Fiscal policy

Key features of fiscal policy `

Involves government spending and taxation- it can influence the economy as a whole or individual firms and people

Two important features of fiscal policy are:

Automatic stabilisers- these reduce the problems a recession causes but at the expense of creating a budget deficit

Discretionary policy- this is where the governments deliberately change their level of spending and tax

Expansionary fiscal policy

Expansionary fiscal policy- involves boosting AD by increasing government spending or lowering taxes- it’s likely to involve a government having a budget deficit (government spending >revenue)

Expansionary policy is likely to be used during a recession or when there is a negative output gap- it’ll increase economic growth and reduce unemployment but it will also increase inflation and worsen the current account of the balance of payments because as income increase more is spent on imports

Contractionary fiscal policy

Contractionary fiscal policy- involves reducing AD by reducing government spending or increasing taxes- it’s likely to involve a government having a budget surplus (government spending<revenue)

Likely to be used during a boom or when there is a positive output gap- it’ll reduce economic growth and increase unemployment, but it’ll also reduce price levels and improve the current account of the balance of payments because as incomes fall less is spent on imports

Governments raise tax revenue through direct taxation and indirect taxation

Also use different tax systems to achieve this such as progressive tax, regressive tax and proportional tax

Progressive tax- where an individuals taxes rise as their income rises, and it is often used to redistribute income and reduce poverty - government can use this tax revenue from those on high incomes and redistribute it to those on low incomes in the form of benefits

Regressive tax- is where an individuals taxes fall as their income rises and they’re used by the government to encourage supply side growth- By reducing the taxes of the rich the government will hope that the economy will benefit from the trickle down effect - gives an incentive to work harder and earn more income but may increase inequality

Proportional tax- where everyone pays the same proportion of tax regardless of their income level - however it is difficult to apply as for the low incomes it can be difficult to afford

Different types of tax

VAT- fixed percentage regardless of the selling price of the product

A more progressive system of VAT might be to tax luxury goods at a higher tax rate

Size of government spending can be affected by several things

Size and structure of a country’s population will affect levels of government spending - country with a large population may require greater levels of government spending than a country with a small population

Government policies on inequality, poverty and redistribution of income will alter the amount of government spending - might vary from each government depending on their political views

Fiscal policies government use to tackle certain problems in a country will also have an effect- during a recession a government may increase public spending to encourage growth and reduce unemployment

Large budget deficit can cause big problems

A budget deficit (also known as public sector borrowing) must be paid by the public sector borrowing, so that the government can spend more money than it receives in revenue

Borrowing is fine in the short run especially if the money is used to stimulate demand in a country

There will be problems if there is excessive borrowing as this could cause demand pull inflation partly due to the fact that government borrowing increases the money supply so there’s more money in the economy that can be matched by output

As borrowing may cause inflation it can lead to a rise in interest rates to curb the inflation- higher interest rates will discourage investment by firms and make a country’s currency rise in value meaning that it’s exports are less price competitive

Continued government borrowing will increase a country’s national debt

Large and long term national debt can cause several problems such as:

If a country’s debt becomes very large then it may cause firms and foreign countries to stop lending money to that country;s government- limits the country’s ability to grow in future

A large national debt suggests that there has been excessive borrowing which causes inflation and interest rates to rise

A country with large debt is less attractive to foreign direct investment (FDI) - as foreign countries will be uncertain how the debtor nation’s economy will do in future and whether it will be a good investment

Methods to correct a budget deficit will depend on what kind of budget deficit it is

Cyclical budget deficit- caused by recessions and comes about due to a governments automatic stabilisers (when government spending on benefits increases and tax revenue falls) - this kind of deficit will be corrected when the economy recovers again - the deficit will be replaced by a surplus

Structural budget deficit- caused by excessive borrowing is harder to solve. governments will have to raise taxes and reduce public spending so that they can pay off their debt - these actions could harm economic growth and cause other problems

Governments can

Borrow to invest in things like infrastructure but cannot borrow to fund current expenditure e.g. wages

Following these rules helps to prevent a government continuously borrowing and overspending which increases national debt and inflation

These rules can also influence the behaviour of businesses and consumers by increasing their confidence- consumers may be more willing to spend and firms may increase investment

Using fiscal policy to tackle poverty

Can be used to reduce poverty in a country- do this through benefits, provision of certain goods and services and progressive taxation

Government spending e.g. pensions is a way of helping those who are unemployed or unable to work and reducing absolute poverty

Government can also spend its tax revenue to provide goods and services such as free healthcare and education to enable those who are suffering from poverty to have access to these things

By providing some goods and services to poorer members of society a government will be investing in the improvement of the country’s human capital - i.e. spending may make labour much more productive

Progressive taxation may reduce relative poverty by narrowing the gaps between people’s disposable income and this revenue raised can pay for benefits and the state provision of goods and services