Candidates should understand that fiscal policy can have both macroeconomic and microeconomic functions. They should be able to explain how it could be used to influence aggregate demand and aggregate supply, and also how government spending and taxation can affect the pattern of economic activity.

The word fiscal seems to be of 16th century origin from the Latin fiscalis or from the French fiscus,meaning ‘purse or treasury’. Fiscal therefore relates to managing your purse or your budget and in economics fiscal policy is about managing and manipulating government spending, taxation and borrowing. We talk and write about fiscal policy in a number of ways, as being: discretionary, autonomous, expansionary or contractionary.

Discretionary Fiscal Policy

Discretionary means to choose deliberately, so discretionary fiscal policy is the deliberate attempt to affect the whole or part of the economy by managing and manipulating government spending, taxation and borrowing. There are a number of effects from using fiscal policy and the four areas in the diagram above show them. Higher rates of taxation on rich people raises revenue for the government, but also redistributes resources to the poor. A tax on alcohol raises revenue, but it also discourages consumption and reallocates resources from one use to another. When the government taxes alcohol to reduce alcoholism it also makes people who spend a high proportion of their income on alcohol poorer. A change in one circle inevitably has an effect on the others too. The rectangle around the circles represents the whole economy. Fiscal policy is sometimes used to make the economy grow, and this affects all the areas: revenue raising, redistribution and reallocation. A larger economy means more tax revenue, more public and merit goods and help for the poor. Reducing rates of personal and corporate taxation might increase incentives and get people working harder but in doing so it may create a less equal society. Therefore trying to change one part of the economy will inevitably affect another.

Raising revenue
The most obvious point to make about taxation is that it is required to raise revenue in order to finance the government and its activities. Tax revenue comes from various sources; direct taxes like income tax, national insurance and corporation tax are paid straight to the government and indirect taxes which are paid to government via a third party. Most people in the UK pay income tax through the Pay As You Earn (PAYE) system. With PAYE, income tax and national insurance is deducted from an employee’s gross pay by the employer and paid to the government leaving the net pay. Excise duties and value added tax (VAT), on the other hand, are paid to a retailer who then passes the tax on to the government.

Revenue from taxation does not come in evenly throughout the year because VAT receipts are larger at Christmas, and corporation tax is paid by business only at the end of the financial year. Government expenditure is however paid out more evenly because a huge amount is government worker’s salaries and they get paid in twelve equal monthly installments. This means that even if the government balances the budget, it needs to borrow in some months and has excess funds in others.

UK government tax revenues
The biggest slice of government revenue in the UK comes from income tax and like most countries it is charged using a system of increasing marginal rates. This means that as people’s incomes rise they don’t just pay more tax but also a higher proportion too. The government creates bands of taxation so that people in the lowest tax band pay no or little tax but as incomes increase the marginal tax rate rises. Let’s look at a hypothetical citizen, for example a head of mathematics in a school who earns about £50,000 per annum. They pay nothing on the first £6,475, and 20% on the next £37,400 which equals £7,480. Adding £6,475 and £37,400 together gives £43,875, so there is £6125 (£50,000-£43,875) more to be taxed and this is at the marginal rate of 40% which is £2450.

The story doesn’t quite end there because employees also pay National Insurance. If you earn more than £139 a week and up to £817 a week, you pay 12 per cent of the amount you earn between £139 and £817, and if you earn more than £817 a week, you also pay 2 per cent of all your earnings over £817. National Insurance for our hypothetical worker on £50,000 works out at £4,259. This means he pays £9,930 + £4,259 = £14,189 in tax and national insurance which works out at 28.4% of his gross income. This sort of system, which has increasing marginal rates of taxation, is also described as being progressive because it takes a bigger proportion of incomes from higher earners.

