2.5.1a Fiscal policy and its functions

Fiscal Policy Uses Spending, Taxation and the Budget Balance to Steer the Economy

1. Fiscal policy uses government spending, taxation and the budget balance to influence the economy.
2. In the UK it is set by HM Treasury and announced by the Chancellor in the annual Budget.
3. Expansionary fiscal policy raises spending or cuts taxes to lift aggregate demand.
4. Contractionary fiscal policy cuts spending or raises taxes to slow it.

Three Functions: Demand-Side, Supply-Side and Microeconomic

1. Fiscal policy works mainly on the demand side, but it also has supply-side and microeconomic effects.

• Demand-side: changes in spending and taxation shift aggregate demand, affecting output, employment and the price level.
• Supply-side: tax changes alter incentives to work and invest, and spending on skills or infrastructure raises productive capacity.
• Microeconomic: government spending and taxation change the pattern of economic activity, affecting households, firms and particular markets differently.

Showing Fiscal Policy on an AD/AS Diagram

1. Label the axes as the average price level and real output.
2. Expansionary policy shifts aggregate demand to the right, raising real output, the price level and employment; contractionary policy shifts it to the left.
3. How far output rises rather than the price level depends on the slope of the AS curve and how close the economy is to full capacity.

How Effective Is Fiscal Policy?

1. Time lags: recognition, decision and impact lags can mean the policy arrives too late.
2. Crowding out: extra borrowing can raise interest rates and displace private investment.
3. The multiplier: if saving or import leakage is high, each £1 of spending circulates less and the effect is muted.
4. Political constraints: governments may avoid unpopular tax rises or spending cuts, or act for electoral reasons.
5. Fiscal policy is most effective in a deep recession with spare capacity, where the multiplier is large and crowding out is unlikely.
6. Near full capacity the same policy mainly raises the price level, so it interacts with monetary policy and works best when the two pull in the same direction.

2.5.1b Public expenditure and taxation

Public Spending and Taxation: Types, Reasons and How Taxes Are Classified

Types and Reasons for Public Expenditure

1. Capital spending is investment in long-lived assets, such as new roads or hospitals.
2. Current spending covers day-to-day running costs, such as public sector wages, state schools and defence.
3. Transfer payments move income between groups, such as the State Pension and Universal Credit, and are not payment for output.
4. Governments spend to provide public and merit goods, to redistribute income towards those in need, and to manage the level of aggregate demand.

Why Governments Tax, and Direct Versus Indirect Taxes

1. Governments levy taxes to fund public spending, redistribute income, correct market failure and influence aggregate demand.
2. Direct taxes are levied on income and wealth, such as income tax and National Insurance.
3. Indirect taxes are levied on spending, such as VAT.
4. A good tax is judged on principles such as equity (fairness), certainty, convenience and efficiency.

Progressive, Proportional and Regressive Taxes

1. Progressive tax: the average rate rises as income rises, for example UK income tax.
2. Proportional tax: the average rate stays constant as income rises.
3. Regressive tax: the average rate falls as income rises, as with VAT, which takes a larger share of a low income.
4. It is the average rate ($\frac{tax\; paid}{income}\times 100$), not the marginal rate (the tax on the next £1 earned), that tells you whether a tax is progressive.
5. The mix of taxes therefore shapes the distribution of income.

Worked Example: Average and Marginal Tax Rates

1. Someone earning £30,000 who pays £6,000 in tax faces an average rate of £6,000£30,000×100=20%\dfrac{\pounds 6{,}000}{\pounds 30{,}000} \times 100 = 20\%£30,000£6,000​×100=20%.
2. If income rises to £40,000 and tax rises to £9,000, the extra £3,000 on the extra £10,000 is a marginal rate of £3,000£10,000×100=30%\dfrac{\pounds 3{,}000}{\pounds 10{,}000} \times 100 = 30\%£10,000£3,000​×100=30%.
3. The average rate rises from $20\%$ to £9,000£40,000×100=22.5%\dfrac{\pounds 9{,}000}{\pounds 40{,}000} \times 100 = 22.5\%£40,000£9,000​×100=22.5%, so the tax is progressive.
4. UK income tax is progressive for exactly this reason.
5. A tax-free personal allowance (around £12,570) is followed by a 20 per cent basic rate, a 40 per cent higher rate and a 45 per cent additional rate.
6. Even though each band has a fixed marginal rate, moving into higher bands pulls the average rate up, so higher earners pay a larger share of their income.

