Sample Notes: Fiscal Policy

O Level and IGCSE Economics

Chapter 4.3 – Fiscal Policy

4.3.1 Definition of the Government Budget

• A government budget is a comprehensive financial plan that outlines a government’s anticipated revenue and its intended expenditures over a fiscal year.
• It reflects the government’s fiscal intentions and economic priorities, determining how it will raise revenue (mostly through taxes) and where it will allocate spending (education, healthcare, defense, infrastructure, etc.).

Types of Budget:

• Balanced Budget: Government revenue = government spending
  • Often seen as a sign of fiscal responsibility, though not always optimal for economic growth.
• Budget Surplus: Revenue > spending
  • Can reduce national debt or be saved for future needs; may indicate under-spending on public services.
• Budget Deficit: Spending > revenue
  • Often used to stimulate economic activity in times of recession but can lead to rising public debt if persistent.

4.3.2 Reasons for Government Spending

Government spending is central to economic activity and affects all sectors of society. It can be grouped into key areas:

1. Provision of Public Goods

• Public goods are non-excludable and non-rivalrous, meaning one person’s consumption doesn’t reduce availability for others, and no one can be effectively excluded.
• Examples: National defense, police services, street lighting.
• Private sector won’t supply these efficiently due to the free-rider problem, so the government must step in.

2. Provision of Merit Goods

• Merit goods are under-consumed if left to the free market due to information failure.
• Examples: Education, healthcare, vaccinations.
• Government intervenes to increase their consumption through direct provision or subsidies.

3. Reducing Inequality

• Spending on welfare programs (unemployment benefits, pensions, housing support) redistributes income and provides a safety net.
• Helps to alleviate poverty and improve living standards.

4. Infrastructure Development

• Investment in roads, bridges, transport, power supply, and communication networks supports long-term economic growth and increases productivity.
• Essential for attracting foreign investment and improving the business environment.

5. Economic Stabilization

• During recessions, governments increase spending to boost aggregate demand (AD).
• During booms, they may reduce spending to prevent inflation.
• This is part of counter-cyclical fiscal policy.

6. Support for Specific Industries

• Governments may provide subsidies or bailouts for industries in distress (e.g., agriculture, banking) or promote strategic sectors like renewable energy.

7. Spending on Law, Order, and Administration

• Includes salaries for civil servants, police, judiciary, and general government functioning.
• Essential for maintaining a stable environment for economic activities.

4.3.3 Reasons for Taxation

Taxation is the primary source of government revenue and serves several purposes:

1. To Raise Revenue

• Most basic function: Fund public goods and services (education, health, defense, etc.).
• Allows government to operate without relying on excessive borrowing or printing money.

2. To Redistribute Income

• Progressive taxation (higher rates on high-income earners) helps reduce income inequality.
• Funds collected can be used for social welfare programs.

3. To Influence Behavior

• Sin taxes discourage harmful consumption (e.g., tobacco, alcohol).
• Environmental taxes (carbon tax) reduce pollution.

4. To Manage the Economy

• Used as a fiscal tool to influence aggregate demand:
  • Reducing taxes can stimulate spending and investment.
  • Increasing taxes can cool down an overheating economy.

5. To Protect Local Industries

• Tariffs (taxes on imports) protect domestic producers from international competition.
• Encourages consumption of locally produced goods.

4.3.4 Classification of Taxes

Taxes can be classified in several ways:

A. By Incidence

• Direct Taxes: Paid directly to the government by individuals or organizations.
  • Examples: Income tax, corporate tax, capital gains tax.
  • Cannot be passed on to others.
• Indirect Taxes: Levied on goods and services and collected by intermediaries.
  • Examples: VAT, sales tax, excise duties.
  • Passed on to consumers as part of the product price.

