Fiscal Policy (Copy)

4.3.1 Definition of the Government Budget

• Government budget = Statement of government’s planned revenue (mainly taxation) and expenditure over a year.
• Balanced budget: Government revenue = Government expenditure.
• Budget deficit: Government expenditure > Government revenue.
• Budget surplus: Government revenue > Government expenditure.
• Deficits usually financed by borrowing (from public, banks, or foreign lenders).

Diagram: Budget Position

Revenue = Expenditure   → Balanced Budget
Revenue > Expenditure   → Surplus
Revenue < Expenditure   → Deficit

4.3.2 Reasons for Government Spending

• Public goods: Provided because private firms would not (e.g., defense, street lighting).
• Merit goods: Encouraged for social benefit (e.g., education, healthcare).
• Redistribution: Welfare payments, unemployment benefits, pensions.
• Infrastructure: Roads, ports, power, communication.
• Law and order: Police, courts, prisons.
• Economic management: Subsidies, investment in industries, stabilisation.
• International obligations: Aid, contributions to global organisations.

Diagram: Areas of Spending

Government Spending
│
├─ Public goods
├─ Merit goods
├─ Welfare
├─ Infrastructure
├─ Law & order
└─ International

4.3.3 Reasons for Taxation

• Source of revenue for government services.
• Redistribute income (progressive taxation reduces inequality).
• Control consumption (taxes on cigarettes, alcohol, fuel).
• Manage economy (reduce inflation by cutting disposable income).
• Environmental aims (carbon taxes, plastic taxes).
• Protectionism (tariffs on imports to protect domestic industries).

Diagram: Purpose of Taxes

Raise Revenue → Fund Spending
Redistribute → Reduce Inequality
Discourage → De-Merit Goods
Protect → Domestic Industry

4.3.4 Classification of Taxes

By Relationship to Income:

• Progressive tax: Higher % tax as income rises (e.g., income tax).
• Regressive tax: Lower % tax as income rises (e.g., sales tax hits poor harder).
• Proportional tax: Same % tax regardless of income.

By Method of Collection:

• Direct tax: Paid directly to government by taxpayer (e.g., income tax, corporation tax).
• Indirect tax: Levied on goods/services, collected by sellers and passed to government (e.g., VAT, excise duty).

Diagram: Tax Types

Taxes
│
├─ Direct (income, corporation, property)
└─ Indirect (VAT, excise, tariffs)

4.3.5 Principles of Taxation (Qualities of a Good Tax)

• Equity: Fair (rich pay more).
• Certainty: Tax rules and rates clear to taxpayers.
• Convenience: Easy to pay (deducted at source, simple procedures).
• Economy: Low collection cost relative to revenue raised.
• Elasticity: Revenue should increase when economy grows.
• Non-distortionary: Should not discourage work, saving, or investment excessively.

Diagram: Principles

Good Tax
│
├─ Fair
├─ Certain
├─ Convenient
├─ Efficient
├─ Elastic
└─ Non-distortionary

4.3.6 Impact of Taxation

On Consumers:

• Higher prices, reduced purchasing power.
• Lower consumption of de-merit goods (if taxed).

On Producers:

• Higher costs of production.
• Lower profits if unable to pass tax onto consumers.
• May reduce output and investment.

On Government:

• Main source of revenue for spending.
• Can control inflation/deflation by altering disposable income.

On Economy:

• Redistribution of income.
• Possible reduction in efficiency if high taxes discourage work/investment.
• Possible effect on international competitiveness.

Diagram: Tax Impact Flow

Tax → Consumers → Less Spending
Tax → Producers → Higher Costs
Tax → Gov → More Revenue

4.3.7 Definition of Fiscal Policy

• Fiscal policy = Use of government spending and taxation to influence economy.
• Expansionary fiscal policy: Increase spending / cut taxes → boost demand, growth, employment.
• Contractionary fiscal policy: Cut spending / raise taxes → reduce demand, inflation.
• Neutral fiscal policy: Balanced approach, no significant stimulus or restraint.

Diagram: Fiscal Policy Types

Expansionary → Spending ↑, Taxes ↓ → Growth ↑
Contractionary → Spending ↓, Taxes ↑ → Inflation ↓

4.3.8 Fiscal Policy Measures

• Tax changes:
  • Reduce income tax → increases disposable income → demand rises.
  • Increase excise duties → reduce demand for harmful goods.
• Government spending changes:
  • Increase infrastructure spending → creates jobs, long-term growth.
  • Cut spending → reduce deficit, slow demand.
• Budget balance adjustment:
  • Surplus used to reduce debt.
  • Deficit financed by borrowing.

Calculation example:

Gov Revenue = $400 bn
Gov Spending = $450 bn
Budget Balance = Revenue – Spending
= 400 – 450 = –50 bn
= Budget Deficit $50 bn

4.3.9 Effects of Fiscal Policy on Government Macroeconomic Aims

• Economic Growth:
  • Expansionary fiscal policy stimulates demand, encourages growth.
  • Long-term spending on infrastructure/education improves productivity.
• Employment:
  • Higher spending → more jobs.
  • Tax cuts → more disposable income → more demand → more jobs.
• Stable Prices (Low Inflation):
  • Contractionary policy reduces demand → lower inflationary pressure.
  • But may cause unemployment.
• Balance of Payments Stability:
  • Expansionary policies → imports increase (BOP worsens).
  • Contractionary policies → imports fall (BOP improves).
• Redistribution of Income:
  • Progressive taxation and welfare spending reduce inequality.
  • But high taxation may reduce incentives.

Diagram: Fiscal Policy Effects

Fiscal Policy
│
├─ Growth ↑
├─ Jobs ↑
├─ Prices Stable
├─ BOP Balanced
└─ Inequality Reduced