The government’s handling of its own spending, taxation and government borrowing are the key components of fiscal policy. In this note we delve deeper into some aspects of fiscal policy drawing on the concepts covered at AS level.

What is Fiscal Policy?

Fiscal policy involves the use of government spending, taxation and borrowing to influence both the pattern of economic activity and also the level and growth of aggregate demand, output and employment. A rise in government expenditure, or a fall in the burden of taxation, should increase aggregate demand and boost employment. The size of the resulting final change in equilibrium national income is determined by the multiplier effect. The larger the national income multiplier, the greater the change in national income will be.
However fiscal policy is also used to influence the supply-side performance of the economy. For example, changes in fiscal policy can affect competitive conditions individual markets and industries and change the incentives for people to look for work and for companies to invest and engages in research and development. Government capital spending on transport infrastructure and public sector investment in education and health can also have a direct but unpredictable effect in the long run on the competitiveness and costs of businesses in every industry.

Government Spending

Government spending can be broken down into three main categories:

• General government expenditure - consists of the combined capital and current spending of central government including debt interest payments to holders of government debt
• General government final consumption - is government expenditure on current goods and services excluding transfer payments
• Transfer payments – transfers are transfers from taxpayers to benefit recipients through the working of the social security system. The total welfare bill now exceeds £140 billion per year

Government Spending and Fiscal Policy Objectives

The Treasury has outlined the main goals of fiscal policy to be the following:

• Equity concerns: To ensure that government spending and taxation impact fairly within and across generations – fiscal policy should be equitable to current and future generations
• Funding government spending: To meet the government’s spending and tax priorities without a damaging rise in the burden of government debt
• The benefit principle: This principle seeks to ensure that those who benefit from public services such as the benefits from education, health and transport also meet as far as possible the costs of the services they consume
• Macroeconomic stability: Fiscal policy in the UK is now designed to support monetary policy in ‘smoothing the path of aggregate demand over the economic cycle’ and in contributing to an environment of sustainable growth and stable inflation – this is the main macroeconomic objective of fiscal policy. Gordon Brown has introduced two fiscal rules to support this objective

With the total level of government spending rising above £480 billion in 2004, much concern has been given to the actual results from this level of public sector spending. In particular the size of the state sector has been criticised by those who claim that public sector spending is open to a high level of waste and lack of efficiency. The media often talk of the need for the public services to “deliver” value for money in terms of meeting people’s needs and wants.

Successive governments have striven to improve the efficiency with which public services are provided. This has included the widespread use of contracting-out and competitive tendering where private sector businesses compete with the public sector for the contracts to provide services such as NHS catering, laundry and cleaning services, together with maintenance of the road network and aspects of the prison service. The government has also introduced value for money audits for each major government spending department together with a huge and growing number of performance targets.