5.

2 FISCAL POLICY

Chapter 5 : Government macroeconomic intervention (AS Level )

 CONTENT
5.2.1 meaning of government budget
5.2.2 distinction between a government budget deficit and a government budget surplus
5.2.3 meaning and significance of the national debt
5.2.4 taxation:
▪ types of taxes: direct/indirect, progressive/regressive/proportional
▪ rates of tax: marginal and average rates of taxation ( mrt, art)
▪ reasons for taxation
5.2.5 government spending:
▪ types of spending: capital (investment) and current
▪ reasons for government spending
5.2.6 distinction between expansionary and contractionary fiscal policy
5.2.7 AD/AS analysis of the impact of expansionary and contractionary fiscal policy on the
equilibrium level of national income and the level of real output, the price level and
employment
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5.2.1 Meaning of Government Budget

• Fiscal policy is the use of taxation and government spending to manage aggregate demand in order to achieve the
government’s macroeconomic aims.
• The government’s annual budget is a statement of its fiscal policy.
• The budget often receives much media attention as it is an indicator of both fiscal policy intentions and economic
performance.
• In the budget statement, the finance minister outlines the government’s spending and taxation plans for the year
ahead.

BUDGET SURPLUS BUDGET DEFICIT BALANCED BUDGET

Arises when tax revenue exceeds occurs when government spending when government spending
government spending exceeds tax revenue matches tax revenue

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5.2.1 Meaning of Government Budget
• Most governments seek to achieve a balanced budget over time.
➢ In the short term, a government may aim for, or welcome, a budget deficit if there is a low level of economic
activity.
➢ A budget deficit may occur in this situation as a result of both deliberate government action and of automatic
stabilisers.

Automatic Stabilisers.
• A government can also allow automatic stabilisers to influence aggregate demand.
• Automatic stabilisers are forms of government spending and taxation that change, without any deliberate
government action, to offset fluctuations (changes) in GDP.
Example
During a recession, government spending on unemployment benefits automatically rises because there are more
unemployed people.
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 o For example, during a recession, government spending on unemployment benefits automatically rises because
there are more unemployed people.
o Tax revenue from corporate tax, income tax and indirect taxes will fall automatically as profits, incomes and
expenditure decline.
Figure below shows how tax revenue and government expenditure change automatically as GDP changes.
▪ Initially, the economy is operating below full employment at Y with a significant gap between government spending
and taxation.
▪ As GDP rises, government spending on benefits falls while tax revenue rises with more people in employment and
so receiving more income.

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5.2.3 Meaning and Significance of the National Debt

• The national debt is often expressed as a percentage of GDP.

• Government or public sector debt is the total debt a central government, or the whole public sector, has built up
over time.
• It is connected to budget deficits and budget surpluses.
➢ If a government has a budget deficit in one year it will add to the country’s national debt.
➢ In contrast, the extra revenue earned from a budget surplus can be used to pay off part of the national debt.

• The national debt tends to increase during economic downturns as this is when government expenditure tends to
rise at a more rapid rate than tax revenue.
• There may also be a tendency for a government to spend more than its revenue even during economic booms (a
structural deficit).
• In addition, military conflicts can result in significant increases to the national debt.
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• There are disadvantages in having a large and increasing national debt.
➢ There is the opportunity cost of interest payments on the national debt.
▪ The government revenue used to service the debt might have been used to finance, for instance, the building of new
hospitals.
➢ A large national debt may make financial institutions, firms, individuals and foreign governments reluctant to lend.
▪ This is because it may cause them to have doubts about the government’s ability to pay interest on the debt and to
repay the sum borrowed.
▪ Borrowing a large amount may also push up the rate of interest that has to be paid.

• National debt is not the same as external debt as some of the debt will be owed to citizens of the country.
➢ For example, some households may have purchased government saving certificates and some domestic banks may
have bought government bonds.
➢ However, payments to foreign lenders by the government will involve an outflow of money from the country.

