Fiscal Policy

What fiscal policy is

Fiscal policy is the use of government spending and taxation to influence the economy. In the UK it is set by the Chancellor in the Budget.

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Expansionary (loose): higher spending and/or lower taxes

AD shifts right. Used to close a negative output gap.

Contractionary (tight): lower spending and/or higher taxes

AD shifts left. Used to close a positive output gap or reduce a deficit.

Fiscal policy also has microeconomic functions, correcting market failure through taxes and subsidies (5.2), redistributing income, and providing public goods, and supply-side functions, when spending is directed at infrastructure, education and skills.

Taxation

Direct taxes are levied on income and wealth and are paid directly by the person or firm on whom they fall: income tax, national insurance, corporation tax, capital gains tax, inheritance tax.

Indirect taxes are levied on spending and can be passed on to consumers: VAT, excise duties on fuel, alcohol and tobacco.

By incidence relative to income:

Indirect taxes are inherently regressive, because low-income households spend a larger share of their income and cannot avoid consumption taxes. This is a reliable evaluation point whenever an indirect tax is proposed.

Principles of a good tax system (the canons of taxation): equity, certainty, convenience, efficiency of collection, flexibility, and minimal distortion of incentives.

The Laffer curve argues that beyond some rate, higher tax rates reduce total revenue, because they discourage work and effort, encourage avoidance and evasion, and drive activity abroad. The theoretical point is uncontroversial; the practical dispute is where the peak lies, and the evidence is weak, so it should be used with caution rather than asserted.

The budget position

Budget deficit = government spending exceeds revenue in a given year.
National debt = the accumulated stock of past deficits.

The flow-versus-stock distinction is examined directly. A falling deficit still adds to the national debt; only a surplus reduces it.

Structural and cyclical:

• The cyclical deficit is the part caused by the economic cycle, and it disappears automatically in recovery.
• The structural deficit is the part that persists even at full employment. It is the part that genuinely requires policy action.

Automatic stabilisers moderate the cycle without any policy decision:

1. In a recession, incomes fall so tax revenue falls automatically, while unemployment and means-tested benefits rise automatically
2. the fall in AD is cushioned
3. the deficit widens as a natural consequence, not a policy failure.

They work in reverse in a boom. Their strength depends on how progressive the tax system and how generous the welfare system are.

Discretionary fiscal policy is a deliberate change in spending or tax rates.

Consequences of a large deficit and debt:

• Debt interest consumes revenue that could fund services, a genuine opportunity cost.
• Crowding out: government borrowing raises interest rates, reducing private investment.
• Possible loss of confidence among lenders, raising the cost of borrowing further.
• Intergenerational transfer: future taxpayers service today's borrowing.

Counter-arguments: borrowing to fund investment that raises future capacity is different from borrowing to fund current consumption; what matters is the debt-to-GDP ratio and the interest rate relative to the growth rate, not the absolute figure; and in a recession, borrowing is the cheapest available stabiliser, while crowding out is minimal when private demand is depressed and rates are at their floor.

Effects of fiscal policy

Demand-side: a change in G or T shifts AD, amplified by the multiplier (7.1). Government spending has a larger multiplier than an equivalent tax cut, because part of a tax cut is saved rather than spent.

Supply-side: spending on infrastructure, education, training and R&D shifts LRAS right. Lower marginal tax rates may improve incentives to work, save and invest. Fiscal policy is the only instrument that can act on both AD and LRAS.

Distributional: progressive taxes and transfers reduce inequality; indirect taxes tend to increase it.

Worked example

An economy is in recession with a large negative output gap. The government announces a £20bn package of infrastructure spending, funded by borrowing. MPW = 0.5.

1. k = 1 ÷ 0.5 = 2
2. AD shifts right by £40bn
3. with substantial spare capacity, firms raise output rather than prices
4. real GDP rises, cyclical unemployment falls, and the negative output gap closes with only modest inflation.

1. The infrastructure also raises the economy's productive capacity
2. LRAS shifts right
3. so the package delivers actual growth now and potential growth later, and raises the sustainable non-inflationary growth rate.

As recovery proceeds, automatic stabilisers work in reverse: tax revenue rises and benefit spending falls, so a substantial part of the initial borrowing is recouped without any further policy decision.

Evaluation.

• Time lags are the most serious limitation. Recognition, decision, implementation and impact lags mean large infrastructure projects can take years, so the stimulus may arrive when the economy has already recovered, at which point it is inflationary rather than expansionary.
• Crowding out: borrowing raises the demand for loanable funds and may raise interest rates, reducing private investment. The objection is much weaker in a recession with depressed private demand and interest rates near their floor.
• The multiplier is uncertain and smaller in an open economy with a high marginal propensity to import.
• The debt burden rises, adding to future interest payments; whether this is justified depends on whether the projects actually raise capacity enough to service the debt.
• Ricardian equivalence suggests households may save the stimulus in anticipation of higher future taxes, reducing its effect, though the empirical support is contested.
• The effect depends entirely on the size of the output gap, which is estimated rather than observed.

Judgement: with a large negative output gap and low borrowing costs, capacity-raising fiscal expansion is well justified, it works on both AD and LRAS, and much of the cost is recovered through automatic stabilisers. The main risk is not crowding out but lags, which argues for projects that can start quickly.

Common exam mistakes

• Confusing the deficit (an annual flow) with the national debt (a stock). Reducing the deficit still increases the debt.
• Confusing direct/indirect taxes with progressive/regressive; they are different classifications.
• Saying VAT is progressive; indirect taxes are regressive.
• Ignoring automatic stabilisers and treating every change in the deficit as a policy decision.
• Forgetting that fiscal policy has supply-side effects, not just demand-side.
• Asserting crowding out unconditionally, it depends on the state of the economy.
• Overstating the Laffer curve as established fact.

Exam technique

Use an AD/AS diagram and shift AD by the multiplied amount. Where the spending is on infrastructure or skills, shift LRAS as well, showing both is what distinguishes a top answer.

Distinguish structural from cyclical deficit whenever the data allows; the policy implication differs entirely.

For evaluation, the four reliable angles are time lags, crowding out (with the condition attached), the size of the output gap, and how the spending is financed and what it buys.

Quick revision

• Fiscal policy = government spending and taxation; expansionary shifts AD right, contractionary left.
• Direct taxes on income and wealth; indirect on spending. Progressive / proportional / regressive is a separate classification based on incidence.
• Indirect taxes are regressive.
• Deficit = annual flow. National debt = accumulated stock.
• Structural deficit persists at full employment; cyclical disappears in recovery.
• Automatic stabilisers: tax revenue and benefit spending move counter-cyclically without any decision.
• Fiscal policy affects both AD and LRAS, uniquely among the demand-side instruments.
• Limits: time lags, crowding out, uncertain multiplier, debt interest, Ricardian equivalence.

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