Contents: 15 sections
Cambridge IGCSE Economics 0455
Syllabus points
- Define fiscal policy, government spending and taxation.
- Distinguish direct from indirect taxes and progressive from regressive taxes.
- Explain how fiscal policy affects the government's aims.
What is fiscal policy?
Fiscal policy is the use of government spending and taxation to influence the economy.
It is decided by the government, which is the key difference from monetary policy (4.4), decided by the central bank.
The budget position:
| Position | Meaning |
|---|---|
| Budget deficit | Government spending is greater than revenue |
| Budget surplus | Revenue is greater than spending |
| Balanced budget | The two are equal |
| National debt | The total of all past deficits added up |
A deficit is a flow over one year; the national debt is a stock built up over many years. A government can reduce its deficit and still see its debt grow, because any deficit adds to the total.
Government spending and revenue
Main areas of spending: healthcare, education, defence, infrastructure (roads, railways), welfare benefits and pensions, and interest on the national debt.
Main sources of revenue: income tax, corporation tax, VAT or sales tax, excise duties, and national insurance or social contributions.
Direct and indirect taxes
| Direct tax | Indirect tax | |
|---|---|---|
| Levied on | Income, profit or wealth | Spending on goods and services |
| Paid to government by | The person who bears it | The seller, who passes it on |
| Examples | Income tax, corporation tax, inheritance tax | VAT, excise duty on fuel, alcohol and tobacco |
The distinction is who bears the burden: with a direct tax the person taxed pays it; with an indirect tax the shop collects it but the consumer largely bears it.
Progressive, proportional and regressive
This is about the percentage of income paid, not the amount.
| Type | As income rises… | Example |
|---|---|---|
| Progressive | The percentage paid rises | Income tax with higher-rate bands |
| Proportional | The percentage stays the same | A flat 20% tax on all income |
| Regressive | The percentage paid falls | VAT and excise duties |
Why indirect taxes are regressive, the reasoning is worth learning:
Poorer households spend nearly all their income, while richer households save some of theirs → a tax on spending therefore takes a larger share of a poor household's income than of a rich one's → so VAT is regressive even though everyone pays the same rate.
Expansionary and contractionary fiscal policy
| Stance | Action | Aim | Risk |
|---|---|---|---|
| Expansionary | Raise spending, cut taxes | Increase demand, reduce unemployment, raise growth | Inflation if near capacity; larger deficit |
| Contractionary | Cut spending, raise taxes | Reduce inflation, improve the budget | Slower growth, higher unemployment |
How it works, as a chain:
The government cuts income tax → households have more disposable income → they spend more → firms sell more and produce more → they hire more workers → output and employment rise.
Effects on the government's aims
- Growth and employment: expansionary policy raises demand, output and jobs.
- Inflation: expansionary policy can cause it if the economy is near full capacity; contractionary policy reduces it.
- Balance of payments: higher incomes raise spending on imports, worsening the current account.
- Redistribution: progressive taxes and welfare benefits reduce inequality.
Limitations
- Time lags. Budgets are usually annual, and building infrastructure takes years, so the effect may arrive too late.
- Cost and debt. Deficits add to national debt, and interest payments then consume future revenue.
- Opportunity cost. Money spent on one thing cannot be spent on another.
- Incentives. Very high income tax may discourage work; high corporation tax may deter investment.
- Uncertainty. Governments cannot be sure how much households will spend rather than save.
Worked example
An economy is in recession, with unemployment at 10%. The government cuts income tax and increases spending on building schools.
Lower income tax → higher disposable income → more consumer spending. Higher government spending → construction firms hire workers → those workers spend their wages too → demand rises further → output and employment increase.
Drawbacks to weigh:
- The government must borrow to fund it, adding to the national debt.
- School building takes years, so the boost may arrive after the recession has ended.
- Higher spending raises imports, worsening the current account.
- If the economy recovers to full capacity, further stimulus causes inflation.
A judgement: in a deep recession with idle resources, expansionary fiscal policy is likely to raise output rather than prices, so the inflation risk is small, the stronger objections are the time lag and the debt.
Common exam mistakes
- Confusing fiscal policy (government) with monetary policy (central bank).
- Confusing a budget deficit with the national debt.
- Saying a progressive tax means "the rich pay more". They pay a higher percentage.
- Calling VAT progressive because richer people spend more in total. It is regressive as a share of income.
- Ignoring time lags and the opportunity cost of spending.
Exam technique
Always state whether a policy is expansionary or contractionary, then trace the chain to output, employment and prices.
For tax questions, use the phrase percentage of income; that is what distinguishes progressive from regressive.
For evaluation, three reliable angles: time lags, the deficit and debt, and the effect on other aims, especially the balance of payments.
Building an answer
4 marks, "Explain how expansionary fiscal policy could reduce unemployment."
The government raises its own spending or cuts taxation, which increases total demand in the economy.
Firms facing higher demand need more workers to produce the extra output, so they hire, and unemployment falls. Cutting income tax works through the same channel by raising households' disposable income and therefore their spending.
6 marks, "Analyse the effects of a rise in income tax."
Disposable income falls, so consumption falls and total demand in the economy weakens. Output and employment may fall with it.
Government revenue rises, allowing more spending on healthcare and education, or a smaller budget deficit.
The distributional effect depends on the design: a rise in the higher rate is progressive and narrows income inequality, while a rise in the basic rate affects lower earners proportionally more.
Incentives may weaken, very high marginal rates can discourage extra work, though evidence for this at ordinary tax levels is weak, so the effect should be stated as possible rather than certain.
Direct against indirect taxes
| Direct taxes | Indirect taxes | |
|---|---|---|
| Levied on | Income and wealth | Spending |
| Examples | Income tax, corporation tax, inheritance tax | VAT, excise duty, tariffs |
| Who pays it to government | The person who bears it | The seller, who passes it on |
| Usually | Progressive | Regressive |
| Effect on incentives | May discourage work | Discourages consumption of the taxed good |
Progressive means the rate rises with income; regressive means it takes a larger share of a low income; proportional means the same share regardless. Indirect taxes are regressive because a poorer household spends a larger share of income.
A real case to quote
The UK's 2021 corporation tax announcement. The main rate was set to rise from 19% to 25% in 2023, with a lower rate retained for small companies. It illustrates both sides of the argument in one policy: revenue for deficit reduction, weighed against the fear that higher business taxes deter investment, and the compromise of protecting small firms shows how design matters as much as the rate.
Check you have it
A government wants to reduce both its budget deficit and the amount of poverty in its country. Which fiscal policy measure is most likely to achieve both of these aims?
More questions on fiscal policy →Quick revision
- Fiscal policy = government spending and taxation; set by government.
- Deficit is a flow; national debt is the accumulated stock.
- Direct taxes are on income and profit; indirect taxes are on spending.
- Progressive: percentage rises with income. Regressive: percentage falls.
- VAT and excise duties are regressive, because the poor spend a larger share of income.
- Expansionary: spend more, tax less. Contractionary: the reverse.
- Limits: time lags, debt, opportunity cost, incentives, uncertainty.