3.1 Fiscal Policy

• Fiscal policy:

  This is the use of government expenditure, taxation and borrowing to influence behaviour of economic agents and the level of economic activity within an economy.
• The objective of fiscal policy:

  1. To promote economic stability 2. To reduce market failure 3. To enhance social cohesion
• The main ways government expenditure is used:

  1. Provide public services such as defence 2. To correct market failures 3. Achieve redistributional objectives through transfer payments & benefits in kind 4. Nudge consumer behaviour 5. For political reasons
• Direct taxation:

  Taxation imposed on people's income or wealth, and on firms' profits.
• Indirect taxation:

  A tax imposed upon expenditure. A tax placed upon the selling price of a product, so it raises the firm's costs and shift the supply curve for the product vertically upwards by the amount of the tax. Excise duties are often levied on demerit goods.
• The purpose of taxation:

  1. To create incentives to work 2. To influence the pattern of demand 3. To stimulate business investment 4. For redistributional & macroeconomic objectives effects
• Progressive taxation:

  The tax as a percentage of income increases as income increases. Direct taxes are normally progressive e.g. income tax
• Regressive taxation:

  The tax as a percentage of income decreases as income increases. Indirect taxes are often regressive e.g. VAT
• Proportional taxation:

  The tax as a percentage of income remains constant as income increases; also called a flat tax
• Crowding out:

  Government spending crowds out private sector investment by increasing the rate of interest, which increases the cost of borrowing for private firms, leading to a fall in private sector investment.
• Automatic stabilisers:

  Changes in tax revenue and state spending arising automatically as the economy moves through different stages of the economic cycle.
• The Laffer curve:

  Illustrates the relationship between tax revenue and taxation rates and the optimal rate of tax. Shaped like an upside down U
• Average tax rates:

  Tax paid divided by taxable household income.
• Marginal tax rates:

  Change in tax paid divided by change in taxable income.
• The effectiveness of using fiscal policy to achieve the government's macroeconomic objectives depends on:

  1. The fiscal policy measures being used 2. Unintended consequences 3. The size of the mulitplier 4. Business and consumer confidence 5. Crowding out versus crowding in 6. The cost of borrowing 7. The economic school of thought you follow e.g. neoclassical economists 8. How the fiscal stimulus is managed 9. The credibility of the government
• Define automatic stabilisers

  Mechanisms that reduces the impact of changes in the economy on national income.
• Define average tax rates

  The amount of tax paid as a proportion of income. Expressed by: total tax / total income
• Define balanced budget

  When government spending equals tax revenue
• Define budget deficit

  When the government spends more money than it receives.
• Define budget position on current expenditure

  The flow of cash during one period of time.
• Define budget position/ fiscal stance

  The impact that taxes and government spending has on the future economy.
• Define budget surplus


  When the government receives more money than it spends
• Define capital government expenditure

  Government spending on investment goods such as new roads, schools and hospitals which will be consumed in over a year.
• Define crowding in

  When government borrowing leads to an increase in private investment
• Define crowding out

  When government borrowing discourages private sector investment or when government provision of a good or service prevents it being provided by the private sector.
• Define current government expenditure

  Spending on goods and services which are consumed and last for a short time.
• Define cyclical budget position

  A temporary budget position, which is related to the business cycle
• Define direct tax

  Taxes imposed on income and paid straight to the government by the individual taxpayer.
• Define discretionary fiscal policy

  Deliberate manipulation of government expenditure and taxes to influence the economy; expansionary and deflationary fiscal policy.
• Define fiscal policy

  The use of borrowing, government spending and taxation to manipulate the level of AD and improve macroeconomic performance.
• Define fiscal rules

  A long-term constraint on fiscal policy by putting numerical limits on the budget.
• Define government expenditure

  Spending by the government for the provision of goods and services
• Define indirect tax

  Tax where the person charged with paying the money to the government is able to pass on the costs to someone else
• Define Laffer curve

  Shows that a rise in tax rates doesn't necessarily lead to a rise in tax revenue, due to the impact on incentives and work.
• Define marginal rate of tax

  The rate of tax applied to the unit of currency of the income.
• Define national debt

  The sum of government debt built up over many years.
• Define overall budget position

  An accumulation of deficits and surpluses over time to give the overall budget
• Define progressive taxation

  Where those on higher incomes pay a higher marginal rate of tax.
• Define proportional taxation

  The proportion of income paid on the tax remains the same whilst the income of the taxpayer changes.
• Define regressive taxation

  Where the proportion of income paid in tax falls whilst the income of the taxpayer increases