Economics: Fiscal Policy

Fiscal policy

Decisions on government spending and taxation designed to influence aggregate demand (A.D).

Reasons for government spending

Influence economic activity, reduce market failure, promote equity, pay interest on national debt.

Reasons for levying taxation

Redistribute income, discourage consumption of demerit goods, raise the costs of firms that impose costs on others, discourage imports and protect domestic industries, influence economic activity.

Types of taxes

Direct - on income & wealth; Indirect - on expenditure.

Progressive tax

A tax that takes a larger percentage of income from the rich.

Proportional tax

A tax that takes an equal percentage of income from both rich and poor.

Regressive tax

A tax that takes a larger percentage of income from the poor.

Principles of taxation

Equity, certainty, convenience, economy, flexibility, efficiency.

Equity (tax principle)

Amount of tax paid should be based on ability to pay.

Certainty (tax principle)

Tax should be easy to understand.

Convenience (tax principle)

Tax should be easy to pay.

Economy (tax principle)

Cost of collecting should be significantly less than revenue earned.

Flexibility (tax principle)

Should be possible to change tax if economic activity changes or government aims change.

Efficiency (tax principle)

Tax should improve the performance of the markets or at least not significantly reduce the efficiency of the markets.

Incidence of tax

Distribution of the burden of indirect tax.

Impact of direct taxes

If too high, discourage effort, saving & enterprise.

Impact of indirect taxes

Consumers bear the brunt if producers can charge higher prices; producers bear the brunt if they cannot charge higher prices.

Expansionary fiscal policy

Increase in government expenditure and decrease in tax during a recession, leading to an increase in A.D.

Contractionary fiscal policy

Decrease in government expenditure and increase in tax, leading to a decrease in A.D.