increase in spending, such as government investment,
leads to a larger overall increase in national income, output, and employment as the money
circulates through the economy. For example, if the government spends money to build a road,
workers and businesses earn income and spend it on goods and services, creating further income
and jobs.

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Taxation
Taxes are compulsory charges levied by the government to finance public expenditure.

Reason for Taxation Explanation

Raise government revenue The main aim; tax revenue is the primary source of government
income in many countries.

Redistribute income Higher-income groups pay more tax; some revenue funds benefits
for low-income groups.

Discourage consumption of Taxes on products like cigarettes and sugary drinks reduce their use,
demerit goods as the government considers them more harmful than consumers
realise.

Reduce imports and protect Tariffs on rival imported products make foreign goods more
domestic industries expensive, encouraging people to buy domestic products.

Influence aggregate Cutting taxes boosts consumption and investment (e.g., during
demand rising unemployment); raising taxes can cool the economy.

Encourage environmental Taxes raise costs for firms that cause pollution or environmental
sustainability damage, discouraging harmful activities.

Classifications of Tax
1. Direct vs Indirect
Type Definition Example

Direct Levied on income or wealth; payer bears the burden Income tax

Indirect Levied on spending; burden can be passed to consumers (e.g., VAT, petrol tax, plastic
higher prices) bag tax

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2. Progressive, Proportional, Regressive
Type of Tax Definition Effect as Income Rises Example
Progressive tax One which takes a larger Tax rate increases Income tax
percentage of the income or (higher bands)
wealth of the rich. As income rises, a
larger percentage of
Direct taxes are regressive income is paid in tax.

Proportional tax One which takes the same Tax rate stays constant Flat income tax
percentage of the income or rate
wealth of all taxpayers. As income rises, the
same percentage of
income is paid in tax

Regressive tax One which takes a larger Tax rate decreases (rich Excise duty on
percentage of the income or pay lower % of their petrol, plastic
wealth of the poor. income) bag tax

Indirect taxes are regressive As income rises, a

smaller percentage of
income is paid in tax

Exmaple
Income ($) Progressive Tax Proportional Tax Regressive Tax

100 10% tax rate 25% tax rate 40% tax rate
($10 tax) ($25 tax) ($40 tax)

500 20% tax rate 25% tax rate 30% tax rate
($100 tax) ($125 tax) ($150 tax)

1000 40% tax rate 25% tax rate 20% tax rate
($400 tax) ($250 tax) ($200 tax)

Who pays highest %? Rich All pay same % Poor

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The Main Types of Taxes
1. Direct Taxes (Levied on income or wealth)
Type of Tax Definition

Income tax A tax on income people receive from employment and investments. A tax
allowance (tax-free income) is given; income above this is taxable income.

Corporation A tax on the profits of firms (also called corporate tax).

tax

Capital gains A tax on the profit made when assets are sold for more than their purchase
tax price. Exemptions usually include the sale of a person's main residence.

Inheritance A tax on wealth above a certain amount that is passed on to others when a
tax person dies.

2. Indirect Taxes (Levied on spending)

Type of Tax Definition

Sales tax A tax imposed when products are sold. Main examples: GST (General Sales Tax)
and VAT (Value Added Tax).

Excise Taxes charged on certain domestically produced goods, most commonly:

duties alcoholic drinks, petrol, and tobacco. Charged in addition to VAT.

Customs Taxes on imports (also called tariffs).

duties

Licence A licence may be needed to use products including a television and a car.
fees

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3. Local Taxes (Levied by local authorities)
Used to pay for local services: education, fire services, libraries, roads, refuse collection.

Type of Based on Collected by

Local Tax

Business Property of local firms Government (then distributed to local

rates authorities based on population)

Council tax Value of people's housing and Local authority directly

expenditure of each council

Local sales Sales of products (used in some Local authority

tax countries)

The Impact of Taxation

➢ Tax base
The source of tax revenue (what is taxed). A wide tax base means many items/people are
taxed.
➢ Tax burden
The amount of tax paid by people and firms, sometimes as a % of GDP.
➢ Incidence of taxation
The distribution of an indirect tax shared between consumers and firms.

A wide tax base may enable low tax rates. High tax rates (especially corporation tax) can reduce
the tax base as firms may move abroad.

1. Impact on Consumers

Impact Explanation

Higher prices Firms pass some indirect tax (e.g., GST) to consumers.

