What you'll learn
- How the UK government budget is structured: spending, taxation, borrowing and debt.
- How changes in tax and spending affect aggregate demand using AD/AS analysis.
- Why Keynesian economists support demand-side fiscal policy in some circumstances.
- How fiscal policy can also improve the supply side through incentives and investment.
1. What fiscal policy means
Fiscal policy
Fiscal policy is the use of government spending, taxation and borrowing to influence economic objectives such as growth, inflation, unemployment, inequality and the public finances.
Fiscal policy is set by central government, mainly through the Budget, where the Chancellor announces tax and spending plans. It works through two broad routes:
- Demand side: changing total spending in the economy.
- Supply side: changing incentives, productivity and productive capacity.
The central trade-off
Fiscal policy can support growth and living standards, but it often involves trade-offs: higher spending or lower taxes may boost demand now, while also increasing borrowing and public sector debt.
2. The structure and purpose of the Budget
The Budget
The Budget is the government’s annual plan for how much it expects to raise in revenue, how much it plans to spend, and whether it needs to borrow.
The Budget has several purposes:
- Financing public services, such as the NHS, schools, defence and policing.
- Redistributing income, for example through benefits and progressive taxation.
- Stabilising the economy, by supporting demand in recessions or reducing inflationary pressure in booms.
- Improving long-run performance, through investment in infrastructure, education and technology.
- Correcting market failures, such as taxing pollution or subsidising merit goods.
Government spending
Major areas of UK government expenditure include:
- Social protection: pensions, Universal Credit and other welfare payments.
- Health: NHS spending.
- Education: schools, colleges, universities and training.
- Debt interest: payments on past borrowing.
- Defence, transport, law and order, and local government services.
Current and capital expenditure
Current expenditure is day-to-day spending, such as public sector wages, benefits and debt interest. Capital expenditure is investment in long-lasting assets, such as roads, hospitals, schools and broadband networks.
Capital spending is often more likely to raise productive capacity, but current spending can still be economically valuable: for example, health and education spending may improve human capital, meaning the skills, knowledge and health of workers.
Government revenue
The main UK sources of tax revenue include:
- Income tax and National Insurance contributions.
- VAT, a tax on spending.
- Corporation tax, a tax on company profits.
- Excise duties, such as fuel, alcohol and tobacco duties.
- Council tax, business rates and other smaller taxes.
Direct and indirect taxes
A direct tax is paid directly by individuals or firms on income, wealth or profit, such as income tax or corporation tax. An indirect tax is placed on spending and is usually collected by firms, such as VAT or fuel duty.
Direct taxes can be more progressive, meaning richer households pay a higher proportion of income. However, high direct tax rates may reduce incentives to work, invest or take risks.
Indirect taxes are often easier to collect and can discourage harmful consumption, such as smoking. However, they can be regressive, meaning they take a larger proportion of income from poorer households, and they can raise the cost of living.
Deficits, surpluses and debt
Deficit, surplus and debt
A budget deficit occurs when government spending is greater than tax revenue in a year. A budget surplus occurs when revenue is greater than spending. Public sector debt is the accumulated stock of past government borrowing that has not yet been repaid.
Calculating the budget balance
Suppose government revenue is £1,050bn, current expenditure is £1,000bn, and capital expenditure is £95bn.
- Add current and capital expenditure: total spending is £1,000bn + £95bn = £1,095bn.
- Compare revenue with total spending: £1,050bn − £1,095bn = −£45bn.
- The negative figure means the government has a budget deficit of £45bn.
- If public sector debt was £2,500bn before this borrowing, it would rise to approximately £2,545bn, ignoring other adjustments.
Deficit is not the same as debt
A deficit is annual borrowing. Debt is the total accumulated borrowing from many years. A country can reduce its deficit but still have rising debt if it is still borrowing overall.
3. Fiscal policy and aggregate demand
Aggregate demand
Aggregate demand, or AD, is total planned spending in the economy at a given price level. It is made up of consumption, investment, government spending, and net exports: AD=C+I+G+(X−M)AD = C + I + G + (X - M)AD=C+I+G+(X−M).
Fiscal policy affects AD in several ways:
- Higher government spending directly increases GGG.
- Lower income tax can raise disposable income, which is income after tax, increasing consumption.
- Higher welfare payments may raise consumption because lower-income households often spend a high proportion of extra income.
- Lower corporation tax or investment allowances may increase investment by firms.
An expansionary fiscal policy means higher spending, lower taxes, or both. A contractionary fiscal policy means lower spending, higher taxes, or both.
The effect depends heavily on whether the economy has spare capacity. If unemployment is high and firms have unused capacity, higher AD may mostly raise real GDP. If the economy is close to full capacity, higher AD is more likely to cause inflation.
Using the multiplier
Suppose the government increases infrastructure spending by £12bn. The marginal propensity to withdraw is 0.40.
- Identify the initial injection: the extra £12bn of government spending increases aggregate demand directly.
- Calculate the multiplier using k=1MPWk = \frac{1}{MPW}k=MPW1, so k=10.40=2.5k = \frac{1}{0.40} = 2.5k=0.401=2.5.
- Estimate the final change in national income: ΔY=12×2.5=30\Delta Y = 12 \times 2.5 = 30ΔY=12×2.5=30, so real GDP may rise by up to £30bn.
- Judge the diagram: if there is spare capacity, the rise in real GDP is more likely to be large; near full capacity, more of the effect becomes inflationary.
Diagram judgement
Do not just say “AD shifts right”. Explain where the economy starts. Spare capacity makes fiscal stimulus more effective; full capacity makes inflation more likely.
