Fiscal policy | IGCSE Class 10 Economics Notes

This note covers the government budget and why governments spend, the reasons for taxation and how taxes are classified (progressive, regressive, proportional, direct, indirect), the qualities of a good tax, the impact of taxation on consumers, producers, government and the economy, the meaning of fiscal policy, how fiscal policy measures create a budget deficit or surplus (with calculations), and how fiscal policy can help a government reach its macroeconomic aims, including growth, employment, price stability, the balance of payments and redistribution.

What is a government budget?

A government budget is a statement, usually prepared for one year, of a government's planned revenue and planned spending.

The revenue side records the receipts the government expects to collect, mainly from taxation, and the expenditure side records the spending the government plans to undertake on public services, infrastructure, welfare payments and other programmes.

Definition: government budget. A statement of a government's estimated receipts (mainly tax revenue) and estimated expenditure for a given period, usually one year.

Comparing the two sides of the budget shows whether the government has a balanced budget, a budget surplus or a budget deficit. A balanced budget occurs when planned spending equals planned revenue.

A surplus occurs when revenue exceeds spending, and a deficit, the most common outcome for most governments, occurs when spending exceeds revenue.

The budget is not simply an accounting record; governments also use it as a policy tool to influence the level of output, employment and prices in the economy, which is the subject of fiscal policy later in this note.

Why do governments spend money?

Governments spend on a wide range of goods and services for several linked reasons.

Providing public goods

Some goods cannot be provided through the ordinary market exchange between individual buyers and sellers. These are called public goods, and examples include national defence, roads and general government administration. Public goods have two key features.

First, they are non-rivalrous: one person's consumption does not reduce the amount available to others, so many people can enjoy the same benefit at once (for example, a public park).

Second, they are non-excludable: there is no practical way of stopping someone who has not paid from enjoying the benefit. People who enjoy a good without paying for it are called free riders.

Because of free riding, private firms generally will not supply these goods profitably, so the government must step in and provide them, financing them through the budget.

Definition: public good. A good that is non-rivalrous (one person's use does not reduce availability to others) and non-excludable (non-payers cannot be stopped from benefiting), so it is normally financed through government spending rather than sold in a private market.

Other main areas and reasons for spending

Beyond pure public goods, the main areas of government spending include education, health, defence, interest payments on past borrowing, salaries and pensions for public employees, and subsidies, for example on food, fertiliser or exports, which aim to make essential goods more affordable or support particular industries.

Spending in these areas has several effects: it raises the incomes and welfare of recipients, it can redistribute resources towards lower-income groups, and because spending adds directly to demand in the economy, an increase in government spending tends to raise national output and employment, working through the allocation function (supplying goods the market under-provides), the redistribution function (changing the distribution of income through transfers and taxes) and the stabilisation function (raising or reducing total demand to correct unemployment or inflation) of the budget.

Why do governments levy taxation?

Taxation is the main source of government revenue, and governments levy taxes for several linked reasons that go beyond simply paying the bills.

1. To raise revenue to finance government spending on public goods, merit goods such as education and health, and transfer payments.
2. To redistribute income, for example by taxing higher incomes at higher rates and using the revenue to fund welfare spending for lower-income households.
3. To influence the pattern of consumption, for example taxing demerit goods such as tobacco more heavily to discourage their use while taxing necessities lightly.
4. To manage the overall level of demand in the economy as part of fiscal policy, raising taxes to reduce demand when the economy is overheating or cutting taxes to boost demand in a slowdown.

These four reasons are not separate in practice; a single tax change usually does more than one job at once. A higher rate of income tax on top earners, for example, raises revenue for the budget, narrows the gap between high and low incomes, and, by reducing disposable income across the economy, slightly dampens total spending.

Because taxation touches every household and firm, governments also have to weigh these reasons against the effect taxes have on people's incentive to work, save and invest, which is why the design of a good tax, considered next, matters as much as the amount it raises.

How are taxes classified?

Taxes can be classified in two overlapping ways: by how the tax rate changes with income, and by how the tax is collected.

By the rate structure

A progressive tax takes a higher proportion of income as income rises, so the tax rate increases with income; personal income tax is usually levied this way.

A proportional tax takes the same proportion of income or profit regardless of the amount, so the tax rate stays constant; company or corporation tax is often charged at a flat proportion of profits.

A regressive tax takes a higher proportion of a lower income than of a higher income, so it falls more heavily, relative to income, on the poor; indirect taxes on goods are regressive in this sense because they take the same amount from a rich and a poor consumer buying the same item, which is a larger share of the poorer consumer's income.

