Fiscal Policy: An Introduction (AQA A Level Economics)

• Fiscal Policy involves the use of government spending and taxation (revenue) to influence aggregate demand in the economy
  
• Fiscal policy can be expansionary in order to generate further economic growth
  • Expansionary policies include reducing taxes or increasing government spending
    
• Fiscal policy can be contractionary in order to slow down economic growth or reduce inflation
  • Contractionary policies include increasing taxes or decreasing government spending 
    
• Fiscal Policy is usually presented annually by the Government through the  Government Budget 
  • A balanced budget means that government revenue = government expenditure
  • A budget deficit means that government revenue < government expenditure
  • A budget surplus means that government revenue > government expenditure
    
• A budget deficit has to be financed through public sector borrowing
  • This borrowing gets added to the public debt

Macroeconomic impacts

• Fiscal policy is used to help the government achieve their macroeconomic objectives
• Specifically, the use of fiscal policy aims to
  • Maintain a low and stable rate of inflation
  • Maintain low unemployment
  • Reduce the business cycle fluctuations
  • Create a stable economic environment for long-term economic growth
  • Redistribute income so as to ensure more equity
  • Control the level of exports and imports (net external balance)
    
• When a policy decision is made, it creates a ripple effect through the economy, impacting the macroeconomic objectives of the government
• Changes to fiscal policy can influence several of the components of AD
  • A change to any component of AD helps to achieve at least one of the goals of fiscal policy
    

Microeconomic impacts

• Fiscal policy includes making changes to policies such as taxes and subsidies 
  • Income tax cuts can influence labour to be more productive 
  • Tax cuts can encourage firms to increase output or be more entrepreneurial
  • Subsidies can lower costs of production in the industry, leading to higher output

Expansionary fiscal policy

• Expansionary fiscal policies include reducing taxes or increasing government spending with the aim of increasing AD 
• AD = household consumption (C) + firms investment (I) + government spending (G) + exports (X) - imports (M)
  • AD = C + I + G + (X - M
    
• Expansionary fiscal policy aims to shift aggregate demand (AD) to the right
  

Diagram: expansionary fiscal policy

Expansionary fiscal policy which increases real GDP (Y1 →Y2) and average price levels (AP1 → AP2) 

Diagram analysis

• The economy is initially in macroeconomic equilibrium AP1Y1: there is a recessionary gap
• The Government wants to boost economic growth and lowers the rate of income and corporation taxes
• Lower taxes cause investment and consumption to increase, which are components of AD
• Aggregate demand increases from AD→ AD₁
• The economy reaches a new equilibrium at AP₂Y₂ - a higher average price level and a greater level of national output

Examples of the Impact of Expansionary Fiscal Policy

Contractionary fiscal policy

• Contractionary fiscal policies include increasing taxes or decreasing government spending with the aim of decreasing AD  
• AD= household consumption (C) + firms investment (I) + government spending (G) + exports (X) - imports (M)
  • AD = C + I + G + (X - M
    
• Changes to fiscal policy can influence government spending or consumption or investment
  • Changing taxation can influence household consumption and the investment by firms
    
• Contractionary fiscal policies aims to shift aggregate demand (AD) to the left

Diagram: contractionary fiscal policy

Contractionary fiscal policy aims to decrease real GDP (YFE →Y1) and average price levels (AP1 →AP2)

Diagram analysis

• The economy is initially in macroeconomic equilibrium AP₁Y_FE - an inflationary output gap is developing
• The economy is booming and the Government wants to lower inflation towards its target of 2%
• The Government increases the rate of income tax
• Higher tax rates cause households to have less discretionary income, causing consumption to decrease
• Aggregate demand decreases from AD1→ AD2
• The economy reaches a new equilibrium at AP₂Y₁ - a lower average price level and a smaller level of national output
   

Examples of the Impact of Contractionary Fiscal Policy

• Many fiscal policies have the ability to improve the productive potential (supply-side) of an economy

  • E.g. Education subsidies to help the poorest households constitute an annual expenditure for the government. However, in the long term, they help to improve human capital, which boosts productivity and output

  • The fiscal policy is short-term (annually); however, the supply-side impact occurs in the long term

• Government spending and taxation influence the level of economic activity
  • Government spending is an injection and increases economic activity
  • Taxation is a withdrawal and decreases economic activity
• The government budget is usually set once a year
• This fiscal policy then operates automatically in the background producing a stabilising effect as the economic activity fluctuates

  • Automatic stabilisers are automatic fiscal changes that occur as the economy moves through stages of the business/trade cycle 

The impact of automatic stabilisers on an economy during a boom and recession

Effects in a recession

• In a recession, there will automatically be lower tax revenue due to the nature of progressive taxation - as incomes fall households are taxed less

• In a recession, as unemployment rises, the government will pay higher unemployment benefits and transfer payments, which households will then use for consumption

• Both of the above will result in real GDP being higher than it would otherwise have been

Effects in a boom

• In a boom, there will automatically be higher tax revenue due to the nature of progressive taxation - as incomes rise, households are taxed more

• In a boom, as unemployment falls, the government will pay fewer unemployment benefits / transfer payments which will decrease household consumption

• Both of the above will result in real GDP being lower than it would otherwise have been

• This is effectively an automatic disinflationary effect