Chapter 31
FISCAL POLICY
Government Policy Instruments and Fiscal Policy
Introduction to Policy Instruments
Governments have several tools at their disposal to influence the overall
performance of the economy. These tools are known as policy instruments.
Definition:
Policy instruments are economic variables that governments can manipulate to
achieve their macroeconomic objectives, such as:
•Controlling inflation
•Reducing unemployment
•Promoting economic growth
•Managing aggregate demand
Examples of policy instruments include:
• Interest rates
• Taxation rates
• Government expenditure
Governments can use these tools directly or indirectly, and any
change in these variables can significantly impact:
• Aggregate demand
• Inflation
• Employment levels
• Gross Domestic Product (GDP)
Fiscal Policy
One of the most critical policy instruments is fiscal policy.
Definition:
Fiscal policy involves the use of government spending and taxation to
influence the economy.
Goals of Fiscal Policy:
• Stimulate or slow down economic activity
• Maintain economic stability
• Influence the behavior of firms and individuals
Example:
Governments may impose high taxes on cigarettes to reduce their
consumption, thereby addressing public health concerns.
Government Budgeting and Fiscal Planning
Each year, governments prepare a budget that outlines:
• Spending plans for various sectors
• Revenue sources, such as taxes
• Borrowing levels if spending exceeds revenue
The budget plays a crucial role in implementing fiscal policy, showing:
• How funds will be allocated
• How much will be collected in taxes
• Whether there will be a surplus or deficit
Introduction to Government Taxation: Taxation is the main source of revenue for
governments worldwide. It plays a vital role in financing public services and shaping
economic behavior.
Reason for Taxation Explanation Example(s)
Provides revenue for essential Education, healthcare,
Fund public services services and infrastructure that infrastructure, national
benefit society. defense
Discourage harmful Imposes taxes to reduce activities Cigarette tax to reduce
activities that cause health, social, or smoking; landfill tax to
environmental harm. promote recycling
Control aggregate Helps regulate economic activity by Increasing taxes to reduce
demand influencing spending and managing inflationary pressure
inflation.
Promote fairness in Uses progressive taxation to Higher tax rates for the
wealth distribution redistribute wealth and reduce wealthy compared to the
income inequality. poor
Types of Taxes:
Government taxes are commonly divided into two major
categories:
•Direct taxes: are imposed directly on individuals and businesses,
and are typically based on income or wealth.
•Indirect taxes: are taxes that are not directly paid on income or
wealth but instead are applied to spending. They are usually
collected by businesses at the point of sale and then passed on to
the government.
Direct Taxes Indirect Taxes
Taxes paid directly to the government by Taxes collected indirectly through
Definition
individuals or businesses of goods and services
Paid by the person or entity on whom it is Collected by sellers but paid by
Taxpayer
levied consumers
Can be shifted to others (passed o
Burden Cannot be shifted to others
consumers in prices)
Income tax, corporation tax, inheritance tax, VAT, sales tax, customs duties, exc
Examples
capital gains tax duties, stamp duty
Based on a person’s income, profit, or
Link to Income/Wealth Based on expenditure (spending)
assets
Often progressive Often regressive
Progressive Nature
higher income = higher tax affects lower-income groups more
Collected at the point of sale, often
Ease of Collection Collected annually or monthly, with records
automatically
Raises revenue and influences
Purpose Raises revenue and promotes equity
Types of Direct Taxes Description Who Pays It Purpose / Notes
Tax on the income Employed and self- Widely used globally to fund
Income Tax earned by individuals employed individuals public services
Similar to income tax, Individuals and Funds pensions, healthcare, and
Social Insurance but revenue is used for employers (varies by other benefits
Taxes specific social programs country) Example: Canada (2015): CAD
1,065,000 million
Corporation Tax Tax on profits made by Limited companies Sole traders and partnerships
limited companies usually pay income tax instead
Tax on profit made from Individuals and Applied on the gain (selling price
minus purchase price)Ensures
Capital Gains Tax selling assets like shares, businesses selling investment gains contribute to
businesses, or property assets public finances
Often has a tax-free threshold
Used to prevent untaxed wealth
Tax on money or assets Beneficiaries of an transfer and promote
Inheritance Tax inherited from someone redistribution
who has died inheritance It can also be a tool for
promoting wealth
redistribution.
Type of Indirect
Tax Description Examples / Notes Who Pays It
Common in EU:- Denmark: 25%- Belgium:
21%- Italy: 22%Some essentials (food,
Taxes applied on purchases Consumers (collected
Sales Taxes (VAT) medicine, books, public transport) may be
of goods and services by sellers)
zero-rated. Small businesses with low
turnover may be exempt.