By how the tax is collected

A direct tax is paid directly by the person or firm on whom it is levied and cannot easily be passed on to someone else; personal income tax and corporation tax are examples.

An indirect tax is levied on goods and services and is usually built into the price paid by the buyer, so the seller collects it on the government's behalf; excise duties on goods produced within a country, customs duties on imports and exports, and a general sales or value-added tax are examples.

What are the principles of a good tax?

A good tax is normally judged against several qualities. It should be based on the taxpayer's ability to pay, so that those with higher incomes contribute more; it should be certain, so the taxpayer knows how much is owed and when; it should be convenient to pay, collected at a time and in a manner that suits the taxpayer; and it should be economical to collect, so the cost of collecting the tax is small compared with the revenue it raises.

A good tax should also be difficult to avoid or evade, and should not unduly distort people's economic decisions, for example by discouraging work or investment more than necessary.

Definition: qualities of a good tax. A good tax should be based on ability to pay, certain in amount and timing, convenient to pay, economical to collect, difficult to evade and should cause minimal distortion to economic decisions.

What is the impact of taxation?

Taxation affects every group in the economy.

Impact on consumers

Direct taxes on income reduce disposable income and so reduce the amount consumers can spend and save. Indirect taxes on goods raise the price consumers pay, which can reduce the quantity they buy, particularly for goods with elastic demand.

Impact on producers

An indirect tax raises a firm's costs or reduces the price it effectively keeps after the tax is paid, which can reduce output, profits and the incentive to invest, unless the firm can pass the full tax on to consumers through a higher price.

Impact on government

Taxation is the main source of revenue that allows the government to finance its spending programmes without running an excessive budget deficit, and changing tax rates is one of the main tools of fiscal policy.

Impact on the economy as a whole

Because taxes reduce disposable income and therefore consumption, an increase in taxation tends to reduce total demand, output and employment in the economy, while a tax cut tends to raise them.

Taxes that rise automatically as income rises, such as a proportional income tax, also act as an automatic stabiliser: they reduce disposable income by more when incomes are high (restraining a boom) and by less when incomes fall (cushioning a slump), stabilising consumer spending without any new decision by the government.

Advantages and limitations of relying on taxation

Relying heavily on indirect taxes has advantages: they are relatively cheap and simple to collect, difficult to avoid because they are built into the price of goods, and can be used to discourage consumption of harmful goods.

Their main limitation is that they tend to be regressive, falling more heavily, relative to income, on lower-income households, and they can also push up prices.

Direct, progressive taxes have the advantage of being linked to ability to pay and so help redistribute income, but their limitation is that very high rates may discourage people from working extra hours or earning more, and they are generally more complicated and costly to assess and collect.

What is fiscal policy?

Fiscal policy is the use of government spending and taxation to influence the level of output, employment and prices in the economy.

Through changes in its expenditure and taxes, the government attempts to increase output and income and seeks to stabilise the ups and downs in the economy, creating a budget surplus when total receipts exceed expenditure, or a budget deficit when total expenditure exceeds receipts, rather than keeping expenditure exactly equal to receipts.

Definition: fiscal policy. The use of changes in government spending and taxation to influence total demand, output, employment and prices in the economy.

Fiscal policy can be discretionary, meaning the government deliberately changes spending or tax rates to offset an unwanted change elsewhere in the economy, for example raising government spending to offset a fall in private investment.

It can also work through automatic stabilisers such as a proportional income tax, which smooth out fluctuations in disposable income and spending without any new government decision being taken.

How do fiscal policy measures create a budget deficit or surplus?

A government's fiscal policy measures, that is, its decisions on tax rates and spending levels, directly determine whether the budget is balanced, in surplus or in deficit, and by how much.

Budget balance = Government revenue − Government spending

A positive value of the budget balance is a budget surplus; a negative value is a budget deficit, whose size is the amount by which spending exceeds revenue. The size of the imbalance is found by subtracting the smaller total from the larger one.

Governments can move from deficit towards balance or surplus either by raising tax revenue or by cutting spending.

Raising revenue can come from increasing tax rates or improving tax collection; cutting spending can come from making programmes more efficient or withdrawing from some areas of activity, although cutting spending on areas such as education, health or poverty relief can harm welfare, so the choice of measure involves a trade-off.

Worked example 1. A government plans total revenue of $540 million for the year and total spending of $540 million.

Answer: Step 1: Budget balance = Government revenue − Government spending = $540 million − $540 million = $0. Step 2: Because revenue exactly matches spending, this is a balanced budget, not a surplus or a deficit, so the government does not need to borrow or build up a surplus this year.