Incidence depends on Who bears most of the tax depends on demand

elasticity elasticity.

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➢ The proportion of tax borne by consumers is represented by the change in price multiplied
by the quantity sold.

➢ The proportion borne by producers is the amount by which the price producers receive ater
tax is below the original market price, multiplied by the quantity sold.

Comparison of inelastic and elastic demand

Incidence of Taxation
Demand Who bears most Reason
Elasticity tax?
Inelastic Consumers Firms can pass on most tax as higher price because
demand demand won't fall much.

Elastic Firms Firms cannot pass on much tax because sales would
demand fall significantly.

Also affected by supply elasticity:

➢ More inelastic supply → Firms bear more tax

➢ More elastic supply → Consumers bear more tax

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2. Impact on Workers
Impact Explanation

Lower disposable Higher income tax widens gap between pre-tax income and take-
income home pay.

Reduced purchasing Less money to spend on goods and services.

power
Disincentive effect High tax rates may stop people working overtime, taking
promotions, or entering labour force.

Incentive effect High tax rates may encourage some to work harder (e.g., those
with fixed commitments like mortgages).

No effect on some Workers on fixed-hour contracts cannot change their hours.

Two opposing effects: High taxes can either discourage or encourage extra work depending on
personal circumstances.

3. Impact on Producers / Firms

Impact Explanation

Pay indirect taxes Firms are legally responsible for paying GST, excise duties, etc., to
government.

Pay corporation Tax on firm's profits.

tax
Discourages High corporation tax may discourage entrepreneurs from expanding or
expansion investing in new markets.

Encourages Firms may move to countries with lower corporate tax rates.
relocation.
May not After-tax profits are still high due to strong demand or government
discourage if... spending on training/infrastructure that reduces costs.

Benefit from Domestic firms competing with imports may welcome tariffs (customs
import taxes duties) as they give a competitive price advantage.

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4. Impact on the Government
Impact Explanation

Main source of revenue Most governments get most revenue from taxation.

More tax = more Higher revenue allows more spending on healthcare,

spending education, etc.

Influence aggregate Taxes can be raised or lowered to manage the economy.

demand
Reduce market failure Taxes on demerit goods (e.g., alcohol, cigarettes) reduce
consumption.

Reduces pressure on Lower consumption of demerit goods may reduce

healthcare government healthcare spending.

5. Impact on the Economy

Impact Explanation

Affects saving High taxes on income from saving reduce returns → some save
less, but target savers may save more.

Risk of discouraging Direct taxes set too high may discourage effort, enterprise, and
effort saving.

Benefits of direct taxes Redistribute income/wealth; good source of revenue.

Indirect taxes are Fall more heavily on those living in poverty.

regressive
Indirect taxes may Raising prices → workers demand wage increases → rising
cause inflation prices (inflation).

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Benefits of Indirect Taxes
Benefit Explanation

Easy and cheap to collect Firms do some of the work.

Less disincentive to effort Than direct taxes.

Can be used selectively E.g., reduce alcohol consumption.

Harder to evade Than direct taxes.

Easier to adjust Government can change rates quickly.

More consumer choice People can avoid highly taxed products by choosing what to buy.

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 Fical Policy

Fiscal policy involves the use of government spending and taxation (revenue) to influence
total (aggregate) demand in the economy.
OR

Decisions on government spending and taxation designed to influence aggregate demand.

Fiscal policy measures

When using fiscal policy, the government can change two main elements:

1. 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

2. 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.

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.

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 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

Rises in government expenditure and/or cuts in taxation designed to increase aggregate
demand.

➢ Lower taxes and/or higher government spending

✓ Increases total (aggregate) demand in the economy, encouraging higher output and
employment.
✓ 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.

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 Contractionary fiscal policy
Cuts in government expenditure and/or rises in taxation designed to reduce aggregate
demand.
➢ 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 ▪ Fund job creation schemes and infrastructure projects,
unemployment 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

When discussing sustainability in fiscal policy, focus on long-term benefits. For example:
“Government investment in renewable energy creates jobs now while reducing future
environmental costs"

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 Examples of fiscal policy
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)
• Less corporation tax available for redistribution
• Sustainability may worsen due to lower green subsidies being
available

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Expansionary fiscal policy

Example 1 The government decreases corporation tax

Effect on the economy ▪ Firms' net profits increase → investment by firms increases →
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 economy • Household income increases → consumption increases → 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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