Duties (Excise High taxes on specific goods Raise revenue and discourage harmful Consumers (via price
Duties) like petrol, alcohol, cigarettes consumption increases)
In UK, goods from non-EU countries attract
Customs Duties Taxes on imported goods customs duties. Aims to protect local Importers/consumers
industries and regulate trade
Local tax paid by residents to
fund local services such as Based on the value of residential property
Council Tax Residents/occupants
refuse collection and and paid by occupants
infrastructure
Local tax on commercial Paid by businesses based on value of their
Business Rates Businesses
properties business property
Tax paid when purchasing
One-time tax collected at point of transfer
Stamp Duties certain high-value assets Buyers
or sale
such as houses and shares
ENVIRONMENTAL TAX
Tax Type Description Goal / Purpose Who Pays It
Tax on the disposal of
Landfill Tax waste in landfill sites, Encourage recycling and Waste producers / landfill
usually charged by weight waste reduction operators
Help meet greenhouse gas
Tax paid mainly by energy reduction targets;
Climate Change Levy suppliers (electricity, gas, promote energy efficiency Energy suppliers
coal) and lower carbon
emissions
Tax on extraction of Reduce environmental
natural materials like sand, damage from quarrying; Extractors / quarry
Aggregates Levy gravel, and rock used in encourage reuse of operators
construction materials
Introduction to Government Spending
Each year, governments announce their planned expenditure in the national
budget. This includes how much they intend to spend and on what areas.
Spending is usually categorized as:
• Mandatory Spending:
Spending that the government is legally obligated to make.
Example: Jobseeker’s Allowance – if someone is made redundant, the
government must provide this support.
• Discretionary Spending:
Optional or new spending that is decided annually by the government.
Example: Funding for a new motorway.
•CLASS ACTIVITY
•State whether the following are mandatory or
discretionary spending
• GROUP B
•GROUP A
• New sports stadium construction
• State pensions • Social security disability benefits
• Jobseeker’s Allowance • Space exploration program
• Public school teacher salaries • Fire department equipment
• New motorway construction purchase
• Military equipment purchase • Primary school lunch program
• National park maintenance • Foreign aid to developing
• Disaster relief fund countries
• Public housing rent subsidies • Street lighting maintenance
• Funding for an art festival • Prison operating costs
• Hospital building maintenance • National holiday fireworks display
Main Categories of Government Spending
Category Main Examples
Social Protection State benefits, pensions, child benefits, jobseeker’s allowance, disability
support
Health Care Salaries for medical staff, cost of medicines, hospital equipment and programs
Education Teacher salaries, school equipment, student grants
Defence Maintaining armed forces (army, navy, air force)
Interest Payments on national debt and other borrowings
Public Order/Safety Police, fire services, justice system, prison service, health and safety
Social Services Care for children, elderly people, and those with learning disabilities
Other Transport, housing, environment, agriculture, training, recreation
Fiscal Deficits and Fiscal Surpluses
•Fiscal Deficit: The amount by which government spending exceeds government revenue.
•Fiscal Surplus: The amount by which government revenue exceeds government spending.
In many years, governments tend to spend more money than they receive from taxes. This
situation creates a fiscal deficit.
• To cover this deficit, governments must borrow money, which may come from domestic or
foreign banks and sometimes other governments.
For example, Canada planned to borrow CAD 439,000 million to cover its fiscal deficit in
a given year.
Conversely, if a government spends less than it receives in tax revenue, it results in a fiscal
surplus.
• Fiscal surpluses are important because they \ be used to repay government debts.
For instance, Sweden experienced several years of fiscal surplus before 2009 but then
ran deficits from 2009 to 2014. By 2015, Sweden managed to generate another surplus.
Impact of a Fiscal Deficit and a Fiscal Surplus
• National Debt: The total amount of money owed by a country.
• Stimulate: To encourage an activity to begin or develop further.
Fiscal Deficits
• Governments generally prefer to avoid running fiscal deficits because they must
borrow money to cover overspending.
• If deficits persist over time, the national debt increases continuously.
• A growing national debt means more government revenue is spent on interest
payments.
• This spending has a high opportunity cost—money spent on debt interest could
instead fund social programs, infrastructure, or tax reductions.
• Persistent fiscal deficits also risk burdening future generations with debt they did
not create, which raises fairness concerns.
Fiscal Surpluses
•Fiscal surpluses occur when a government collects more revenue than it spends.
•Surpluses can be used positively in several ways:
• To improve public services.
• To reduce taxes.
• To pay off national debt, which lowers future interest payments and
strengthens the country’s financial position.
•When analyzing deficits or surpluses, it is important to consider their size relative to
the nation's GDP to better understand their economic impact.
Fiscal Policy Type Description Actions Taken by Purpose
Government
- Increase budget Boost economic
Expansionary Fiscal Used to stimulate deficit (spend more or activity by
Policy the economy. tax less) encouraging spending
and investment.
