An Overview of Fiscal Policy (DP IB Economics)
Revision Note
Written by: Steve Vorster
Reviewed by: Jenna Quinn
An Introduction to 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
Sources of Government Revenue
The main sources of government revenue include taxation, the sale of goods/services by government owned firms, and the sale of government owned assets (privatisation)
1. Taxation
Direct taxes are taxes imposed on income and profits
They are paid directly to the government by the individual or firm
E.g. Income tax, corporation tax, capital gains tax, national insurance contributions, inheritance tax
Indirect taxes are imposed on spending
The supplier is responsible for sending the payment to the government
Depending on the PED and PES producers are able to pass on a proportion of the indirect tax to the consumer
The less a consumer spends the less indirect tax they pay
E.g Value Added Tax (20% VAT rate in the UK in 2022), taxes on demerit goods, excise duties on fuel etc.
2. Sale of goods/services
Government owned firms sometimes charge for the goods/services that they provide
E.g. Charges on public transport and fees paid to access some medical services
3. The sale of government owned assets
Privatisation can generate significant government revenue during the year in which the government sells the asset
Most assets can only be sold once e.g. national airlines or railways
Some assets, such as the right for mobile phone operators to use the airwaves, can be sold every few years (the airway license is for a defined period of time)
Government Expenditure
Government expenditure represents a significant portion of the aggregate demand in many economies. The expenditure can be broken down into three categories
Current expenditures: These include the daily payments required to run the government and public sector. E.g. The wages and salaries of public employees such as teachers, police, members of parliament, military personnel, judges, dentists etc. It also includes payments for goods/services such as medicines for government hospitals
Capital expenditures: These are investments in infrastructure and capital equipment. E.g. High speed rail projects; new hospitals and schools; new aircraft carriers
Transfer payments: These are payments made by the government for which no goods/services are exchanged. E.g. Unemployment benefits, disability payments, subsidies to producers and consumers etc. This type of government spending does not contribute to aggregate demand as income is only transferred from one group of people to another
The Goals of Fiscal Policy
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
Expansionary & Contractionary Fiscal Policy
1. 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
Classical diagram illustrating expansionary fiscal policy which increase 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 is wanting 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
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Effect on the economy | Firms net profits increase → investment by firms increases → AD increases |
Impact on macroeconomic aims |
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Effect on the economy | Household income increases → consumption increases → AD increases |
Impact on macroeconomic aims |
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2. 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
Keynesian diagram illustrating how a 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 AP1YFE - an inflationary output gap is developing
The economy is booming and the Government is wanting 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
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Effect on the economy | Households pay more tax → discretionary income reduces → consumption reduces → AD reduces |
Impact on macroeconomic aims |
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Effect on the economy | Wages stagnate or reduce → Consumer confidence falls → consumption decreases → AD decreases |
Impact on macroeconomic aims |
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Effect on the economy | Less demand for goods/services → less income for firms → output and profits decrease → AD decreases |
Impact on macroeconomic aims |
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