B. By Progressivity

• Progressive Taxes: Rate increases as income increases.
  • Example: A person earning $10,000 might pay 10%, while one earning $100,000 pays 30%.
  • Redistributive effect – reduces inequality.
• Regressive Taxes: Take a higher percentage from low-income earners.
  • Example: Sales tax – everyone pays the same amount regardless of income.
• Proportional Taxes: Constant rate regardless of income.
  • Example: A flat income tax rate of 15% for all individuals.

C. Other Classifications

• Ad Valorem Tax: Based on the value of the item (e.g., VAT).
• Specific Tax: Fixed amount per unit sold (e.g., $1 per cigarette pack).

4.3.5 Principles of Taxation (Qualities of a Good Tax)

According to Adam Smith’s Canons of Taxation, a good tax should fulfill these principles:

1. Equity: Tax should be fair; those with higher ability to pay should contribute more.
2. Certainty: Amount and method of payment should be clear and predictable.
3. Convenience: Tax should be collected in a manner and time that is convenient to the taxpayer.
4. Economy: Cost of collection should be low relative to the revenue raised.

Additional modern principles include:

• Flexibility: Should adapt to changes in the economy.
• Neutrality: Should not excessively distort behavior or market decisions.
• Administrative Simplicity: Should be easy to understand and comply with.

4.3.6 Impact of Taxation

Taxation affects various stakeholders:

A. Consumers

• Higher indirect taxes increase the price of goods and services.
• May reduce disposable income and consumption.
• Could be regressive if it disproportionately affects lower-income groups.

B. Producers

• Corporate taxes reduce profits and may discourage investment.
• Higher production costs due to indirect taxes may reduce competitiveness.
• Some producers pass the tax burden onto consumers through higher prices.

C. Government

• Revenue generation enables provision of public services.
• Tool to influence economic activity through fiscal policy.
• Poor tax design or collection inefficiency can lead to revenue shortfalls.

D. The Economy as a Whole

• Well-designed taxes support economic growth and stability.
• Over-taxation or unfair tax systems may reduce incentives to work, save, or invest.
• Progressive taxes can reduce inequality but may reduce entrepreneurship.

4.3.7 Definition of Fiscal Policy

• Fiscal policy is the use of government spending and taxation to influence the economy.
• Managed by the Ministry of Finance or Treasury Department in most countries.
• Part of demand-side policies, focusing on influencing aggregate demand (AD).

4.3.8 Fiscal Policy Measures

Fiscal measures are classified based on their impact and direction:

1. Expansionary Fiscal Policy

• Increases in government spending and/or reductions in taxation.
• Aims to stimulate AD during recession or economic slowdown.
• Leads to higher employment, output, and consumption.

2. Contractionary Fiscal Policy

• Decreases in government spending and/or increases in taxation.
• Used to control inflation or reduce budget deficits.
• May reduce aggregate demand and economic overheating.

4.3.9 Effects of Fiscal Policy on Government Macroeconomic Aims

Fiscal policy is used to pursue the following macroeconomic objectives:

1. Economic Growth

• Public investment in infrastructure and education increases productive capacity and boosts long-term growth.
• Short-term boosts to demand can reduce unemployment and increase output.

2. Low Unemployment

• Expansionary fiscal policy increases job creation in public and private sectors.
• Government-funded job schemes or subsidies to employers can lower joblessness.

3. Price Stability

• Fiscal tightening helps control demand-pull inflation.
• Reduction in government spending or increase in taxes curbs excessive consumption.

4. Balance of Payments Stability

• Fiscal policy can influence imports and exports indirectly.
• For example, taxes on imports (tariffs) can reduce trade deficits.

5. Redistribution of Income

• Progressive tax systems and targeted spending (welfare, education) help redistribute wealth.

Key Calculations Involving Fiscal Policy

• Budget Balance = Government Revenue – Government Expenditure
  • Positive value = Budget Surplus
  • Negative value = Budget Deficit

Example:
If a government collects $300 billion in revenue and spends $350 billion,
Budget Balance = 300 – 350 = –50 billion (deficit)

Summary of Key Terms