-Reduce budget surplus
Used to reduce Slow down economic
Contractionary Fiscal aggregate - Decrease budget deficit activity to control
Policy demand. (or increase surplus) inflation.
- Spend less or increase
taxes
Topic Explanation
Contractionary fiscal policy reduces inflation by cutting
government spending or raising taxes, which lowers
Inflation
disposable income and demand, easing inflationary
pressure.
Expansionary fiscal policy stimulates growth by
increasing government spending and cutting taxes, which
Economic Growth
raises demand and investment in projects like schools
and transport.
Expansionary fiscal policy reduces unemployment by
increasing government spending and cutting taxes,
Unemployment stimulating demand, leading firms to produce more and
hire more workers, especially in labor-intensive
industries like construction.
Fiscal policy can help reduce a large current account
Current Account Deficit deficit by contractionary measures that reduce demand
and imports.
Governments use fiscal policy to address environmental
issues through taxes like landfill tax and climate change
Fiscal Policy and the Environment
levies, and subsidies to encourage environmentally
friendly practices.
- Use contractionary fiscal policy to reduce inflation - Cut government spending
or increase taxes - Higher taxes reduce disposable income - Lower disposable
Inflation income reduces consumer spending and demand - Reduced demand eases
inflationary pressure
- Use expansionary fiscal policy to boost growth - Increase government spending
and cut taxes - More spending means higher aggregate demand - Hiring civil
Economic Growth servants and workers raises demand for goods/services - Investment in
infrastructure projects (schools, transport) creates jobs and growth
- Expansionary fiscal policy helps lower unemployment - Government increases
spending and cuts taxes to stimulate demand - Higher demand leads firms to
Unemployment produce more and hire workers - Direct government spending to labor-intensive
projects (hospitals, motorways, rail links) - Job creation reduces unemployment
- Fiscal policy can help balance the current account - Use contractionary policy to
Current Account Deficit reduce aggregate demand if deficit is large - Lower demand reduces imports -
Helps improve the current account balance
- Governments use fiscal policy to tackle environmental issues - Environmental
Fiscal Policy and taxes (landfill, climate change, aggregates levy) encourage sustainable behavior -
Taxes create financial incentives to reduce waste and emissions - Subsidies
Environment support environmentally friendly activities - Helps reduce environmental damage
and promote green growth
The Egyptian economy is expected to grow between 2.8% and 4%
in the financial year 2020–2021. Even higher levels of economic
growth are forecast for the following year. Unemployment rates
have fallen to 7.3% in the third quarter of 2020 from 7.8% in 2019.
Egypt's annual inflation rate increased to 6.3% in 2020, up from
2.7% in 2019.
(c) With reference to the data above and your knowledge of
economics, evaluate the extent to which fiscal policy can be used to
control inflation in a country such as Egypt. (12)
Make this a 9 mark question. . Evaluate replaced with assess
Which one of the following is considered to be a progressive tax
in the UK?
(1)
A Income tax
B Value added tax (VAT)
C Excise duties
D Import tariff
San Francisco, a city in the US, raises its own taxes and plans its own
spending. It expects its budget to have a fiscal surplus for the first
time since 1998. The city is expecting this surplus to be $108m.
“Over the last two years, while we have invested heavily in key
priorities like homelessness and mental health, we have also made
smart budgeting decisions, and this surplus is a result of that work,”
said the Mayor of San Francisco. The Mayor has not decided where
to spend the surplus, but this week called for more funding for
police and to improve public safety.
(g) With reference to the data above and your knowledge of
economics, assess the benefits of having a fiscal surplus for a city
such as San Francisco. (9)
June 2023 Int GCSE Economics 4EC1 02R
Definition
Advatage 1 of fiscal surplus … explain ----analyze it
Advantage 2 of fiscal surplus ---explain ---analyze it
2 disadvantages of fiscal surplus ….or why FS might
not be an advantage
Conclusion
Fiscal surplus is when government revenue is greater than government expenditure. A benefit
of having a fiscal surplus for a city such as San Francisco is that the government has more
money to spend on things that may improve the standard of living in the city, such as funding
for police in order to improve public safety, as mentioned in the data above.
The government could also use the $108m surplus to improve other aspects in the economy,
such as high inequality, which can be countered with benefit payments.
However, a negative effect of having a fiscal surplus for a city such as San Francisco is that
taxes had to be raised in order to reach a fiscal surplus of $108m. Increased taxes can have
negative effects towards an economy, such as people having less disposable income of which
they could have used to spend on things that would increase their standards of living. A
greater financial burden is also placed on the citizens of the city, as they need to pay a greater
amount of money in taxes to the government. This may create problems with people being
able to meet basic financial needs, such as buying food, which is a negative effect to the
economy as Aggregate demand decreases as people have less money to spend on goods &
services, which decreases AD, therefore decreasing economic growth.