4. Keynesian demand-side fiscal policy
Keynesian economists, following John Maynard Keynes, argue that economies can get stuck below full employment because aggregate demand is too low. Wages and prices may be slow to adjust, so unemployment can persist unless the government intervenes.
Output gap
An output gap is the difference between actual real GDP and potential real GDP. A negative output gap means the economy is producing below potential, with spare capacity and cyclical unemployment.
Keynesians therefore support demand-side fiscal policy when:
- There is a recession or weak growth.
- Unemployment is high.
- Business confidence is low.
- Monetary policy, meaning central bank policy using interest rates and money supply, is less effective.
For example, during the COVID-19 pandemic, UK fiscal policy included the furlough scheme to protect jobs and household incomes. During the cost-of-living squeeze, energy bill support helped maintain disposable incomes, though it also added to borrowing.
Automatic and discretionary fiscal policy
Automatic stabilisers
Automatic stabilisers are features of the tax and welfare system that reduce fluctuations in the economy without new government decisions. In a recession, tax receipts fall and welfare spending rises, supporting household incomes.
Discretionary fiscal policy means deliberate changes, such as a new tax cut, public investment programme or spending reduction.
Evaluating demand-side fiscal policy
Demand-side fiscal policy can be powerful, but it is not guaranteed to work perfectly.
It is likely to be more effective when:
- There is a large negative output gap.
- The multiplier is high.
- Extra income goes to households with a high tendency to spend.
- Imports do not absorb too much extra spending.
Possible side effects include:
- Higher public sector debt and debt interest.
- Inflation if AD rises beyond productive capacity.
- Crowding out, where government borrowing or resource use reduces private investment.
- Time lags: projects and tax changes may take months or years to affect the economy.
- Future tax rises may be expected, causing households to save rather than spend tax cuts.
Borrowing can be sensible or risky
Government borrowing is not automatically “bad”. Borrowing to fund productive investment may raise future GDP. But persistent borrowing for day-to-day spending can become risky if debt interest rises or investors lose confidence.
5. The Laffer curve and tax incentives
The Laffer curve, associated with economist Arthur Laffer, shows a possible relationship between tax rates and tax revenue.
At a 0% tax rate, revenue is zero. At a 100% tax rate, revenue may also be very low because people have little incentive to earn taxable income. Somewhere between these extremes is a revenue-maximising tax rate.
Tax base
The tax base is the income, spending, wealth or profit that a tax is charged on. Tax revenue depends on both the tax rate and the size of the tax base.
The Laffer curve is often used to analyse whether cutting high tax rates could increase incentives to work, invest or declare income. However, it is difficult to know where the economy is on the curve.
Testing a tax cut on the Laffer curve
Suppose the top income tax rate falls from 50% to 45%. Initially, the taxable income base is £100bn.
- Calculate initial revenue using T=t×BT = t \times BT=t×B: T=0.50×100=50T = 0.50 \times 100 = 50T=0.50×100=50, so revenue is £50bn.
- Find the tax base needed to keep revenue unchanged at a 45% rate: B=500.45≈111.1B = \frac{50}{0.45} \approx 111.1B=0.4550≈111.1, so the tax base must rise to about £111.1bn.
- Compare with the original base: taxable income must rise by about £11.1bn, or 11.1%, just to maintain revenue.
- Conclude carefully: the tax cut raises revenue only if incentives, reduced avoidance and extra economic activity expand the tax base by more than this.
Misusing the Laffer curve
Do not claim that “tax cuts always increase revenue”. The Laffer curve only suggests this may happen when tax rates are already very high and behavioural responses are strong.
6. Supply-side fiscal policy
Supply-side fiscal policy
Supply-side fiscal policy uses tax and spending decisions to improve the economy’s productive capacity, productivity and incentives in the long run.
Supply-side fiscal policy aims to shift long-run aggregate supply, or LRAS, to the right. LRAS represents the economy’s potential output when resources are fully employed.
Examples include:
- Infrastructure spending on transport, energy and broadband.
- Education, apprenticeships and healthcare to improve human capital.
- Research and development subsidies or tax credits.
- Lower corporation tax or investment allowances to encourage capital investment.
- Childcare support or changes to income tax thresholds to increase labour market participation.
Analysing infrastructure spending
Suppose the government funds a £10bn rail upgrade in a region with poor transport links.
- In the short run, the £10bn spending is an injection into aggregate demand, increasing construction activity and employment.
- In the long run, better rail links may reduce firms’ transport costs, widen labour markets and raise productivity, shifting SRAS and LRAS to the right.
- Evaluate the impact: the policy is more effective if the project is completed on time, connects productive areas, and encourages private investment; it is less effective if costs overrun or demand for the route is weak.
Supply-side fiscal policy is attractive because it can raise growth while reducing inflationary pressure. However, it often has long time lags and uncertain results. Education reforms, for example, may take many years to affect productivity.
Demand side versus supply side
Demand-side fiscal policy mainly affects actual output now. Supply-side fiscal policy mainly affects potential output later. The best policies may do both, such as productive infrastructure spending during a downturn.
In the exam
- Define the fiscal policy tool precisely: spending, tax, borrowing, direct tax, indirect tax, current spending or capital spending.
- Use an AD/AS diagram to show the transmission mechanism, then explain the chain from policy to AD or LRAS to growth, inflation and unemployment.
- Evaluate using context: spare capacity, multiplier size, debt interest, inflation, time lags, incentives, distributional effects and possible government failure.
Check yourself
- Why might a cut in income tax increase AD but also worsen inflation?
- How is a budget deficit different from public sector debt?
- When would supply-side fiscal policy be more appropriate than demand-side fiscal policy?
