The definition and types of fiscal policy

Fiscal policy involves the government's decisions on taxation and public spending to influence the economy. It can affect the overall economy through macroeconomic impacts, or have microeconomic effects on specific businesses and individuals.

Main types of fiscal policy

• Reflationary fiscal policy - Also known as expansionary or loose policy, this increases aggregate demand by raising government spending or cutting taxes. It often leads to a budget deficit.
• Deflationary fiscal policy - Also known as contractionary or tight policy, this decreases aggregate demand by lowering government spending or raising taxes. It typically results in a budget surplus.

Key features of fiscal policy

Fiscal policy includes elements that respond automatically to economic changes and those that require deliberate government action.

Automatic stabilisers:

• In a recession, spending on benefits rises while tax revenues fall.
• In a boom, tax revenues increase and benefit spending decreases.

Discretionary policy involves intentional adjustments to spending or tax rates in response to current economic conditions.

The fiscal stance refers to the overall direction of government policy, which could be reflationary, deflationary, contractionary, or neutral if it has no net impact on aggregate demand.

Effects and applications of fiscal policy

Fiscal policy is applied strategically depending on the economic situation.

When fiscal policy is used

• Reflationary policy is implemented during a recession or when there is a negative output gap.
• Deflationary policy is used during an economic boom or positive output gap.

Impacts of reflationary fiscal policy

• Positive effects - Enhances economic growth and lowers unemployment.
• Negative effects - Can lead to higher inflation and a worsening current account position.

Impacts of deflationary fiscal policy

• Positive effects - Reduces inflation and price levels, while improving the current account.
• Negative effects - Slows economic growth, which may increase unemployment in the short term.

Budget positions and government expenditure

The government's budget position reflects its fiscal health over different timeframes, influenced by economic cycles. Expenditure is divided into categories based on its nature and longevity.

Types of budget positions

• Structural budget position - Represents the long-term fiscal stance across an entire economic cycle.
• Cyclical budget position - Reflects short-term variations due to the current stage of the economic cycle.
• Cyclical budget deficit - Occurs during downturns and is offset by surpluses in booms.
• Structural budget deficit - Indicates a persistent expansionary approach.

Categories of government expenditure

Government spending supports public services and infrastructure, with different types serving immediate or long-term needs.

• Current expenditure - Covers day-to-day items that are used up quickly, such as salaries for public sector workers.
• Capital expenditure - Involves investment in durable assets, like building roads or schools.

Factors influencing government spending

• Population size and demographics.
• Policies aimed at reducing inequality.
• Prevailing economic conditions.

Tax systems and principles

Taxes form a core part of fiscal policy, funding government activities while aiming to be fair and efficient. The design of tax systems follows key principles to ensure they work effectively.

Principles guiding tax systems

Taxes should be inexpensive to collect, straightforward for people to pay, and difficult to evade. They must avoid creating negative incentives. Systems should promote horizontal equity and vertical equity.

Types of tax systems

Tax structures vary in how rates change with income levels, affecting incentives and equality.

• Progressive taxation - Tax rates increase as income rises, redistributing wealth, reducing poverty, and aligning with the ability-to-pay principle to achieve vertical equity.
• Regressive taxation - Tax rates decrease as income rises, potentially boosting supply-side growth and work incentives, but it may widen inequality.
• Proportional taxation - Everyone pays the same percentage of income, often called a flat tax, promoting horizontal equity and simplicity, though it may lack vertical equity without adjustments like allowances.

The Laffer curve

The Laffer curve illustrates the link between tax rates and government revenue. At low rates, revenue is minimal, but as rates rise, revenue increases up to an optimal point. Beyond this, higher rates reduce incentives to work or invest, causing revenue to fall.

Budget deficits, national debt, and fiscal rules

A budget deficit occurs when spending exceeds revenue, leading to borrowing and national debt accumulation. Managing these requires rules and oversight to ensure sustainability.

Understanding budget deficits and national debt

• Budget deficit - Arises when government expenditure outstrips income, measured as public sector net borrowing (PSNB).
• National debt - The total stock of outstanding government borrowing, known as public sector net debt (PSND), built up over time from repeated deficits.

Problems caused by excessive borrowing

• Demand-pull inflation.
• Higher interest rates that deter private investment.
• Reduced international competitiveness.
• Risk that lenders refuse further credit.
• Burden on future generations.
• Crowding out of private sector activity.
• Decreased appeal to overseas investors.

Correcting budget deficits

• Cyclical deficits often resolve naturally as the economy improves and revenues rise.
• Structural deficits need active measures, such as tax increases and spending cuts, often termed austerity.

A surplus might signal overly high taxes or inadequate public spending, potentially limiting growth.

Role of fiscal rules

Fiscal rules are self-imposed limits to control borrowing and prevent excessive spending. For example, the golden rule allows borrowing only for investment, not current spending, which supports growth, cuts debt, curbs inflation, and builds stability and confidence.

The Office for Budget Responsibility (OBR)

The OBR is an independent organisation that monitors fiscal matters. It produces reports on spending, taxes, and economic forecasts, evaluates government progress on fiscal targets, and provides long-term projections for sustainable public finances.

Using fiscal policy to reduce poverty

• Benefits systems provide support for those unable to work.
• Public provision of essential services like education and healthcare.
• Progressive taxes help narrow income differences.
• Policies promoting economic growth generate employment and raise incomes overall.