Fiscal Policy - Principles, Spending and Taxation

Define fiscal policy

Macroeconomic policy implemented by the government

What are the main instruments of fiscal policy

• Government spending - welfare and public service

• Taxation - direct & indirect

• Fiscal balance - surplus/deficit of spending and tax revenue

What are the key roles of fiscal policy

• Correcting market failure

• Changing the final distribution of wealth and income

• Stabilising and stimulating AD and GDP

• Improving economy’s supply side potential (LRAS) - healthcare, education and infrastructure

• Responding to crises after economic shock

How does fiscal policy influence aggregate supply

SRAS = taxation and subsidies change business costs, government spending on infrastructure increases SRAS

LRAS = Investment in human capital, R&D, tax incentives and capital stock increase LRAS

Explain difference between current and capital spending

Current - spending on public services

Capital - Spending in infrastructure

What are justifications/the significance for government spending?

• Provide efficient level of public and merit goods to manage market failure

• Provide welfare benefits to the poorest to distribute wealth to achieve equity

• Infrastructure via capital spending

• Manage level of AD to meet macro objectives

How can government spending affect income

• Universal child benefits

• Unemployment benefits

• State pensions and other state provided services

• Targeted welfare payments linked to income

What is crowding out?

A rapid growth of government spending leads to a transfer of scarce productive resources from the private to public sector where productivity is lower.

What is a direct tax

A tax levied on income, wealth and profit

• Burden can not be passed on

What is an indirect tax

Taxes on spending

• Producers may be able to pass on indirect tax depending on PED

What is a progressive tax and describe the UK tax system

A tax where the marginal rate of tax (MRT) rises as income rises. UK income tax is progressive:

0 - 12,570 = 20%

12,571 - 50,000 = 40%

50,000 - 125,000 = 45%

What is a regressive tax?

The marginal rate of tax falls as income rises e.g. duties on tobacco and alcohol

What are the reasons for taxation

• Generating revenue

• Redistribution of wealth/income

• Economic stabilisation

• Regulation and incentives e.g. demerit goods

• Provide public goods

What are the effects of taxation on aggregate demand

• Changes on peoples disposable incomes

• Changes in corporation tax may affect post-tax profit available for businesses to invest

• VAT brings changes to retail prices and real income

What are the effects of taxation on aggregate supply

• Direct impact on LRAS and SRAS

• Changes in VAT affect business costs

• Direct taxes can influence work incentives

• Changes in business tax can affect level of FDI

What is vertical equity

Tax burden should be distributed fairly and reflect ability to pay

What are automatic stabilisers

Automatic fiscal changes as an economy moves through different stages of the business cycle

What are the automatic stabilisers in a boom

• Higher incomes increases tax burdens

• Government spending on benefits will be low as unemployment is low

• As a result government finances improve

What are the automatic stabilisers in a recession

• Falling incomes means lower tax burden = higher AD

• More spending on unemployment benefits/welfare

• This will increase the budget deficit as an injection into circular flow

What does the effect of automatic stabilisers depend on

• Whether they fully operate

• Relative generosity of the welfare system

• MPC/MPS

What is the fiscal multiplier

Estimates the final change in real national income as a result of a change in government spending/revenue plans

What is expansionary fiscal policy

Government aiming to increase AD by increasing government spending and/or lowering taxes

What is contractionary fiscal policy

Government aiming to decrease AD by reducing spending and/or increasing taxes