Politicians are aware that 40% or 50% sounds a lot so they have another trick up their sleeves. The way that ‘National Insurance’ is phrased makes it seem like there is an insurance scheme and a separate pot of money that workers pay into. The reality is that money from national insurance and income tax goes into the same big treasuries pot as all the other tax revenue. Old age pensions are not paid out from a carefully invested fund of pensioner’s savings; instead today’s taxpayers fund today’s pensioners. This sleight of hand allows the Chancellor of the Exchequer to say the basic rate of income tax is only 20%, and if he increases the rate of national insurance he can still claim he didn’t increase income tax.

The story still does not end because our hypothetical citizen also has to pay council tax, and this depends on how much his home is worth. Again there are bands whereby people in cheaper houses pay less than those in expensive houses. Council taxes, which are sometimes referred to as ‘the rates’, are paid to local councils and each county charge slightly differently. In Oxfordshire a middle band household pays about £2000 a year with a discount of 25% for people who live alone. Our hypothetical citizen earning £50,000, pays £14,189 in income tax and national insurance and £2000 in council tax, leaving him with £33,811 in disposable income.

UK government expenditure

Once workers have this disposable income in their bank accounts, the choice of how to spend it is theirs. If they spend all their money on children’s clothes , basic foodstuffs or books and newspapers they will escape paying value added tax and excise duties. But if they spend their cash on adult clothes, dinners out, Sky Sports, drinking alcohol and smoking tobacco they will pay 20% on top of the price in Value Added Tax (VAT), 40p a pint in excise duty on the beer and 15.5p for every cigarette. Fortunately for our mathematics teacher’s children, they will probably avoid paying inheritance tax when he dies because this only applies to estates worth more than £325,000 and only a very few people leave this amount in their wills, anything above that is taxed at 40%.
Businesses also pay tax. Corporation tax is a 25% tax on profits but there are lots of relief schemes so that if the profit is reinvested in the business it might be possible to reduce the bill. Business rates are similar to council tax and are paid to local councils to help pay for things like rubbish removal.

Reallocation of goods and services
Public goods are goods such as streetlights, the police and the armed forces; they have the properties of non-excludability and non-diminishability. Merit goods are goods that have positive externalities and are under-provided by the free market such as health and education. The government, depending on whether it is a believer in free markets or more socialist in tendency, spends taxpayer’s money on providing fewer or more of them. In figure above you will see that £33 billion pounds is spent on public order and safety, and £89 billion on education. You will learn more about public goods and merit goods in the microeconomics part of the course, but merit goods and public goods have to be paid for and the government requires tax revenue to do so. However, discretionary fiscal policy can also be used to influence the market, for example subsidizing a good or service encourages its consumption. For example, children’s clothes are exempt from VAT and medicines are provided free of charge by the National Health Service to children and heavily subsidized for adults. Demerit goods such as cigarettes are taxed for two reasons; to raise revenue and discourage consumption. VAT and excise duties are said to be regressive as they take a bigger proportion of a poor person’s income. This is because VAT and excise duties are taxes on expenditure and poor people spend nearly all their income while rich people save some of theirs.

Redistribution of income and wealth
Income and wealth are not the same things. Wealth is a stock of assets such as property, savings in bank accounts and shares in a business. Queen Elizabeth the second is a wealthy woman and her property includes land, fine art, gems and an impressive stamp collection, although many of the assets you associated with royalty are not her personal possession. Buckingham Palace, Windsor Castle and the Crown Jewels are actually held in trust for the nation.

Income is the amount of money or its equivalent received during a period of time in exchange for labour, which is how of most people earn money, but rent from land, interest in capital or profit from entrepreneurship are other sources. According to Forbes magazine the land and capital the queen owns, earns her £12.5 million in income.

Thus wealth is a stock of assets whereas income is a flow of money or its equivalent. Jane Austen knew a thing of two about the importance of income. In Pride and Prejudice Mrs. Bennet remarks of Mr. Bingley, ‘A single man of large fortune; four or five thousand a year. What a fine thing for our girls! Whilst a family might be wealthy in that they own their own house, they might still struggle because their income is low.

Five thousand pounds is about £400,000 today’s money and considerably more than the average UK income of £25,000 a year. Then as now, incomes in the UK are unequal as we can see in the next diagram. The mean of £517 a week is what the average family income is but this average is dragged up by the fact that there are a small number of people on extraordinarily high incomes. This results in a median family income of only £413 meaning that half of families earn below this amount.

