Fiscal Policy: An Introduction (AQA A Level Economics)

Fiscal Policy

• Fiscal Policy involves the use of government spending and taxation (revenue) to influence aggregate demand in the economy
  

• Fiscal policy can be expansionary in order to generate further economic growth

  • Expansionary policies include reducing taxes or increasing government spending
    

• Fiscal policy can be contractionary in order to slow down economic growth or reduce inflation

  • Contractionary policies include increasing taxes or decreasing government spending 
    

• Fiscal Policy is usually presented annually by the Government through the  Government Budget 

  • A balanced budget means that government revenue = government expenditure

  • A budget deficit means that government revenue < government expenditure

  • A budget surplus means that government revenue > government expenditure
    

• A budget deficit has to be financed through public sector borrowing

  • This borrowing gets added to the public debt

Macroeconomic & Microeconomic Impacts of Fiscal Policy

Macroeconomic impacts

• Fiscal policy is used to help the government achieve their macroeconomic objectives

• Specifically, the use of fiscal policy aims to

  • Maintain a low and stable rate of inflation

  • Maintain low unemployment

  • Reduce the business cycle fluctuations

  • Create a stable economic environment for long-term economic growth

  • Redistribute income so as to ensure more equity

  • Control the level of exports and imports (net external balance)
    

• When a policy decision is made, it creates a ripple effect through the economy, impacting the macroeconomic objectives of the government

• Changes to fiscal policy can influence several of the components of AD

  • A change to any component of AD helps to achieve at least one of the goals of fiscal policy
    

Microeconomic impacts

• Fiscal policy includes making changes to policies such as taxes and subsidies 

  • Income tax cuts can influence labour to be more productive 

  • Tax cuts can encourage firms to increase output or be more entrepreneurial

  • Subsidies can lower costs of production in the industry, leading to higher output

Fiscal Policy and Aggregate Demand

Expansionary fiscal policy

• Expansionary fiscal policies include reducing taxes or increasing government spending with the aim of increasing AD 

• AD = household consumption (C) + firms investment (I) + government spending (G) + exports (X) - imports (M)

  • AD = C + I + G + (X - M
    

• Expansionary fiscal policy aims to shift aggregate demand (AD) to the right
  

Diagram: expansionary fiscal policy

Expansionary fiscal policy which increases real GDP (Y1 →Y2) and average price levels (AP1 → AP2) 

Diagram analysis

• The economy is initially in macroeconomic equilibrium AP1Y1: there is a recessionary gap

• The Government wants to boost economic growth and lowers the rate of income and corporation taxes

• Lower taxes cause investment and consumption to increase, which are components of AD

• Aggregate demand increases from AD→ AD₁

• The economy reaches a new equilibrium at AP₂Y₂ - a higher average price level and a greater level of national output

Examples of the Impact of Expansionary Fiscal Policy

Contractionary fiscal policy

• Contractionary fiscal policies include increasing taxes or decreasing government spending with the aim of decreasing AD  

• AD= household consumption (C) + firms investment (I) + government spending (G) + exports (X) - imports (M)

  • AD = C + I + G + (X - M

• Changes to fiscal policy can influence government spending or consumption or investment

  • Changing taxation can influence household consumption and the investment by firms

• Contractionary fiscal policies aims to shift aggregate demand (AD) to the left

Diagram: contractionary fiscal policy

Contractionary fiscal policy aims to decrease real GDP (YFE →Y1) and average price levels (AP1 →AP2)

Diagram analysis

• The economy is initially in macroeconomic equilibrium AP₁Y_FE - an inflationary output gap is developing

• The economy is booming and the Government wants to lower inflation towards its target of 2%

• The Government increases the rate of income tax

• Higher tax rates cause households to have less discretionary income, causing consumption to decrease

• Aggregate demand decreases from AD1→ AD2

• The economy reaches a new equilibrium at AP₂Y₁ - a lower average price level and a smaller level of national output
   

Examples of the Impact of Contractionary Fiscal Policy

Fiscal Policy & Aggregate Supply

• Many fiscal policies have the ability to improve the productive potential (supply-side) of an economy

  • E.g. Education subsidies to help the poorest households constitute an annual expenditure for the government. However, in the long term, they help to improve human capital, which boosts productivity and output

  • The fiscal policy is short-term (annually); however, the supply-side impact occurs in the long term

The Influence of Taxation & Spending on Economic Activity

• Government spending and taxation influence the level of economic activity

  • Government spending is an injection and increases economic activity

  • Taxation is a withdrawal and decreases economic activity

• The government budget is usually set once a year

• This fiscal policy then operates automatically in the background producing a stabilising effect as the economic activity fluctuates

  • Automatic stabilisers are automatic fiscal changes that occur as the economy moves through stages of the business/trade cycle 

The impact of automatic stabilisers on an economy during a boom and recession

Effects in a recession

• In a recession, there will automatically be lower tax revenue due to the nature of progressive taxation - as incomes fall households are taxed less

• In a recession, as unemployment rises, the government will pay higher unemployment benefits and transfer payments, which households will then use for consumption

• Both of the above will result in real GDP being higher than it would otherwise have been

Effects in a boom

• In a boom, there will automatically be higher tax revenue due to the nature of progressive taxation - as incomes rise, households are taxed more

• In a boom, as unemployment falls, the government will pay fewer unemployment benefits / transfer payments which will decrease household consumption

• Both of the above will result in real GDP being lower than it would otherwise have been

• This is effectively an automatic disinflationary effect