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2.4 Fiscal Policy: The government budget 


Fiscal policy: the use of government spending and taxation to influence the level of economic activity. 


Sources of government revenue: primarily from taxes (direct and indirect), as well as from the sale of goods and services, profits from state owned enterprises, sale of state owned enterprises and rent from government owned buildings and land. 


Current spending: day-to-day expenditure on wages, books for schools, drugs for the health sector. 


Capital spending: adding to the capital stock of the economy, e.g. road network.


Transfer payments: benefits paid for which no goods and services are received in return, such as unemployment benefits and pensions. 


Budget surplus: if government revenues exceed total expenditures. 


Budget deficit: if total expenditures exceed government revenue.  


Balanced budget: if total expenditures and government revenue are equal.   


National debt: the sum of all past debt/borrowing and interest on the debt.


A budget deficit increases the national debt and surplus reduces it. 


The role of fiscal policy


An increase in government spending, as a component of aggregate demand, shifts AD outwards. However, an increase in taxation, as a factor of aggregate demand, shifts AD inwards.    


Discretionary fiscal changes: deliberate changes in direct and indirect taxation and government spending, e.g. fiscal stimulus which would involve spending on infrastructure. 


Expansionary fiscal policy 


Expansionary/Reflationary fiscal policy: increase in government spending and reduction in taxation.


AD will initially increase and the effect will increase further due to the multiplied effect.  


A decrease in income tax: disposable income (Y) increases and because of the consumption function C = a + bY, consumption increases. Accelerator effect shows investment relies on consumption, more consumption induces more investment. As C and I are components of AD, AD increases. 


A decrease in corporation tax: increases the proportion of retained profits, increasing investment and AD. 


A decrease in indirect tax like sales tax (VAT): increases the purchasing power of consumers and real income, so AD increases.  


Increase in government spending on investment: increases AD due to the multiplier effect.  Investment provides jobs which increases income and consumption. Profits of firms increase and investment, as well as capital and current spending. 


The economy reflates as the price level increases from P to P1. Unemployment would decrease if more labour is needed to produce extra output, as the economy grows. The balance of payments deteriorates as imports increase. 


Contractionary fiscal policy 


Contractionary/Deflationary fiscal policy: decrease in government spending and increase in taxation to reduce inflation.


AD decreases.


Income tax: increases

Corporation tax: increases

VAT: increases

Government spending: decreases


The economy deflates as the price level decreases from P to P1. Unemployment would increase if less labour is needed to produce less output, as the economy shrinks. 


Automatic stabilisers


Automatic fiscal changes/stabilisers:  changes in taxation and government spending arising automatically as the economy moves through different phases of the business cycle. 


Tax revenues:  as economy expands tax revenue increase, taking more money out of the circular flow of income and spending.


Transfer of payments:  a growing economy means that the government does not have to spend as much on means-tested welfare, such as income support and unemployment benefits.


Evaluation of fiscal policy 


Time lags:

Recognition lag: takes time to realise GDP is falling too much or increasing too much.

Administrative lag: takes time to implement appropriate responses.

Impact lag: takes time for the changes in fiscal policy to work. 


Government spending and tax cuts: government spending increase has a greater impact on AD than tax cuts by the same amount. This is because individuals can decide how to spend extra income from tax cuts, which may be savings, to pay other indirect taxes or to buy imports.  Therefore, increasing withdrawals from the circular flow of income and make the value of the multiplier lower.


Direct crowding out: the effect on private expenditure and investment which decreases, as a result of increased government spending.

For instance new libraries means less books are bought from shops; new state school means less consumption of private schools.


Indirect crowding out: increase in government spending, so budget deficit and borrowing increases. Therefore, the demand for money increases/loans and interest rates rise, as banks sell bonds. Consumption and investment decrease.  























Crowding out depends on the government spending, so it is unlikely to make the fiscal policy completely ineffective. But large budget deficits need financing from taxation. Neo classical economists believe that increases in taxation drags down business investment, labour market incentives and productivity growth. 


Political influences: politicians may not act in the best interests of the economy as a whole, instead to get votes in the run up to the election.

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