(source: IFS)
Governments may or may not try to make this distribution more equal depending on their ideologies and ability to do so. Providing health care and education free of charge boosts the living standards of everyone, but living standards of the poor are increased more as a proportion because they had so little to start with. The other way of redistributing income is by imposing higher marginal rates of income taxation. In the 1970s the highest income tax band had a marginal rate of taxation of 80% and in the Denmark today the highest earners may be paying 57% of their gross income in tax.

Economists and politicians who are more inclined to free market solutions see an unequal distribution of wealth and income as desirable. They see envy of the rich as an incentive to others to work hard and to encourage entrepreneurs. Even the super-rich have their purposes as they encourage people to innovate and come up with new inventions and technologies that transform the way we live and raise everyone’s living standards. And what then is the point of wanting to be rich if you cannot then leave your wealth to your children? Believers in free markets would say socialist and communist systems lack incentives.

Those politicians and economists that would like to see more equal distributions do so for a variety of reasons. Some argue on the basis of fairness. The queen for example didn’t earn her income from dreaming up new technology but rather because she inherited it. Is it fair that four million children in the UK are born into poverty? Inequality also carries with it the risk of social unrest and perhaps the sort that led to the French and Russian revolutions or to the rise of Hitler in Germany. Other economists who would not wish to be associated with communism or socialism argue less about fairness and more that inequality brought about by capitalism bears the seeds of its own destruction. The rich accumulate their wealth and this excessive wealth leads to asset price bubbles such as those of the 1929 stock market crash or the banking crises of 2008. Lack of aggregate demand, caused by hoarding of wealth, results in a concomitant rise in unemployment. To avoid these problems Liberal Democrats have argued that it might be better to tax wealth rather than income so that the incentives to work hard remain but the overall problems of inequality are addressed.

Inequality is also a regional phenomenon. Generally the South East of England is better off than North and some areas of the UK in particular suffer disproportionately. Areas of the country that specialised in coal mining, shipbuilding or steelmaking have suffered in recent years. The Welsh valleys, Tyneside, Teeside, Wearside and the River Clyde in Scotland have all been particularly hard hit. Regional unemployment still blights these areas 30 years after the decline in heavy industry. Help from fiscal policy comes in the form of regional development grants from both the UK and Europe Union and lower rates of corporation tax.

Expansionary Fiscal Policy
Government spending is an injection into the circular flow of income and taxation is a leakage. Changes in either government spending or taxation are therefore going to have an effect on aggregate demand and therefore the size of national income. What exactly will happen is a matter of much discussion and disagreement amongst economists. There are a number of schools of economic thought and much more will be said of this in other sections of the text. Keynesians who are followers of the ideas of John Maynard Keynes (1883-1946) believe that an increase in government spending, other things being equal, will increase aggregate demand by the same amount and then further still as the injection is multiplied. Keynesian economics’ central tenet is the belief that recessions and depressions are caused by a lack of aggregate demand. The economy might stay in disequilibrium for a long time, just as it did in the Great Depression of the 1930s, with the resulting problems of unemployment and social unrest. Keynes worried that a political reaction to this might end up with extreme left or right wing dictators such as Stalin or Hitler coming to power. The answer Keynes suggested was for the government to step in and raise government spending, even if that meant borrowing. This increase in government spending would increase aggregate demand and then through the multiplier process get the economy growing again. Newspapers and politicians sometimes use the phrase ‘giving the economy a kick start’ or ‘priming the pump’ to explain the idea.