Worked example 2. A government expects total revenue of $480 million and plans total spending of $560 million for the year.

Answer: Step 1: Budget balance = Government revenue − Government spending = $480 million − $560 million = −$80 million. Step 2: The negative sign shows a budget deficit, and its size is $80 million, the amount the government must borrow. Step 3: As a share of spending, the deficit is $80 million ÷ $560 million × 100 = about 14%.

Worked example 3. In the following year the same government raises total revenue to $610 million and holds total spending at $560 million.

Answer: Step 1: Budget balance = Government revenue − Government spending = $610 million − $560 million = $50 million. Step 2: The positive value shows a budget surplus of $50 million, so the government has revenue left over after its spending and can use it to repay past borrowing or to cut taxes.

Worked example 4. A government has total revenue of $300 million and total spending of $375 million. It wants a balanced budget next year without changing spending.

Answer: Step 1: Budget balance = $300 million − $375 million = −$75 million, so the budget deficit is $75 million. Step 2: To balance the budget with spending unchanged, revenue must rise by $75 million, from $300 million to $375 million. Step 3: This is a rise of $75 million ÷ $300 million × 100 = 25% in revenue, which the government could seek through higher tax rates or better tax collection.

Advantages and limitations of using fiscal policy to manage the economy

Fiscal policy has clear advantages. Government spending and tax changes act directly and relatively quickly on total demand, and spending can be targeted at specific groups or regions that most need support, for example increasing welfare spending during a downturn.

It can also be used precisely, raising or lowering particular tax rates rather than relying on a single blunt instrument.

Fiscal policy also has limitations. Raising government spending to boost the economy increases the budget deficit, which must eventually be financed by borrowing, taxation or, in principle, printing money, and persistent borrowing builds up government debt and future interest payments.

Government borrowing can also compete with private firms for available savings, an effect sometimes called "crowding out", reducing the funds available for private investment.

Spending and tax changes can also take time to design and implement, so by the time a fiscal measure takes effect the state of the economy may have already changed.

Some governments try to limit these problems with their own binding rules on the size of the deficit they will allow, for example a legal target to keep the budget deficit below a set share of GDP, together with rules on borrowing from the central bank and regular reporting of deficit trends to the legislature, showing one way a government can try to keep discretionary fiscal policy within self-imposed limits.

How can fiscal policy measures help a government achieve its macroeconomic aims?

Because government spending is itself a component of total demand in the economy, and tax changes affect the disposable income available for consumption, both tools can be used to move total demand towards the level needed for the government's macroeconomic aims.

Growth and employment

If the economy has unused resources and demand is too low for full employment, an increase in government spending, or a cut in taxes, raises total demand and so raises output and employment, helping a government reach its growth and employment aims.

Conversely, if demand is too high and threatens to exceed what the economy can produce, raising taxes or cutting spending reduces demand and can help contain inflation.

Price stability

Whether an expansionary fiscal policy is inflationary depends on how close the economy is to full capacity. If firms cannot raise output to meet the extra demand, prices are likely to rise.

However, if there are unused or unemployed resources, the extra demand is mostly met by higher output rather than higher prices, so a larger deficit need not be inflationary.

The balance of payments

Fiscal policy can also affect a country's balance of payments. Higher government spending and lower taxes raise domestic incomes, so households buy more imports as well as more home-produced goods, which tends to worsen the current account of the balance of payments.

Higher domestic demand can also raise domestic prices relative to prices abroad, making exports less competitive and imports more attractive, which worsens the current account further. A contractionary fiscal policy, cutting spending or raising taxes, works in the opposite direction and can help reduce a current account deficit, though at the cost of lower output and employment.

Redistribution of income

Fiscal policy is also used to redistribute income. Progressive taxes take a larger share from higher incomes, while government spending on welfare benefits, state education and health services mainly benefits lower-income households.

Together, these measures can narrow the gap between rich and poor, which is one of the government's macroeconomic aims. The size of the effect depends on how progressive the tax system is and on how much of the spending is directed at those on low incomes.

Automatic stabilisation

Because a proportional income tax takes a larger absolute amount from income as income rises, it automatically slows the rise in disposable income and consumption during a boom, and automatically cushions the fall in disposable income and consumption during a slump, without the government taking any new decision.

This built-in effect reduces only part of the fluctuation in the economy; the rest requires deliberate, discretionary fiscal policy.

Going beyond the syllabus

These ideas extend the unit and are not needed for the questions on it. They are included to show how economists measure government borrowing in more detail.

