‹ Back to Economics topics

Fiscal policy

Fiscal policy: Decisions about government spending, taxation and borrowing that affect aggregate demand in the economy.

Aggregate demand is total demand in the economy. Every year, the government publishes its budget, which sets out how much it plans to spend, how it will raise the money and how much it will borrow. By changing its spending and taxes, it can push total demand up or down to help meet its macroeconomic objectives.

Government revenue: direct and indirect taxes

Taxes are the main way a government raises money. They pay for public services, and they can also be used to discourage harmful activities, such as smoking, to control demand and to make the spread of income fairer.

Direct taxes: taxes levied on the income earned by firms and individuals.

Indirect taxes: taxes levied on spending, such as VAT.

Common direct taxes:

• Income tax: paid by employed and self-employed people on what they earn.
• Corporation tax (business tax): paid by limited companies on their profits.
• Capital gains tax: paid on the profit made when assets, such as shares or property, are sold for more than they cost.
• Inheritance tax: paid on money passed on when someone dies, usually above a set amount.

Common indirect taxes:

• Sales taxes: charged on most goods and services, e.g. VAT. Some items, such as food or medicines, may be charged at 0%.
• Excise duties: high taxes on a few goods, e.g. petrol, cigarettes and alcohol.
• Customs duties: taxes on imports.

Government expenditure: main areas of focus

The main areas of government spending:

• Social protection: state pensions and benefits, e.g. payments to the unemployed, disabled people and families with children.
• Healthcare: wages for doctors and nurses, medicines and hospital equipment.
• Education: teachers’ wages, school equipment and grants for students.
• Defence: running the army, navy and air force.
• Interest: interest paid on money the government has borrowed, known as the national debt.
• Public order and safety: the police, fire service, prisons and courts.
• Social services: care for children, the elderly and people with learning disabilities.
• Other: e.g. transport, housing, the environment, agriculture and training.

Fiscal deficits and fiscal surpluses

Fiscal deficit: When government tax receipts are lower than government spending.

Fiscal surplus: When government revenue is greater than government expenditure.

Many governments run a fiscal deficit in most years, so they have to borrow to cover the gap, e.g. from banks at home and abroad. A fiscal deficit is about the government’s own finances. It is not the same as a current account deficit, which is about a country’s trade with the rest of the world.

Formula:

Fiscal balance = Government revenue – Government expenditure

A positive answer is a fiscal surplus and a negative answer is a fiscal deficit. Show the currency, and keep the minus sign for a deficit.

A deficit is a much bigger problem for a small economy than for a large one. So, to compare countries, a deficit or surplus is usually given as a percentage of GDP.

The impact of a fiscal deficit and a fiscal surplus

Impact of a fiscal deficit:

• Rising national debt: the government must borrow every year it has a deficit, so if deficits go on for years, the national debt keeps growing.
• Interest payments: more and more tax revenue goes on interest. This has an opportunity cost, as the money could have paid for schools and hospitals, or been used to cut taxes.
• Higher taxes or spending cuts later: to pay back the debt, the government may have to raise taxes or cut public services in future.
• A burden on future generations: people not yet born may end up paying for today’s borrowing.
• Can boost the economy: if the borrowing pays for projects such as new roads and railways, it creates jobs, cuts unemployment and helps economic growth.

Impact of a fiscal surplus:

• Paying off debt: most governments use a surplus to repay part of the national debt. This cuts future interest payments and makes the government’s finances stronger.
• Lower taxes: the surplus can be handed back to households and firms through tax cuts.
• Better public services: the extra money can be spent on, e.g., healthcare, policing or training schemes.
• Possible drawbacks: a surplus may mean taxes were higher than needed, or that public services were cut. Cuts tend to hurt low-income families most, as they rely more on these services, so inequality may rise.

The impact of fiscal policy on macroeconomic objectives

The two directions fiscal policy can take:

• Expansionary fiscal policy: the government spends more or taxes less to boost aggregate demand. This makes a deficit bigger or a surplus smaller.
• Contractionary fiscal policy: the government spends less or taxes more to reduce aggregate demand. This makes a deficit smaller or a surplus bigger.

How fiscal policy affects each objective:

• Economic growth: expansionary policy raises demand, as tax cuts leave households and firms more to spend and extra government spending creates jobs. Firms respond by producing more. Spending on capital projects, such as schools, airports and transport links, does most for growth.
• Unemployment: with higher demand, firms need more workers, so unemployment falls. Spending on construction, such as new hospitals and railways, creates a lot of jobs because building work needs many workers.
• Inflation: contractionary policy can reduce demand-pull inflation. Higher direct or indirect taxes cut people’s disposable income, so they spend less, and lower government spending cuts demand directly. However, raising indirect taxes such as VAT pushes prices up, and fiscal policy may not work if inflation is cost-push.
• Current account: contractionary policy lowers demand, so people buy fewer imports, which helps to reduce a current account deficit.
• The environment: taxes such as a landfill tax discourage activities that cause damage, and subsidies encourage greener activities, e.g. producing cleaner fuels.