Fiscal policy

Fiscal policy is one of the primary macroeconomic instruments used by governments to manage the level of economic activity. By adjusting its own spending and changing the rates and structure of taxation, a government can directly and indirectly influence Aggregate Demand ($AD$), redistribute income, and shape the long-term productive capacity of the economy.

What you'll learn

• How the government structures its spending (current vs. capital) and raises revenue through direct and indirect taxation.
• The difference between budget deficits, surpluses, national debt, and cyclical versus structural budget positions.
• How to calculate average and marginal tax rates to assess the progressivity of a tax system.
• The limits of fiscal policy, including automatic stabilisers, discretionary policy, crowding out, the Laffer curve, and key evaluative arguments.

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1. The Government Budget and Expenditure

At its simplest, the government budget (or fiscal budget) is an annual financial plan detailing the state's planned expenditures and expected tax revenues for the upcoming fiscal year.

In the UK, this is presented by the Chancellor of the Exchequer in the Autumn Statement and Spring Budget. Government expenditure can be broken down into three key categories:

Current Expenditure

This is spending on the day-to-day, recurring costs of running public services and maintaining state administration. It does not create new physical assets but maintains the existing ones. Examples include:

• Salaries for public sector workers (e.g., NHS doctors, teachers, police officers).
• Consumable items used in public services (e.g., medicines for hospitals, stationery for schools).

Capital Expenditure

This is spending on physical, long-term assets that add to the economy's capital stock and productive capacity. It represents investment by the public sector. Examples include:

• Infrastructure projects (e.g., building new motorways, upgrading railway networks like HS2).
• Building physical public capital (e.g., new hospitals, school buildings, flood defences).

Transfer Payments

These are payments made by the state to individuals for which no economic output is given in return. They are designed to redistribute income and provide a social safety net. Examples include:

• State pensions.
• Welfare benefits (e.g., Universal Credit, Jobseeker's Allowance, disability benefits).

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2. Taxation: Principles and Structures

Taxation is the primary source of revenue for governments. Taxes can be categorized both by how they are collected and by how they affect different income groups.

Direct vs. Indirect Taxes

Tax Structures: Progressive, Proportional, and Regressive

The impact of a tax on income distribution depends on its structure:

• Progressive Taxation: A tax where the proportion of income paid in tax rises as income increases. The marginal tax rate is higher than the average tax rate. Income tax in the UK is a key progressive tax, because higher income bands are taxed at higher rates (e.g., 20%, 40%, and 45%).
• Proportional Taxation: A tax where the proportion of income paid in tax remains constant as income increases (often called a "flat tax"). The marginal tax rate equals the average tax rate. For example, if a country has a flat 15% income tax rate for all citizens, it is proportional.
• Regressive Taxation: A tax where the proportion of income paid in tax falls as income increases. Even if the tax is a fixed physical amount or a flat rate on a good, it represents a larger percentage of a low-income earner's total income than a high-income earner's. Most indirect taxes, such as excise duty on cigarettes or petrol, are regressive.

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3. Calculating Average and Marginal Tax Rates

To evaluate whether a tax system is progressive, proportional, or regressive, you must understand the distinction between average and marginal tax rates.

• Average Tax Rate: The total tax paid divided by total gross income. It represents the overall tax burden on an individual.
• Marginal Tax Rate: The tax rate paid on the very next pound of income earned. It represents the incentive (or disincentive) effect of the tax system on earning more income.

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4. Budget Balances, National Debt, and the Economic Cycle

The relationship between total tax revenue ($T$) and government expenditure ($G$) determines the budget position in any given fiscal year.

• Budget Deficit: Government spending exceeds tax revenues in a fiscal year ($G>T$).
• Budget Surplus: Tax revenues exceed government spending in a fiscal year ($T>G$).
• Balanced Budget: Government spending equals tax revenues ($G=T$).

Cyclical vs. Structural Budget Positions

A budget deficit can be divided into two distinct components:

1. Cyclical Deficit: The portion of the deficit that fluctuates directly with the economic cycle. During a recession, automatic stabilisers cause tax receipts to fall (as output and employment decline) and welfare spending to rise. This creates a temporary deficit. When the economy recovers, the cyclical deficit automatically shrinks and disappears.
2. Structural Deficit: The portion of the deficit that remains even when the economy is operating at full capacity (its trend rate of growth). It is caused by a fundamental imbalance between permanent state spending commitments and tax structures. To eliminate a structural deficit, a government must take discretionary action (raising taxes or cutting public services).

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5. Automatic Stabilisers vs. Discretionary Fiscal Policy

Governments can influence aggregate demand using two different mechanisms:

Automatic Stabilisers

These are pre-existing tax and spending structures that automatically work to dampen the economic cycle without any explicit, deliberate intervention by the government.

