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. It is important to realise that changes in fiscal policy affect both aggregate demand (AD) and aggregate supply (AS).

Fiscal Policy and Aggregate Demand

Traditionally fiscal policy has been seen as an instrument of demand management. This means that changes in government spending, direct and indirect taxation and the budget balance can be used to help smooth out some of the volatility of real national output particularly when the economy has experienced an external shock. For example, from 2001-2005 there has been a fiscal stimulus to the UK economy through substantial increases in government spending on transport, and in particular heavier spending in the twin areas of health and education. This fiscal stimulus will come to an end in the next couple of years as the government slows down the rate of which its own spending is increasing.

• The Keynesian school argues that fiscal policy can have powerful effects on aggregate demand, output and employment when the economy is operating well below full capacity national output, and where there is a need to provide a demand-stimulus to the economy. Keynesians believe that there is a clear and justified role for the government to make active use of fiscal policy measures to manage the level of aggregate demand.

• Monetarist economists on the other hand believe that government spending and tax changes can only have a temporary effect on aggregate demand, output and jobs and that monetary policy is a more effective instrument for controlling demand and inflationary pressure. They are much more sceptical about the wisdom of relying on fiscal policy as a means of demand management.

The fiscal policy transmission mechanism

How does a change in fiscal policy feed through the economy to affect variables such as aggregate demand, national output, prices and employment? This simple flow-chart above identifies some of the possible channels involved with the fiscal policy transmission mechanism.

The multiplier effects of an expansionary fiscal policy depend on how much spare productive capacity the economy has; how much of any increase in disposable income is spent rather than saved or spent on imports. And also the effects of fiscal policy on variables such as interest rates

Government spending

Government (or public) spending each year takes up over 40% of gross domestic product. Spending by the public sector can be broken down into three main areas:

• Transfer Payments:  Transfer payments are government welfare payments made available through the social security system including the Jobseekers’ Allowance, Child Benefit, the basic State Pension, Housing Benefit, Income Support and the Working Families Tax Credit. These transfer payments are not included in the national income accounts because they are not a payment for output produced directly by a factor of production. Neither are they included in general government spending on goods and services. The main aim of transfer payments is to provide a basic floor of income or minimum standard of living for low income households in our society. And they also provide a means by which the government can change the overall distribution of income in a country.
• Current Government Spending: i.e. spending on state-provided goods & services that are provided on a recurrent basis every week, month and year, for example salaries paid to people working in the NHS and resources used in providing state education and defence. Current spending is recurring because these services have to be provided day to day throughout the country. The NHS claims a sizeable proportion of total current spending – hardly surprising as it is the country’s biggest employer with over one million people working within the system!
• Capital Spending: Capital spending would include infrastructural spending such as spending on new motorways and roads, hospitals, schools and prisons. This investment spending by the government adds to the economy’s capital stock and clearly can have important demand and supply side effects in the medium to long term.

Government spending is justified on economic and social grounds including the desire to correct for perceived market failure when the market mechanism might fail to provide sufficient public and merit goods for social welfare to be maximized.

Therefore we justify government spending on these grounds:

• To provide a socially efficient level of public goods and merit goods
• To provide a safety-net system of welfare benefits to supplement the incomes of the poorest in society – this is also part of the process of redistributing income and wealth
• To provide necessary infrastructure via capital spending on transport, education and health facilities – an important component of a country’s long run aggregate supply
• As a means of managing the level and growth of AD to meet the government’s main macroeconomic policy objectives such as low inflation and high levels of employment

The Private Finance Initiative (PFI)

The Private Finance Initiative is a way of funding expensive infrastructure developments without running up debts. Rather than borrowing to fund new projects, John Major's government entered into a long-term leasing agreement with private contractors. Under a PFI, companies borrow the cash to build and run new hospitals, schools and prisons for a period of up to 60 years. So far, about 150 PFI contracts have been signed, worth more than £40bn, with more in the pipeline.  PFI is often portrayed as using private money to pay for improvements in public services. But, critics argue, it is still paid for through the public purse. It is not new money. Furthermore, the critics say, private finance is, by its nature, more expensive than public capital. The government of the day may feel it is getting a hospital or school at a bargain price but the country will pay more in the long run.

Automatic stabilisers and discretionary changes in fiscal policy

Discretionary fiscal changes are deliberate changes in direct and indirect taxation and govt spending – for example a decision by the government to increase total capital spending on the road building budget or increase the allocation of resources going direct into the NHS.

Automatic stabilisers include those changes in tax revenues and government spending that come about automatically as the economy moves through different stages of the business cycle

• Tax revenues: When the economy is expanding rapidly the amount of tax revenue increases which takes money out of the circular flow of income and spending
• Welfare spending: A growing economy means that the government does not have to spend as much on means-tested welfare benefits such as income support and unemployment benefits
• Budget balance and the circular flow: A fast-growing economy tends to lead to a net outflow of money from the circular flow. Conversely during a slowdown or a recession, the government normally ends up running a larger budget deficit.