Weighing the Relative Merits of the Main UK Taxes

1. Income tax is progressive and equitable and raises large, reliable revenue, but high marginal rates can weaken work incentives and encourage avoidance.
2. VAT is broad-based, hard to evade and gives stable revenue, but it is regressive because it takes a larger share of a low income.
3. Corporation tax raises substantial revenue, but can deter investment and weaken international competitiveness if set too high.
4. Excise duties correct externalities and give stable revenue from inelastic demand, but are regressive and can encourage smuggling.

2.5.1c Budget balances and the national debt

The Budget Balance Is a Yearly Flow; the National Debt Is the Accumulated Stock

The Budget Balance and Budget Positions

1. Budget balance: the difference between government spending and tax revenue over a year.
2. Budget deficit: spending exceeds revenue, so the government must borrow.
3. Budget surplus: revenue exceeds spending, allowing debt to be repaid.
4. A balanced budget is where the two are equal.

Deficit and Debt: A Flow and a Stock

1. A fiscal (budget) deficit is a flow: the amount by which spending exceeds revenue in a single year.
2. The national debt is a stock: the total accumulated past borrowing not yet repaid.
3. Each year's deficit adds to the national debt, while a surplus reduces it.
4. Think of a bath: the deficit is the flow from the tap, and the debt is the water in the bath.
5. So the debt can keep rising even when the deficit is falling, because a smaller deficit still adds to the stock, just more slowly.

1. The debt is usually judged as a share of GDP, not in cash terms, so a growing economy can carry a rising debt if GDP grows faster.

Cyclical and Structural Deficits and Surpluses

1. A cyclical deficit arises because output is below trend, with lower tax revenue and higher benefit spending; it fades as the economy recovers.
2. A structural deficit remains even at the trend level of output and needs policy action to remove.
3. The balance moves automatically over the cycle, improving in a boom and worsening in a downturn, so sustainability depends mainly on the structural part.

Consequences and the Significance of the National Debt

1. A deficit can support aggregate demand in a recession, while a surplus withdraws demand; persistent deficits add to the debt.
2. A large debt must be serviced with interest, which has an opportunity cost in lost spending on schools or hospitals and raises questions of fairness between generations.
3. A very high debt can risk a credit downgrade and higher borrowing costs.
4. A rising debt is not automatically harmful, though: borrowing to fund investment can raise future output, so the cost of borrowing must be weighed against the return on what it finances and the size of the debt relative to GDP.

2.5.1d The Office for Budget Responsibility

The OBR Is an Independent Forecaster and Scrutineer, Not a Policymaker

1. The OBR was set up in 2010 to bring independent, transparent forecasting to the Budget process, ending the previous practice in which the Treasury produced its own forecasts and could be tempted to present them favourably.

What the OBR Does

1. Independent forecasts: it produces the official economic and fiscal forecasts, published in its Economic and Fiscal Outlook at least twice a year alongside the Budget.
2. Scrutiny of costings: it scrutinises the costing of the government's tax and spending measures.
3. Sustainability: it assesses the long-run sustainability of the public finances and reports on the outlook for the national debt.
4. It judges whether the government is on track to meet its fiscal rules.

Why Independence Matters

1. An independent body improves transparency and reduces the temptation to publish over-optimistic forecasts.
2. This raises the credibility of fiscal policy in the eyes of investors who lend to the government.
3. Even so, forecasting is inherently uncertain, so OBR projections are frequently revised as new data arrive and should not be treated as guaranteed outcomes.