Key features of fiscal policy

Fiscal policy, also known as budgetary policy, involves government decisions on spending (public expenditure) and taxation. It influences the economy at both macroeconomic and microeconomic levels, affecting overall activity or specific firms and individuals.

Fiscal policy can stimulate aggregate demand (AD) by adjusting spending and taxes to achieve economic objectives.

Components and effects of fiscal policy

• Government spending - Includes funds allocated to areas like infrastructure, education, and benefits, which can boost economic activity.
• Taxation - Involves collecting revenue from individuals and businesses, which can be adjusted to influence spending power and demand.
• Macroeconomic effects - Changes in fiscal policy shift the AD curve, impacting growth, inflation, and employment across the economy.
• Microeconomic effects - Targeted policies can affect individual sectors, such as subsidies for certain industries or tax relief for low-income households.

A government's fiscal stance describes its overall approach: expansionary (boosting AD), contractionary (reducing AD), or neutral (no net effect on AD).

Reflationary and deflationary fiscal policies

Governments use reflationary or deflationary fiscal policies to manage economic cycles, shifting the AD curve to achieve stability.

Reflationary fiscal policy

Reflationary policy, also called expansionary or loose fiscal policy, increases AD by raising government spending or cutting taxes. This often leads to a budget deficit, where spending exceeds revenue.

When used:

• Typically during recessions or negative output gaps to stimulate growth.

Effects:

• Increases economic growth and output.
• Raises inflation.
• Worsens the current account of the balance of payments, as higher incomes lead to more imports.

Deflationary fiscal policy

Deflationary policy, also known as contractionary or tight fiscal policy, reduces AD by lowering government spending or increasing taxes. This often results in a budget surplus, where revenue exceeds spending.

When used:

• Usually during booms or positive output gaps to cool the economy.

Effects:

• Reduces economic growth and increases unemployment.
• Lowers price levels.
• Improves the current account of the balance of payments, as lower incomes reduce spending on imports.

Automatic stabilisers and discretionary policy

Fiscal policy can operate automatically or through deliberate government actions, helping to smooth economic fluctuations.

Automatic stabilisers

These are built-in mechanisms that adjust spending and taxation without direct intervention, responding to economic cycles.

During recessions:

• Government spending rises (e.g., more unemployment benefits).
• Tax revenue falls (e.g., due to lower incomes).
• This creates a budget deficit that cushions the downturn.

During booms:

• Tax revenue increases (e.g., from higher earnings).
• Spending on benefits decreases.
• This generates a budget surplus that curbs overheating.

They reduce the severity of economic cycles but can lead to fluctuating budget positions.

Discretionary policy

This involves deliberate changes to spending and taxation by the government:

• Examples - Investing in new infrastructure like roads or public transport, or adjusting tax rates to fund projects.
• Reactive use - In a recession, governments might increase spending and cut taxes to boost AD; in stable times, they could raise taxes for specific initiatives.
• Purpose - Allows targeted responses to economic conditions, beyond automatic adjustments.

Cyclical and structural budget positions

Budget positions reflect a government's fiscal health over short and long terms, influenced by economic cycles and policy choices.

Government spending divides into current expenditure (recurring costs like wages) and capital expenditure (long-term investments like infrastructure).

Cyclical budget position

This is the short-term fiscal stance, affected by the economic cycle:

• During booms - Automatic stabilisers create surpluses (contractionary position) as tax revenue rises and benefit spending falls.
• During recessions - They generate deficits (expansionary position) from lower taxes and higher benefits.
• Cyclical budget deficit - A temporary deficit during downturns, offset by surpluses in upturns.

Structural budget position

This represents the long-term fiscal stance over a full economic cycle, including booms and recessions:

• Structural budget deficit - Occurs when long-term spending exceeds revenue, adding to national debt regardless of the cycle.
• Key difference from cyclical - Structural positions indicate underlying policy choices, while cyclical ones fluctuate with economic conditions.

Different types of tax systems

Governments design tax systems to raise revenue efficiently while meeting objectives like equity and economic growth. Taxes should be cheap to collect, easy to pay, hard to avoid, and free from undesirable disincentives (e.g., discouraging work or saving).

Taxes can be direct (e.g., income tax) or indirect (e.g., VAT or excise duties).

Principles of equity in taxation

• Horizontal equity - People with similar incomes and ability to pay should contribute the same amount.
• Vertical equity - Those with higher incomes and greater ability to pay should contribute more.
• Promoting equality - Taxes can reduce income disparities by raising funds for benefits and public services.

Progressive taxation

In this system, the tax rate as a percentage of income rises with income levels:

• Objectives - Redistributes wealth to reduce poverty and inequality, following the ability-to-pay principle (achieves vertical equity).
• How it works - Revenue from high earners funds benefits or merit goods like healthcare and education for low earners.
• Effects - Increases equality but may discourage high earners if rates are too steep.

Regressive taxation

Here, the tax rate as a percentage of income falls as income rises:

• Objectives - Encourages supply-side growth by reducing taxes on the wealthy, hoping for a trickle-down effect to benefit the economy.
• Effects - Provides incentives to work harder and earn more, but can widen inequality.
• Laffer curve - Illustrates that excessive tax rates reduce revenue by disincentivising work; optimal rates maximise revenue without deterring effort.

Proportional taxation

Also known as a flat tax, everyone pays the same percentage of their income regardless of earnings.

Advantages:

• Achieves horizontal equity, simplifies the system, reduces evasion incentives, and encourages higher earnings.

Challenges:

• Setting a fair rate is difficult; it may burden low earners and fail to raise sufficient revenue from high earners for public services.
• Lacks vertical equity but can be made more progressive with a tax-free allowance (no tax below a certain income).

Supporters view it as streamlining taxation and boosting economic incentives.