Taxation

We now turn to the revenue that flows into the government’s accounts from taxation. There are so many different kinds of taxation and the tax system itself often appears to be horrendously complex! But one important distinction to make is between direct and indirect taxes.

• Direct taxation is levied on income, wealth and profit. Direct taxes include income tax, national insurance contributions, capital gains tax, and corporation tax.

• Indirect taxes are taxes on spending – such as excise duties on fuel, cigarettes and alcohol and Value Added Tax (VAT) on many different goods and services

By far the biggest source of income for the government is income tax. In the last tax year the state received over £127 billion in income tax receipts, nearly fifty billion pounds higher than the income from national insurance contributions.

Income from selected range of taxes for the UK government	1999-00	2004-05
	£ billion	£ billion
Income tax	95.7	127.2
National Insurance contributions	56.1	78.1
VAT	56.4	73.0
Corporation tax	34.3	34.1
Fuel duties	22.5	23.3
Council Tax	13.1	20.1
Business rates	15.4	18.7
Other taxes	8.1	11.7
Stamp duties	6.9	9.0
Tobacco duty	5.7	8.1
Vehicle excise duty	4.9	4.7
Beer & cider duties	3.0	3.3
Inheritance tax	2.1	2.9
Spirits duties	1.8	2.4
Capital gains tax	2.1	2.3
Wine duties	1.7	2.2
Customs Duties & levies	2.0	2.2
Betting & Gaming duties	1.5	1.4
Petroleum revenue tax	0.9	1.3
Air Passenger duty	0.9	0.9
Source: HM Treasury Public Finance Statistics

 

Progressive, proportional and regressive taxes

• With a progressive tax, the marginal rate of tax rises as income rises. I.e. as people earn more income, the rate of tax on each extra pound earned goes up. This causes a rise in the average rate of tax (the percentage of income paid in tax). The UK income tax system is progressive. Everyone is entitled to a tax-free income. Thereafter, as income grows, people pay the starting rate of tax (10%) before moving onto the basic tax rate (22%). Higher income earners pay the top rate of tax (40%) on each additional pound of income over the top rate tax limit. This is the highest rate of income tax applied.

• With a proportional tax, the marginal rate of tax is constant. For example, we might have an income tax system that applied a standard rate of tax of 25% across all income levels. If the marginal rate of tax is constant, the average rate of tax will also be constant. National insurance contributions are the closest example in the UK of a proportional tax, although low-income earners do not pay NICs below an income threshold, and NICs also do not rise for income earned above a top threshold.

• With a regressive tax, the rate of tax falls as incomes rise – I.e. the average rate of tax is lower for people of higher incomes. In the UK, most examples of regressive taxes come from excise duties of items of spending such as cigarettes and alcohol. There is well-documented evidence that the heavy excise duty applied on tobacco has quite a regressive impact on the distribution of income in the UK.

Fiscal Policy and Aggregate Supply

Changes to fiscal policy can affect the supply-side capacity of the economy and therefore contribute to long term economic growth. The effects tend to be longer term in nature.

• Labour market incentives: Cuts in income tax might be used to improve incentives for people to actively seek work and also as a strategy to boost labour productivity. Some economists argue that welfare benefit reforms are more important than tax cuts in improving incentives – in particular to create a “wedge” or gap between the incomes of those people in work and those who are in voluntary unemployment.

• Capital spending. Government capital spending on the national infrastructure (e.g. improvements to our motorway network or an increase in the building programme for new schools and hospitals) contributes to an increase in investment across the whole economy. Lower rates of corporation tax and other business taxes might also be used as a policy to stimulate a higher level of business investment and attract inward investment from overseas
• Entrepreneurship and new business creation: Government spending might be used to fund an expansion in the rate of new small business start-ups
• Research and development and innovation: Government spending, tax credits and other tax allowances could be used to encourage an increase in private business sector research and development – designed to improve the international competitiveness of domestic businesses and contribute to a faster pace of innovation and invention
• Human capital of the workforce: Higher government spending on education and training (designed to boost the human capital of the workforce) and increased investment in health and transport can also have important supply-side economic effects in the long run. An enhanced transport infrastructure is seen by many business organisations as absolutely essential if the UK is to remain competitive within the European and global economy

Free market economists are normally sceptical of the effects of government spending in improving the supply-side of the economy. They argue that lower taxation and tight control of government spending and borrowing is required to allow the private sector of the economy to flourish. They believe in a smaller sized state sector so that in the long run, the overall burden of taxation can come down and thus allow the private sector of the economy to grow and flourish.

However targeted government spending and tax decisions can have a positive impact even though fiscal policy reforms take a long time to feed through. The key is to help provide the right incentives for individuals and businesses – for example the incentives to find work and incentives for businesses to increase employment and investment.