John Maynard Keynes 1883 -1946

In the diagram below we can see the effects of expansionary fiscal policy. A rise in government spending, other things being equal, moves the AD curve to the right, which increases real national income from Y1 to Y2. This reduces the negative output gap and moves the economy closer to the full employment level of national income Yfe. However as spare capacity in the economy is used up firms also raise their prices causing the price level, and therefore inflation, to rise too. The extent to which real national income rises compared to the price rises depends where the economy was to start with. If the economy is close to Yfe to begin with an increase in AD will merely be inflationary with little effect on real national income.
Monetarist economists like Milton Friedman (1912-2006) believed that the rise in aggregate demand might have a short-run effect but that ultimately government spending will cause inflation and this will cause business to reduce their level of investment, i.e. that government spending merely crowds-out private investment. New classical economists like Robert Lucas (b. 1937) believe that government spending causes inflation instantly because people have rational expectations and they know that increased government spending causes inflation, so they and change their behavior immediately. So for monetarists and new classical economists any increase in national income caused by discretionary fiscal policy is likely to be nominal and not real. Monetarists and new classical economists would also prefer government spending to be a small proportion of the total GDP and for the government to balance its budget because they are believers in free markets and are against big government. In this case you might describe their fiscal stance as being neutral. A policy of government spending that is larger than tax revenue is described as expansionary, and if government spending is less than tax revenue it is said to be contractionary.

The multiplier
The multiplier is a concept that needs to be understood better later at A2 and a simple grasp of the idea is all that is needed at the moment. The multiplier is sometimes called the Keynesian multiplier because it is central to Keynes theory of employment, interest and money. Keynes said that if there were a new injection into the economy other things being equal this would immediately increase the size of GDP by that amount. So if the government borrowed £1b and increased spending by that amount then GDP would increase by £1bn. If the money were spent on motorways and schools then the firms who did the work would take on more staff and buy more raw materials and capital goods. Of the extra income earned by workers, some would be paid in taxes and some saved. The rest would be spent and this we call consumption. The firms who sold the raw material and capital would also take on new workers and they too would increase their consumption. This consumption would in turn lead to yet more employment, perhaps in clothes shops, supermarkets and restaurants. On and on the cycles of spending would go although each time the amount would be a little less because workers didn’t spend all their earnings.

What the multiplier principle suggests is that an initial injection into the circular flow of income will cause an increase in aggregate demand much larger than the initial injection. How much more depends on the size of the multiplier. There is disagreement first about whether the theory is correct and second, supposing the theory is correct, the value of the multiplier. Some economists point out that in the UK we have a high propensity to import goods so that much of the injection leaks out of the circular flow.

Contractionary fiscal policy
This is used to reduce the level of aggregate demand. When the economy is in recovery or the boom phase of the economic cycle the problem becomes not one of unemployment but inflation, whereby aggregate demand exceeds aggregate supply. This also results in increases imports as the home economy lacks the capacity to keep up with the rise in demand. For Keynesians the idea here is to decrease government spending or increase taxes or a mixture of both to take the heat out of the economy. After Keynes had died in 1946, economists in the Treasury believed that they could fine-tune the economy by manipulating government spending and taxes so that the booms and slumps in the economic cycle could be evened out. However there are a number of problems with these ‘stop-go’ policies. In the early 1980s Mrs. Thatcher’s Chancellor, Geoffery Howe, deliberately cut government expenditure as means of reducing inflation, which had by then reached 20 %.

Automatic stabilizers
Germany was the first country to provide a national insurance scheme for sickness in 1884. In 1908 Lloyd George, the Chancellor of the Exchequer in the Liberal government, under pressure from the Labour Party, introduced a National Insurance Act which gave the British working classes the first contributory insurance scheme against illness and unemployment. The Act passed into law in 1911 despite opposition from the Conservatives. Part I of the act provided medical benefits. Workers earning less than £160 a year had to insure themselves and they paid four pence, the employer contributed three pence and the government two pence. Workers who were then sick could claim ten shillings a week. Part two of the act provided unemployment benefit. The worker paid two and a half pence for it, the employer contributed the same, and three pence came from the taxpayer. The worker would then be entitled to seven shillings a week for up to fifteen weeks in the event of unemployment. This was commonly referred to as ‘the dole’. The modern day equivalent of the dole is called Job Seekers Allowance. To get the allowance you must be available, and actively looking for work and (usually) over eighteen. in 2012 single people, under 25 years old received £50.95.

