Fiscal Policy

Key Terms

Fiscal Policy: The manipulation of public spending, taxation and borrowing to achieve the governments macroeconomic objectives.

Injection: An increase in spending into the circular flow of the economy, it includes government spending (G), exports (X) and investment (I).

Withdrawal: A leakage from the circular flow of the economy, it includes taxation (T), imports (M) and savings (S).

Theory

What is Fiscal Policy?

Fiscal policy involves the government changing the rate of taxation and government spending to alter the level of aggregate demand (AD).

Government Spending & Taxation

Government Spending

Government Spending makes up over 45% of GDP and is used to redistribute income, allocate resources and for macro-economic management. Spending is made up of three main areas:

Transfer Payments - Welfare payments e.g. child benefits.

Capital Spending - Spending on infrastructure e.g. hospitals.

Current Spending - Spending on goods and services supplied by the state e.g NHS staff wages.

Taxation

Like government spending, taxation is used to redistribute income and to manage the macro-economy. There are two type of taxation that you will have learn't studying micro-economics.

Direct Taxation - E.g. Income Tax, Corporation Tax and Capital Gains Tax.

Indirect Taxation - E.g. Value Added Tax (VAT).

Types of Fiscal Policy

Expansionary Fiscal Policy

This policy involves the increase of aggregate demand to stimulate growth. The government achieve an increase in AD by increasing government spending (G) and lowering taxation (T).

Lower tax means households have more dispoable income which they can use for spending (C).

Government spending (G) and consumer spending (C) are components of AD (C+I+G+X-M) and therefore act as injections into the circular flow which causes an increase in AD.

Contractionary Fiscal Policy

This policy involved decreasing the level of AD. Lowering government spending (G) and increasing taxation (T) causes a withdrawal from the circular flow, thus lowering AD.

The reason the government chooses to pursue this policy may be to improve the budget deficit or to improve the balance of payments by making the currency more competitive through lower rates of inflation.

Advantages of Fiscal Policy

1) Flexibility

Government spending and taxation can be targeted over a wide range of areas. This is known as hypothecation, where taxation can be earmarked for a specific purpose.

E.g. If the government want to increase employment among the student population they could increase tax free allowed for a specific age range.

2) Stimulating the economy

Keynsian economists in particular argue the potency of fiscal policy in stimulating the macro-economy. Government spending and taxation can be a powerful tool in adjusting the level of aggregate demand since it makes up 45% of GDP.

Disadvantages of Fiscal Policy

1) Uninteded Consequences (Government Failure)

Fiscal policy may not have the desired outcome. For example a decrease in income tax may encourage consumer spending on imports.

2) Political Mypoia (Government Failure)

Fiscal policy is determined by the chancellor of the exchequer which could lead to political influence in decision making. For example in the run up to a general election the leading party may pursue a policy of lower taxation to win voters.

3) Time Lags

It takes time to recognise that AD is growing too quickly or slowly and the budget is also only set once a year. It then takes time for the policy to work e.g. It takes time for households to realise that they can take advantage of government spending schemes.