The concept of fiscal policy

What is fiscal policy?

Refers to the use of Commonwealth Government spending and taxation to affect the level of economic activity and to achieve specific economic and social objectives.

What are the main economic objectives of the government?

Economic growth, full employment and price stability

How does the fiscal policy operate?

Through the Government’s annual Budget Statement setting out its main priorities and its estimates for expenses (spending) and revenue.

What are the three broad categories of government expenses?

1. Government purchases

2. Government investment

3. Government transfer payments

What are government purchases?

Goods and services purchased by the government which accounts for around 60% of government spending.

For example health, education, defence and general public services.

How does an increase in government purchases affect aggregate demand, real GDP and employment?

An increase in aggregate demand and increase real GDP and employment

What are government investments?

Accounts for around 4% of the government’s spending

Includes public infrastructure such as transport, roads and bridges, public buildings such as schools and hospitals.

How does an increase in government investment affect aggregate demand/supply, real GDP and employment?

It will increase aggregate demand and increase real GDP and employment. It increases aggregate supply by adding to the nation’s capital stock.

What are government transfer payments?

Accounts for around 37% of government spending

Includes spending on social security, welfare payments including the age pension, disability payments and unemployment benefits.

How does an increase in transfer payments affect household disposable income, real GDP and consumption expenditure.

It will increase household disposable income and increase consumption expenditure which will then increase real GDP.

What are the three main categories of government taxation?

Personal income tax

Company tax

Consumption taxes

What is personal income tax?

A progressive tax levied on wage and salary earners.

It is the governments main source of income accounting for 47% of the Government’s total revenue.

What will an increase in income tax rate do to consumption expenditure, real GDP, employment, aggregate supply?

Will decrease consumption expenditure, shifting aggregate demand (AD) curve to the left, decreasing real GDP and employment.

An increase in income taxes may also effect the aggregate supply curves because it may reduce workers’ incentive to supply labour and therefore decrease aggregate supply.

What is company tax?

A flat rate tax levied on company profits. It accounts for 20% of the Government’s revenue.

What will an increase in company tax rate do to corporate profits and business investment, real GDP and employment?

An increase in the company tax rate will reduce corporate profits and decrease business investment, shifting the AD curve to the left, decreasing real GDP and employment.

What are consumption taxes?

GST and excise duties are indirect taxes levied on goods and services. These taxes account for around 20% of the government’s revenue.

How will an increase in taxes affect consumption expenditure and aggregate demand.

An increase in these taxes will decrease consumption expenditure which will then decrease aggregate demand.

How does the fiscal policy affect the level of economic activity?

It can directly affect the government purchases component in aggregate demand and indirectly affect the consumption and investment components through taxes and transfer payments.

When did fiscal policy first come around?

Fiscal policy first came into prominence during the Great Depression era of the 1930s when most economies suffered from unemployment rates that reached as high as 30% of the workforce.

What was considered vital for the government prior to the 1930s?

It was considered vital for the government to simply balance its budget and not interfere with the operation of the market economy.

Why was there little need for the government to stabilise the business cycle before the 1930s?

The economy was assumed to operate close to full employment so there was no need for the government to interfere.

Who showed that economies could get stuck in prolonged contractions and what did they suggest?

It was British economist, John Maynard Keynes, who was able to show that economies could get stuck in prolonged economic contractions and that the Government, through fiscal policy could stimulate the economy with increased government spending and/or tax cuts.

What was the Keynesian Revolution based on?

The ‘Keynesian Revolution’ was born based on the premise that aggregate demand was the most important driving force of the economy and that fiscal policy could be used to smooth the business cycle.