In a recession the amount the government pays out in benefits necessarily rise and this causes an injection into the circular flow. So this is what automatic stabilizer means, as the economy shrinks government spending automatically increases. When the economy starts to grow again workers are re-employed, the benefit payments cease and tax revenues begin to rise. So in an expanding economy money is automatically withdrawn from the circular flow. The Organization for Economic Cooperation and Development (OECD) has estimated that fluctuation in UK GDP is dampened by 20% because of these automatic stabilizers.

The Budget
Every year In March or early April the Chancellor of the Exchequer makes a speech to the House of Commons on the state of the government’s finances and proposals for changes to taxation. Income tax and corporation tax are annual taxes, so they must be renewed each year and it is almost impossible to change these rates during the year. Since 1997, the Chancellor of the Exchequer has presented an annual pre-Budget report. This usually takes place in November or early December and includes a report of progress since the previous Budget, an update on the economy and details of proposed changes to taxation. Changes to VAT can be made after the pre-budget report because it is a tax on expenditure and not an annual charge.

PSNCR stands for the Public Sector Net Cash Requirement or in other words the budget deficit. A budget deficit is simply the excess of government spending over and above government revenue for the year. The PSNCR includes the balances of central government, local councils and public corporations. N.B. the PSNCR used to be called the PSBR (the public sector borrowing requirement).

The National debt
The national debt is the sum total of government borrowing. It is all the accumulated budget surpluses and deficits of the past. Being called a national debt gives the impression that the debt is owed to other countries but this is not true. The government borrows money by selling government bonds; sometimes they are called gilts because historically they were edged in gold leaf. Today bonds are just entries in the Bank of England’s computer system. These government securities are sold to financial institutions both here and abroad. Bonds in the UK are mostly long-term debt instruments and they carry an interest rate. These bonds, once sold, can also be sold on again or even sold back to the Bank of England, if the bank is willing to buy them back early.

Structural and cyclical deficits
Since 2010 the Conservative/Liberal coalition has been trying to reduce the size of the budget deficit. Reducing the deficit is of course difficult because as we saw earlier reducing government spending may lead to a shrinking economy because the tax revenue falls and benefit payments rise. The government has therefore been trying to distinguish between which part of the deficit that is cyclical, i.e. is caused by the downswing in the economy and which part is structural i.e. is due to a long-term imbalance between spending and taxation. Arguably it is the structural deficit that it is important to reduce because the part of the deficit, which is cyclical, will disappear when the economy recovers.

Problems with fiscal policy
a. Time lags – because income tax, national insurance and corporation tax can only be changed in the budget once a year so the government cannot instantly make changes and any change in their policy may take over a year to take effect.

b. Fiscal mistiming – a policy to change income tax as we have seen in a. may be delayed, by the time the policy takes effect the economy may be in a different phase of the economic cycle of its own accord. So a reduction in the basic rate of income tax which was intended to help increase aggregate demand in a slump might not take effect until the economy is in the recovery phase leading to an even bigger boom than would have occurred naturally and exacerbating inflation and the deficits on the current account.

c. Crowding out – free market economists suggest that government spending just displaces private investment. First, government borrowing pushes up interest rates increasing the cost of investment for firms and second if the public sector provides more services it takes away profitable opportunities from firms in the private sector.

d. The shape of the short-run aggregate supply curve (SRAS) – New classical economists see the SRAS as vertical meaning any increase merely creates inflation.

e. Other things are not equal – as with all theories and models in economics the ceteris paribus assumption usually applies. But fiscal policy does not happen in a vacuum. It also affects supply side policies, and where government borrowing is concerned it affects the money supply. As the diagram at the start of the section makes clear macro economic changes have micro economic effects and vice-versa. Furthermore there are exogenous events. These are things outside the UK economy over which we have little or no control for example: a tsunami in Japan, a recession in America, or the development of the BRIC countries.

Have a go at these two matching tasks and the multiple choice questions to test your knowledge -

Fiscal policy 1

Fiscal policy 2

Multiple choice test


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