6.3 FISCAL POLICY
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This video is relevant for this section despite it saying that it is for AQA.
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Fiscal policy is the way in which the government adjusts its spending and taxation rates to influence the national economy. The government can use expansionary or contractionary fiscal policies depending on where in the economic cycle the economy is.
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The UK government has a variety of activities which its spends its money, such as defence, education, welfare etc.… They also have a wide range of ways in which they can raise revenue through taxation, such as income tax, corporation tax, VAT and national insurance. If a government runs a balance budget then its tax revenues are exactly the same as their expenditure. However, governments do not always run balanced budgets for a variety of reasons. If a budget is not balanced, it adds to the level of national debt. Debt is a stock and the budget is the flow. Debt must be paid back at a point in time with interest. The UK government borrows by issuing government bonds that are known as gilts. These gilts mature, meaning that the government needs to pay back the amount that they borrowed. They do this by issuing new gilts. These gilts are issued at the market rate and if investors are concerned about the government’s ability to pay what they borrowed back then there is potentially an issue as the interest rate on the gilts will have to rise making borrowing more and more expensive for governments. This is what Greece had the problem with since the financial crisis. International investors were worried that Greece would default on the bond and investors would never get their money back, therefor in return for lending to the Greek government investors demanded higher interest rate (which were caused by the increased risk).
Expansionary Fiscal Policy
Expansionary fiscal policy could be used when the economy is in a down turn. The idea is to stimulate the economy and to get it moving along again. The government can do this by increasing their expenditure or decreasing taxation. If they decrease taxation, both consumers and firms will have higher incomes. Firms will be able to invest this income and households will be able to increase consumption due to a rise in their disposable income. However, consumers and firms may not change their expenditure plans as they may choose to save this additional income as they have poor expectations of the future. If the government chose to increase their expenditure, such an investing in infrastructure like a new railway project, then the increase in government expenditure will have a multiplier effect. Therefore, the government will not have to plug the whole of the negative output gap. Obviously expansionary fiscal policy involves the government spending more and therefore can cause the government to go into a deficit or reduce their surplus.
Expansionary fiscal policy could be used when the economy is in a down turn. The idea is to stimulate the economy and to get it moving along again. The government can do this by increasing their expenditure or decreasing taxation. If they decrease taxation, both consumers and firms will have higher incomes. Firms will be able to invest this income and households will be able to increase consumption due to a rise in their disposable income. However, consumers and firms may not change their expenditure plans as they may choose to save this additional income as they have poor expectations of the future. If the government chose to increase their expenditure, such an investing in infrastructure like a new railway project, then the increase in government expenditure will have a multiplier effect. Therefore, the government will not have to plug the whole of the negative output gap. Obviously expansionary fiscal policy involves the government spending more and therefore can cause the government to go into a deficit or reduce their surplus.
Contractionary Fiscal Policy
Alternatively, if the economy is experiencing a boom, then the government may choose to use contractionary fiscal policies. These policies are designed to take demand out of the economy. The government will increase taxes and decrease their expenditure. This can allow a government to run a surplus and they can use this to pay off existing government debt.
Alternatively, if the economy is experiencing a boom, then the government may choose to use contractionary fiscal policies. These policies are designed to take demand out of the economy. The government will increase taxes and decrease their expenditure. This can allow a government to run a surplus and they can use this to pay off existing government debt.
Automatic Stabilisers
Over the business cycle the government budget will naturally change. During a boom employment will be high (high revenue of income tax and low unemployment benefits), consumption will be high (high level of VAT income) and corporations will be doing well (high level of corporation tax). This results in the government receiving a large income and spending little on welfare, meaning they are taking demand out of the economy. During this period it is likely that the government will run a budget surplus. When times change and the economy moves into a down turn, the opposite will occur. Unemployment rates will be high resulting in large transfer payment occurring. Less revenue will be coming in from income tax, corporation tax and VAT. This causes the government to have an expansionary effect whereby they increase the level of demand that is in the economy.
In addition to these automatic stabilisers, the government may choose other policies to increase the amount of demand in the economy. These could include one off investment projects and a tax rebate to citizens just as America did, post financial crisis.
Over the business cycle the government budget will naturally change. During a boom employment will be high (high revenue of income tax and low unemployment benefits), consumption will be high (high level of VAT income) and corporations will be doing well (high level of corporation tax). This results in the government receiving a large income and spending little on welfare, meaning they are taking demand out of the economy. During this period it is likely that the government will run a budget surplus. When times change and the economy moves into a down turn, the opposite will occur. Unemployment rates will be high resulting in large transfer payment occurring. Less revenue will be coming in from income tax, corporation tax and VAT. This causes the government to have an expansionary effect whereby they increase the level of demand that is in the economy.
In addition to these automatic stabilisers, the government may choose other policies to increase the amount of demand in the economy. These could include one off investment projects and a tax rebate to citizens just as America did, post financial crisis.
The Effect on Aggregate SupplyFiscal policies can also have effects on the aggregate supply as well. The effects that governments can have will be discussed more in the supply side section.
- Changes in income tax and national insurance can increase the incentive for individuals to look for work. If there are increases in the supply of labour then aggregate supply will shift outwards as the economy can now produce more. Lower taxes may also encourage workers to work harder as their income is higher.
- Government spending on capital infrastructure can allow businesses to succeed. For example, investing in roads and fibre optic broadband makes business’s activity easier. A lower rate of corporation tax may provide an incentive for investment into the country as the investor receives a greater benefit.
- Government spending and tax breaks for new firms encourage entrepreneurship and investment in the economy. The level of investment is linked with economic growth.
- Government can also give tax allowance to firms who research. A tax incentive in the UK is for renewable energies. The government subsidises the solar power industry and this increases the level of demand.
- Government spending on education and training increases the productivity of employees. As workers are more productive, a greater number of goods can be made at a lower price. Also, a trained workforce is less likely to be unemployed.