Fiscal Policy

What is fiscal policy? Which is an example of a fiscal policy? And why is

fiscal policy important? Fiscal policy is the use of government spending and
taxation to influence the economy. Governments typically use fiscal policy to
promote strong and sustainable growth and reduce poverty. Historically, the
prominence of fiscal policy as a policy tool has waxed and waned. There are two
major examples of expansionary fiscal policy are tax cuts and increased
government spending. Both of these policies are intended to increase aggregate
demand while contributing to deficits or drawing down of budget surpluses. Fiscal
policy is an important tool for managing the economy because of its ability to
affect the total amount of output produced that is, gross domestic product. If the
economy is at full employment, by contrast, a fiscal expansion will have more
effect on prices and less impact on total output.

 The budget
A budget deficit is when the government’s spending, also sometimes called
public expenditure, is higher than its revenue. In this case, the government will
have to borrow to finance some of its spending.
A budget surplus occurs when government revenue is greater than
government spending. A balanced budget, which occurs less frequently, is when
government spending and revenue are equal.

 The reasons for government spending

To influence economic activity
A government may, for example, increase its spending in order to increase
aggregate demand in the hope that the higher aggregate demand will stimulate
higher output and so result in economic growth.
To reduce market failure
Governments spend on public goods as this would not be financed by the
private sector. They spend on merit goods as market forces would not allocate
sufficient resources to their production. In addition, they spend money regulating
markets where there is a difference between social and private costs and benefits
and abuse of market power.
To promote equity
Governments provide benefits and products to vulnerable groups and the
unemployed. For example, some governments provide state pensions to the retired,
subsidized housing for the poor and free education to children.
To pay interest on national debt
If a government has borrowed in the past to finance a gap between its
spending and its tax revenue, it will have to pay interest on the loans.

 The reasons for levying taxation

To redistribute income from the rich to the poor
Higher income groups usually pay more in lax than the poor and some of the
revenue raised is used to pay benefits to the poor.
To discourage the consumption of demerit goods
Those are products that the government considers more harmful to
consumers than they realize, for example, Cigarettes and alcohol.
To raise the costs of firms that impose costs on others by, for example,
causing pollution
To discourage the consumption of imports and hence protect domestic
industries
By placing tariffs on rival imported products, the country's inhabitants may
buy less foreign and more domestic products.
To influence economic activity
As with government spending, changes in taxation can be used to change
aggregate demand. If an economy is experiencing rising unemployment, its
government may cut taxes to stimulate an increase in consumption and investment.
 The main types of taxes

Income tax
Refers to a type of tax that governments impose on income generated by
businesses and individuals within their jurisdiction.
Corporation tax
Refers to a tax imposed on entities that are taxed at the entity level in a
particular jurisdiction.
Capital gains tax
A type of tax applied to the profits earned on the sale of an asset.
Inheritance tax
A state tax that you pay when you receive money or property from the estate
of a deceased person.

 Key terms

National debt: the total amount the government has borrowed over time.

Multiplier effect: the final impact on aggregate demand being greater than
the initial change.

Direct taxes: taxes on income and wealth.

Indirect taxes: taxes on expenditure.

Progressive taxes: one which takes a larger percentage of the income or

wealth of all taxpayers.

Proportional taxes: one which takes the same percentage of the income or
wealth of all taxpayers.

Regressive taxes: one which takes a larger percentage of the income or

wealth of the poor.
Automatic stabilizers: forms of government expenditure and taxation that
reduce fluctuations in economic activity, without any change in government
policy.

Inflation: the rise in the price level of goods and services over time.

Informal economy: that part of the economy that is not regulated, protected
or taxed by the government.

Flat taxes: taxes with a single rate.

Expansionary fiscal policy: rises in government expenditure and or cuts in

taxation designed to increase aggregate demand.

Contractionary fiscal policy: cuts in government expenditure and or rises

in taxation designed to reduce aggregate demand.