• During a Boom: Real GDP and employment rise. More individuals move into higher progressive tax brackets, increasing tax revenues. Simultaneously, spending on unemployment and welfare benefits falls. This withdraws money from the circular flow, acting as an automatic brake on inflation.
• During a Recession: Real GDP and employment fall. Tax receipts automatically drop as incomes slide, and more citizens qualify for welfare benefits. This injects purchasing power back into the circular flow, cushioning the fall in aggregate demand.

Discretionary Fiscal Policy

This refers to deliberate, active changes to government spending and taxation to achieve specific macroeconomic objectives.

• Expansionary Fiscal Policy: Used to stimulate aggregate demand during a recession. The government deliberately cuts taxes (shifting money to households and firms) or increases its own spending ($G$). This shifts the $AD$ curve to the right, raising real GDP and the price level.

• Contractionary Fiscal Policy: Used to cool down an overheating economy and reduce demand-pull inflation. The government deliberately increases tax rates or cuts its spending, shifting $AD$ to the left.

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6. Supply-Side Limits: Crowding Out and the Laffer Curve

Active fiscal intervention is not a guaranteed success. Economists identify several key structural limits to fiscal expansion.

Crowding Out

This is the theory that increased government spending and borrowing reduces private sector activity. It takes two forms:

1. Financial Crowding Out: To finance a larger budget deficit, the government must issue more bonds (gilts) to borrow money. This increases the demand for loanable funds. If the supply of credit is fixed, this drives up market interest rates. Higher interest rates make borrowing more expensive for private firms, which "crowds out" private investment ($I$) and consumption ($C$).
2. Resource Crowding Out: If the government increases its spending when the economy is already operating close to full capacity (near the $LRAS$), it bids up the price of scarce resources (such as skilled labour and raw materials). As the government employs these inputs, they are no longer available to private firms, directly reducing private sector output.

The Laffer Curve

Developed by economist Arthur Laffer, this curve shows the relationship between the tax rate and the total tax revenue collected.

The logic behind the Laffer curve is straightforward:

• At a 0% tax rate, revenue is £0.
• At a 100% tax rate, revenue is also theoretically £0, because there is no incentive for individuals to work or for firms to produce legally; they will opt for leisure, tax evasion, or migrate to low-tax jurisdictions.
• As the tax rate rises towards an optimal rate ($t^{\ast }$), revenue increases (the normal range).
• If the government increases the tax rate past $t^{\ast }$ (into the prohibitive range), the disincentive effects on work, investment, and enterprise outweigh the higher rate, causing total tax revenue to fall.

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7. Evaluating the Effectiveness of Fiscal Policy

In your H460 exams, you must evaluate the extent to which fiscal policy can achieve macroeconomic goals (growth, low inflation, low unemployment, and a stable balance of payments).

Strengths of Fiscal Policy

• Direct Impact on AD: Unlike monetary policy, which relies on the transmission mechanism of changing interest rates to affect household behaviour, direct changes in government spending ($G$) go straight into the circular flow of income.
• The Multiplier Effect: An initial injection of government spending leads to a larger final increase in national income. The strength of this effect is determined by the marginal propensities to withdraw:

$$Multiplier=\frac{1}{MPW}=\frac{1}{MPS+MPT+MPM}$$

• Dual-Purpose Capital Spending: Public sector investment (e.g., transport infrastructure) boosts $AD$ in the short run through construction jobs, but also shifts the Long-Run Aggregate Supply ($LRAS$) curve outward in the long run by lowering transport costs and boosting productivity.

Weaknesses and Constraints

• Time Lags: Fiscal policy suffers from three distinct lags:
  1. Information lag: Identifying that the economy has entered a recession.
  2. Implementation lag: Designing a fiscal package and getting it passed through Parliament.
  3. Impact lag: The time taken for major capital projects to actually start and for the multiplier effect to ripple through the economy. By the time the policy works, the economic cycle may have naturally corrected, making the policy pro-cyclical and destabilizing.
• Fiscal Drag and Disincentives: Raising taxes to curb inflation can lead to "fiscal drag" where inflation pushes people into higher tax brackets without real wage gains, dampening worker incentives and slowing down economic growth.
• Impact on the Current Account: Expansionary fiscal policy increases domestic disposable income. Because UK consumers have a high marginal propensity to import ($MPM$), much of this new spending leaks out of the economy, widening the current account deficit on the balance of payments.
• Fiscal Sustainability: Persistent deficits accumulate into a high national debt-to-GDP ratio. High debt levels require the government to spend a large portion of tax revenue on interest payments (debt servicing), which carries a massive opportunity cost for public services.