• The national debt to GDP ratio will be reduced if there is either some repayment of the debt or if GDP rises.
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5.2.4 Taxation

INDIRECT TAXES DIRECT TAXES

• Indirect taxes are taxes on the sale of goods and • Direct taxes are taxes on income and wealth.
services. • Two examples of direct taxes are income tax.
• The two most common indirect taxes are VAT (value ➢ personal income tax
added tax) and GST (general sales tax). ➢ corporation tax
• Both of these taxes are ad valorem taxes.
Example
➢ the standard rate of VAT in France in 2019 was 20% and
➢ the standard rate of GST in Pakistan was 17%.
• Specific indirect taxes, Excise duties (Sin Taxes)

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 Marginal rate of taxation (MRT) and
average rate of taxation (ART)
The marginal rate of taxation (mrt) is the proportion of extra income taken in tax

Eg: For example, if a person earns an extra £100 and £30 is taken in tax, the marginal tax
rate is £30/£100 = 0.3. This can also be expressed as 30%.

Average rate of taxation (art) is the proportion of a person’s total income that is taken in tax

Eg: If a person earns £50 000 and pays £10 000 in tax, the average tax rate is 0.2 or 20%.
Nature of Taxation

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Nature of Taxation

Tax Rate

Tax which is imposed at Example

the increasing rate for Income (Y) Tax Rate Tax Revenue ($)
all income levels. 1000 10% 100
2000 15% 300

ART = 100/1000 x100 = 10

MRT = 300 -100 /2000- 1000 x 100 = 20

For a progressive system of taxation:

Income ▪ Tax rate (t) increases with every increase in income.

▪ Tax amount increases more than proportionately
PROGRESSIVE TAX
when income increases
▪ MRT > ART
5.2.4 Taxation

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Nature of Taxation

Tax Rate
Example
Tax which is imposed at
Income (Y) Tax Rate Tax Revenue ($)
the same rate for all
1000 10% 100
income levels.
2000 10% 200

ART = 100/1000 x100 = 10

MRT = 200 -100 /2000- 1000 x 100 = 10

For a proportionate tax system:

Income • Tax rate (t) stays the same at every income level.
• Tax amount increases proportionately when income
PROPORTIONAL TAX
increases.
• MRT =ART
5.2.4 Taxation

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Nature of Taxation

Tax Rate
Tax which is imposed at
Example
the decreasing rate for
Income (Y) Tax Rate Tax Revenue ($)
all income levels.
1000 10% 100
2000 8% 160

ART = 100/1000 x100 = 10

MRT = 160 -100 /2000- 1000 x 100 = 6

For regressive taxation:

Income • Tax rate (t) decreases with every increase in

income.
REGRESSIVE TAX
• MRT < ART
5.2.5 Government Spending

• Government spending can be divided into spending on transfer payments (not counted in measures of national
income), current spending and capital spending.

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5.2.5 Government Spending
• Government spending can be divided into spending on transfer payments (not counted in measures of national
income), current spending and capital spending.

Government spending can also be divided into exhaustive and no exhaustive spending.
Non-exhaustive government spending is spending on transfer
Exhaustive government spending covers payments.
current and capital spending. • This spending does not involve the government deciding how
• It is spending which uses resources and is resources are used.
counted in aggregate demand and GDP. • The people who receive the payments make the decision
about how to use the resources. 17
What factors can influence Government Spending ?

1. Cyclical influences
2. Demographic influences
3. Social changes
4. Demand for government financed public goods and
merit goods
5. Demand for private goods
6. Change of technology
7. Political views/cycles
 5.2.6 Distinction Between Expansionary and Contractionary
Fiscal Policy

i. Discretionary fiscal policy

• planned Fiscal Policy.
• deliberate action by the government to influence economic activity through G and T
• budgetary policy can either budget for a deficit (G > T) or budget for a surplus (T > G
• fiscal stance:
➢ If government budget for a deficit (G > T) - expansionary fiscal policy (used in times of recession)
➢ If government budget for a surplus (T > G) - contractionary fiscal policy (used in times of inflation)

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 5.2.6 Distinction Between Expansionary and Contractionary
Fiscal Policy

Expansionary fiscal policy Contractionary fiscal policy

• Designed to increase aggregate demand. • intended to lower the growth of aggregate demand.
• This can be achieved by a government increasing its • This time, the government will reduce its spending
spending and/or cutting tax rates or the tax base. and/or increase taxes and may aim for a budget
• A government may decide to increase an existing surplus.
budget deficit so as to make a larger net injection into
the circular flow of income.

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