Fiscal policy refers to the use of government spending and taxation to influence the economy and achieve macroeconomic objectives.
Government Budget
Meaning
- A government budget is a statement of:
- Government revenue (mainly taxes)
- Government expenditure (spending)
Budget Positions
- Budget Deficit:
- Government spending > revenue
- Budget Surplus:
- Government revenue > spending
National Debt
Meaning
- The total accumulated borrowing of the government over time
Significance
- High national debt may:
- Increase interest payments
- Limit future government spending
- But can be beneficial if:
- Borrowing finances economic growth
Taxation
Types of Taxes
Direct Taxes
- Paid directly on income or wealth
- Examples:
- Income tax
- Corporation tax
Indirect Taxes
- Paid on goods and services
- Examples:
- VAT
- Excise duties
Tax Structures
- Progressive Tax:
- Higher income → higher % tax
- Regressive Tax:
- Lower income → higher % tax burden
- Proportional Tax:
- Same % for all incomes
Tax Rates
- Marginal Rate of Tax (MRT):
- Tax on the next unit of income
- Average Rate of Tax (ART):
Reasons for Taxation
- Raise government revenue
- Redistribute income
- Discourage harmful goods (e.g. demerit goods)
- Influence economic activity
Government Spending
Types of Spending
- Current Spending:
- Day-to-day expenses
- Wages, benefits
- Capital Spending (Investment):
- Long-term projects
- Infrastructure, schools, hospitals
Reasons for Government Spending
- Provide public goods
- Correct market failure
- Redistribute income
- Promote economic growth
Fiscal Policy Types
Expansionary Fiscal Policy
- Increase AD by:
- Increasing government spending
- Cutting taxes
→ Used during recession
Contractionary Fiscal Policy
- Reduce AD by:
- Cutting spending
- Increasing taxes
→ Used to control inflation
AD/AS Analysis
Expansionary Fiscal Policy
Effects
- AD shifts right
- Real output increases
- Employment rises
- Price level may increase (inflation)
Contractionary Fiscal Policy
Effects
- AD shifts left
- Real output decreases
- Employment falls
- Price level falls (or inflation slows)
Evaluation
Advantages
- Direct impact on demand
- Can target specific sectors
- Useful in recession
Limitations
- Time lags:
- Decision and implementation delays
- Crowding out:
- Government borrowing may reduce private investment
- Inflation risk:
- Expansionary policy may overheat economy
- Political constraints:
- Difficult to reduce spending or raise taxes
Quick Summary
- Budget = government revenue vs spending
- Deficit vs surplus
- National debt = accumulated borrowing
- Taxes:
- Direct/indirect
- Progressive/regressive/proportional
- Spending:
- Current vs capital
- Expansionary → increase AD
- Contractionary → decrease AD
- Impacts:
- Output, employment, price level