Government spending and revenue
Governments spend to provide things markets would not provide well or at all, and to pursue their economic objectives. The main purposes:
• Public services everyone uses — healthcare, education, defence, police, roads • Benefits and pensions, which redistribute income to those with least • Investment in infrastructure that supports future growth — transport, broadband, energy • Correcting market failure, by subsidising goods that would otherwise be under-produced (3.8) • Managing the economy, by raising or lowering total demand
The money comes mainly from taxation, and the specification requires the distinction between two kinds.
A progressive tax takes a higher percentage from higher incomes — UK income tax, with its rising bands, is the example. A regressive tax takes a higher percentage from lower incomes, which is what indirect taxes tend to do: £5 of fuel duty is a larger share of a £200 weekly income than of a £2,000 one, even though the amount is identical.
That is why the specification pairs progressive taxes with redistribution: they are the main tool for narrowing the income gap in 3.3.
The government budget
- Balanced budget
- Government spending equals government revenue over the period.
- Budget surplus
- Revenue is greater than spending — the government takes in more than it spends.
- Budget deficit
- Spending is greater than revenue — the government must borrow to cover the gap.
- National debt
- The total amount the government owes, built up from all past deficits.
A deficit and the national debt are different things, and mixing them up is a common error. A deficit is the shortfall in one year — a flow. The national debt is everything owed in total — a stock. So a government can reduce its deficit while the national debt still grows, because it is still borrowing, just less than before. The debt only falls when there is a surplus.
How fiscal policy works
Fiscal policy is the use of government spending and taxation to influence the economy. It comes in two directions.
The chain of reasoning is what earns the analysis marks, and it should be spelled out step by step rather than jumped over. A cut in income tax raises disposable income, so households have more to spend; higher consumer spending shifts demand right in markets across the economy; firms respond by producing more, which raises output — economic growth; producing more requires more workers, which reduces unemployment. The same chain runs in reverse for a tax rise.
Government spending works more directly still: money spent on building a hospital pays construction workers, who spend their wages in local shops, whose owners then employ more staff. That knock-on effect is why a given amount of spending raises demand by more than the amount itself.
Worked example
An economy is in recession with rising unemployment. Recommend a fiscal policy and evaluate it.
- Identify the problem: low demand causing cyclical unemployment.
- The matching policy is expansionary fiscal policy — higher spending, lower taxes, or both.
- Explain the chain: more spending and higher disposable income raise demand, so firms produce more and hire more.
- Now the costs, which is where the evaluation marks are.
- It worsens the budget deficit, so borrowing rises and interest must be paid on it.
- That borrowing has an opportunity cost, and if demand rises faster than output the result is inflation.
- Reach a judgement and say what it depends on.
Answer: Expansionary fiscal policy — increasing government spending on infrastructure and cutting income tax. Higher spending and higher disposable income raise total demand, so firms produce more and employ more workers, reducing cyclical unemployment. The cost is a larger budget deficit, adding to the national debt and to future interest payments, and that money has an opportunity cost. There is also a risk of inflation if demand rises faster than the economy can produce. In a recession, with spare capacity and unemployed workers available, that inflation risk is small, so the policy is justified — but it should be reversed once recovery is established.
Evaluating redistribution is the last thing the specification asks for. Progressive taxes and benefits narrow the gap between rich and poor, reducing poverty and its social costs, and money given to those on low incomes is largely spent, which supports demand. Against that, very high tax rates on high earners may reduce the incentive to work, to train and to start businesses, may encourage tax avoidance, and may prompt some high earners or firms to move abroad. The judgement usually turns on how high the rates are: moderate progressive taxation achieves redistribution with little effect on incentives, while very high rates begin to cost more than they raise.
Common mistake
Fiscal policy is government spending and taxation. Interest rates are monetary policy, set by the central bank, and belong in 3.6 — attributing them to fiscal policy loses the mark.
Before you practise
- Fiscal policy is the use of government spending and taxation to influence the economy.
- Direct taxes are on income, profits and wealth; indirect taxes are on spending.
- Progressive taxes take a higher percentage from higher incomes; indirect taxes tend to be regressive.
- A budget surplus is revenue above spending; a deficit is spending above revenue and requires borrowing.
- A deficit is one year's shortfall; the national debt is the total owed.
- Expansionary policy raises spending or cuts taxes to raise demand, growth and employment.
- Contractionary policy cuts spending or raises taxes to reduce demand and inflation.
- Spell out the chain: disposable income, spending, demand, output, employment.
- Expansionary policy worsens the deficit and risks inflation; both have an opportunity cost.
- Redistribution reduces poverty but very high rates may weaken incentives.