Fiscal policy and the government budget
Fiscal policy is the use of government spending and taxation to influence the economy. Governments use fiscal policy to affect total demand, employment, inflation, economic growth and the distribution of income.
The government budget is a financial plan showing how much money the government expects to receive and how much it plans to spend in a period of time, usually one year.
1. The government budget
Balanced budget
A balanced budget happens when government revenue is equal to government spending.
Example: tax revenue = $100 billion and spending = $100 billion.
Budget deficit
A budget deficit happens when government spending is greater than government revenue.
Example: revenue = $90 billion and spending = $110 billion.
Budget surplus
A budget surplus happens when government revenue is greater than government spending.
Example: revenue = $120 billion and spending = $100 billion.
2. Classification of taxes
Taxes are compulsory payments made to the government. They are a major source of government revenue.
| Type of tax | Meaning | Examples |
|---|---|---|
| Direct taxes | Taxes paid directly from income, profits or wealth to the government. | Income tax, corporation tax, capital gains tax. |
| Indirect taxes | Taxes placed on goods and services. Consumers usually pay them when they buy products. | VAT, sales tax, excise duty on petrol or cigarettes. |
3. Progressive, regressive and proportional taxation
Taxes can also be classified according to how the rate of tax changes as income changes.
Progressive taxation
A progressive tax takes a higher percentage from people with higher incomes. It is often used to reduce income inequality.
How to read the graph: as income rises from Y₁ to Y₂, the tax rate rises from T₁ to T₂. This means higher-income earners pay a higher percentage of their income in tax.
Regressive taxation
A regressive tax takes a smaller percentage from people with higher incomes. Indirect taxes can be regressive because lower-income households spend a larger proportion of their income on goods and services.
How to read the graph: as income rises from Y₁ to Y₂, the tax rate falls from T₁ to T₂. This means high-income earners pay a smaller percentage of their income in this type of tax.
Proportional taxation
A proportional tax takes the same percentage from all income groups. The rate of tax stays the same even when income changes.
How to read the graph: the tax rate stays constant at 20% for both income levels. This means everyone pays the same percentage of income in tax.
4. Principles of taxation
A good tax system should be fair, simple and not too expensive to collect.
Equitable
A tax should be fair. People with a greater ability to pay should usually pay more.
Economical
A tax should not cost too much to collect. The government should not spend a large amount collecting a small amount of tax.
Convenient
A tax should be easy for taxpayers to understand and pay, and easy for the government to collect.
5. Impact of taxation
- Impact on price and quantity: an indirect tax usually raises the price of a good and reduces the quantity bought and sold.
- Impact on economic growth: high taxes may reduce spending, saving, investment and incentives to work. However, tax revenue can also fund education, healthcare and infrastructure, which support growth.
- Impact on inflation: higher indirect taxes may raise prices and increase cost-push inflation. Lower taxes may increase demand and add to demand-pull inflation.
- Impact on social behaviour: taxes can discourage harmful activities, such as smoking, pollution or drinking sugary drinks.
6. Tax avoidance and tax evasion
| Term | Meaning | Simple example |
|---|---|---|
| Tax avoidance | Legally reducing tax payments by using the rules of the tax system. | A firm uses legal tax allowances to reduce its tax bill. |
| Tax evasion | Illegally not paying tax that should be paid. | A business hides sales income from the tax authority. |
Remember: tax avoidance is legal, but tax evasion is illegal.
7. Fiscal policy measures
Fiscal policy can be used to increase or reduce total demand in the economy.
| Fiscal policy measure | What the government does | Likely effect |
|---|---|---|
| Expansionary fiscal policy | Increases government spending and/or cuts taxes. | Raises total demand, output and employment. It may also increase inflation or create a budget deficit. |
| Contractionary fiscal policy | Reduces government spending and/or raises taxes. | Lowers total demand and can reduce inflation. It may also slow economic growth and increase unemployment. |
8. Impact of fiscal policy on macroeconomic objectives
Fiscal policy affects several government aims at the same time, so governments must often make difficult choices.
- Economic growth: spending on roads, schools and technology can increase output in the long run.
- Employment: expansionary fiscal policy can create more jobs by increasing demand.
- Inflation: contractionary fiscal policy can reduce inflation, but it may also reduce growth.
- Balance of payments: lower demand may reduce imports, but slower growth can affect living standards.
- Redistribution of income: progressive taxes and welfare spending can reduce inequality.
Quick exam tip
For fiscal policy questions, use this simple structure:
- Define the policy or tax.
- Explain the direction: spending/taxes increase or decrease.
- Link to one macroeconomic aim: growth, employment, inflation, balance of payments or equality.
- Mention one possible problem: inflation, unemployment, lower growth, budget deficit or inequality.