AQA Economics AS-level
Macroeconomics
Topic 4: Macroeconomic Policy
4.2 Fiscal policy
Notes
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Fiscal policy involves the manipulation of government spending, taxation and the budget
balance. It can have both macroeconomic and microeconomic functions.
Fiscal policy instruments:
o Government spending and taxation
Governments can change the amount of spending and taxation to stimulate
the economy. The government could influence the size of the circular flow by
changing the government budget, and spending and taxes can be targeted in
areas which need stimulating.
Fiscal policy aims to stimulate economic growth and stabilise the economy.
In the UK, the government spends most of their budget on pensions and
welfare benefits, followed by health and education. Income tax is the biggest
source of tax revenue in the UK.
How fiscal policy can be used to influence AD:
Expansionary fiscal policy
This aims to increase AD. Governments increase spending or reduce taxes to
do this. It leads to a worsening of the government budget deficit, and it may
mean governments have to borrow more to finance this.
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Deflationary fiscal policy
This aims to decrease AD. Governments cut spending or raise taxes, which
reduces consumer spending. It leads to an improvement of the government
budget deficit.
How fiscal policy can be used to influence AS:
The government could reduce income and corporation tax to encourage spending
and investment.
The government could subsidise training or spend more on education. This lowers
costs for firms, since they will have to train fewer workers. Spending more on
healthcare helps improve the quality of the labour force, and contributes towards
higher productivity.
Governments could spend more on infrastructure, such as improving roads and
schools.
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The government budget (fiscal) surplus and deficit:
A government has a budget deficit when expenditure exceeds tax receipts in a
financial year.
A government has a budget surplus when tax receipts exceed expenditure.
It is important to distinguish between the government debt and the government
deficit. The debt is the accumulation of the government deficit over time. It is the amount
the government owes. The deficit (or surplus) is the difference between expenditure and
revenue at any one point.
Direct and indirect taxes:
Direct taxes are imposed on income and are paid directly to the government from
the tax payer. Examples include income tax, corporation tax, NICs and inheritance
tax. Consumers and firms are responsible for paying the whole tax to the
government.
Indirect taxes are imposed on expenditure on goods and services, and they increase
production costs for producers. This increases market price and demand contracts.
There are two types of indirect taxes:
o Ad valorem taxes are percentages, such as VAT, which adds 20% of the unit
price. This is the main indirect tax in the UK.
o Specific taxes are a set tax per unit, such as the 58p per litre fuel duty on
unleaded petrol.
Proportional, progressive and regressive taxes
A proportional tax has a fixed rate for all tax payers, regardless of income. It is also
called a flat tax. For example, all tax payers might have to pay 20% income tax rate.
The incidence of taxes is equal, regardless of the ability of the taxpayer to pay. It
could encourage people to earn higher incomes, because the rate of tax paid does
not increase.
A progressive tax has an increase in the average rate of tax as income increases. As
income increases, the proportion of income taxed increases. For example, in the UK
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income tax is progressive. People have a personal allowance of £10,600 where tax is
not paid. For incomes below £31,785, people only pay the basic rate of 20%. For
incomes between £31,786 and £150,000, people pay the higher rate of 40%. Above
this, a 45% rate is paid. This should help reduce inequality, because those on lower
incomes pay less tax. The tax is based on the payer’s ability to pay. Higher income
households are more able to pay higher rates of tax than lower income households.
Generally, direct taxes are more progressive.
A regressive tax does not relate to income, but means those on lowest incomes have
a higher average rate of tax. In other words, the proportion of income paid as tax is
higher for those on lower incomes than those on higher incomes. For example, as a
percentage of income, the London Congestion Charge and Council Taxes are higher
for those on lower incomes. This leads to a less equitable distribution of income.
Generally, indirect taxes are more regressive.
Limitations of fiscal policy:
o Governments might have imperfect information about the economy. It could
lead to inefficient spending.
o There is a significant time lag involved with employing fiscal policy. It could
take months or years to have an effect.
o If the government borrows from the private sector, there are fewer funds
available for the private sector, which could lead to crowding out.
o The bigger the size of the multiplier, the bigger the effect on AD and the
more effective the policy.
o If interest rates are high, fiscal policy might not be effective for increasing
demand.
o If the government spends too much, there could be difficulties paying back
the debt, which could make it difficult to borrow in the future.
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