Author: Ravi Dhingreja

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5.2 Fiscal Policy

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): ART=Total taxTotal income×100ART = \frac{\text{Total tax}}{\text{Total income}} \times 100

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
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Government Macroeconomic Policy Objectives

Governments use macroeconomic policies to achieve key economic objectives:

  • Price stability
  • Low unemployment
  • Economic growth

These are essential for a stable and efficient economy.

1. Price Stability

Objective

  • Maintain low and stable inflation (often around 2%)

Why It Matters

  • Protects purchasing power
  • Reduces uncertainty
  • Encourages investment and planning

Policies Used

Monetary Policy

  • Interest rates set by central bank
  • Higher interest rates:
    • Reduce borrowing and spending
      → Lower inflation

Fiscal Policy

  • Government spending and taxation
  • Reduce demand if inflation is too high

Diagram

5

2. Low Unemployment

Objective

  • Achieve full employment (very low unemployment, not zero)

Why It Matters

  • Higher living standards
  • Increased tax revenue
  • Lower government spending on benefits

Policies Used

Demand-Side Policies

  • Increase AD:
    • Lower taxes
    • Increase government spending

Supply-Side Policies

  • Improve labour market efficiency:
    • Education and training
    • Reduce unemployment benefits (incentives to work)
    • Increase labour mobility

3. Economic Growth

Objective

  • Increase real GDP over time

Why It Matters

  • Higher incomes
  • Improved standards of living
  • More resources for:
    • Healthcare
    • Education
    • Infrastructure

Policies Used

Demand-Side Policies

  • Stimulate spending:
    • Lower interest rates
    • Tax cuts
    • Higher government spending

Supply-Side Policies

  • Increase productive capacity:
    • Investment in infrastructure
    • Technological improvements
    • Deregulation

4. Policy Trade-offs (Evaluation)

Conflict Between Objectives

  • Inflation vs Unemployment
    • Increasing AD:
      • ↓ Unemployment
      • ↑ Inflation
  • Growth vs Inflation
    • Rapid growth may:
      • Increase inflation

Short Run vs Long Run

  • Short run:
    • Trade-offs more significant
  • Long run:
    • Supply-side policies can reduce conflicts

Effectiveness Depends On

  • Size of policy
  • Economic conditions
  • Time lags
  • Expectations

Overall Evaluation

  • Governments aim for:
    • Stable growth
    • Low inflation
    • Low unemployment
  • However:
    • Objectives often conflict
    • Policies are not always precise

Quick Summary

  • Price stability: Controlled using monetary and fiscal policy
  • Low unemployment: Achieved through demand and supply-side policies
  • Economic growth: Driven by AD and productive capacity
  • Trade-offs exist between objectives