What are revenue, fiscal and primary deficits?

Some governments publish more than one measure of a budget shortfall.

Revenue deficit = Revenue expenditure − Revenue receipts

The revenue deficit covers only day-to-day (current) income and spending, not spending on assets such as buildings or equipment. A revenue deficit means the government is borrowing to cover even its routine running costs, not just its investment.

Fiscal deficit = Total expenditure − Total receipts (excluding borrowing)

The fiscal deficit measures the government's total borrowing requirement for the year: the gap between all its spending and all the revenue it raises without borrowing.

Primary deficit = Fiscal deficit − Interest payments

The primary deficit removes interest payments on past borrowing from the fiscal deficit, to show how much new borrowing is needed to cover current spending decisions, separate from the cost of servicing existing debt.

In a typical budget the fiscal deficit is the largest of the three, because it adds capital spending to the revenue deficit; the primary deficit is smaller than the fiscal deficit, because it strips out interest payments on debt built up from earlier years of borrowing.

Worked example 5. A government's revenue receipts for the year are $620 million and its revenue expenditure is $700 million.

Answer: Step 1: Revenue deficit = Revenue expenditure − Revenue receipts = $700 million − $620 million = $80 million. Step 2: Expressed against revenue receipts, $80 million is roughly 13% of revenue receipts. The government has a revenue deficit of $80 million, meaning it is borrowing to cover part of its routine, day-to-day spending rather than only its investment.

Worked example 6. A government's total expenditure is $900 million. Its revenue receipts are $650 million and its non-debt-creating capital receipts (for example, sales of assets) are $50 million.

Answer: Step 1: Add the non-borrowed receipts: Revenue receipts + Non-debt-creating capital receipts = $650 million + $50 million = $700 million. Step 2: Fiscal deficit = Total expenditure − $700 million = $900 million − $700 million = $200 million. The government must borrow $200 million, equal to about 22% of its total expenditure, to finance this fiscal deficit.

Worked example 7. Using the fiscal deficit of $200 million found in worked example 6, suppose the government's interest payments on existing debt are $60 million.

Answer: Step 1: Primary deficit = Fiscal deficit − Interest payments = $200 million − $60 million = $140 million. Step 2: Of the $200 million total borrowing requirement, $60 million (30% of it) is simply the cost of servicing old debt, while the remaining $140 million reflects new borrowing to fund current spending decisions.

Glossary

• Government budget: a statement of a government's estimated revenue and expenditure for a given period, usually one year.
• Public good: a good that is non-rivalrous and non-excludable, normally provided by government rather than sold privately.
• Free rider: someone who enjoys the benefit of a good or service without paying for it.
• Allocation function: the government's role in providing goods and services the market under-provides, such as public goods.
• Redistribution function: the government's role in changing the distribution of income through taxes and transfer payments.
• Stabilisation function: the government's role in correcting fluctuations in income, output and employment.
• Progressive tax: a tax whose rate rises as income rises.
• Proportional tax: a tax that takes the same proportion of income or profit at all levels.
• Regressive tax: a tax that takes a larger proportion of a lower income than of a higher income.
• Direct tax: a tax paid directly by the taxpayer on income or profit, which cannot easily be passed on.
• Indirect tax: a tax on goods and services, usually built into the price and collected by the seller.
• Fiscal policy: the use of government spending and taxation to influence output, employment and prices.
• Budget deficit: the situation where government spending exceeds government revenue in a period.
• Budget surplus: the situation where government revenue exceeds government spending in a period.
• Automatic stabiliser: a feature of the tax or spending system, such as a proportional tax, that reduces fluctuations without any new government decision.

Common errors and misconceptions

• Misconception: a budget deficit and government debt are the same thing. Correct: the deficit is the shortfall in a single year (a flow); debt is the accumulated total of past borrowing still owed (a stock).
• Misconception: all indirect taxes are regressive by definition because they are "indirect". Correct: indirect taxes tend to be regressive because they take a fixed amount regardless of income, not because of how they are collected as such.
• Misconception: any budget deficit is automatically inflationary. Correct: if there are unused resources in the economy, the extra demand created by a deficit may raise output rather than prices.
• Misconception: a progressive tax and a direct tax are the same thing. Correct: "progressive" describes how the rate changes with income; "direct" describes who pays the tax; a tax can be direct and proportional, as with a flat-rate income tax.
• Misconception: cutting government spending always reduces the budget deficit by the full amount cut. Correct: lower spending can reduce total demand, incomes and so tax revenue, partly offsetting the intended reduction in the deficit.
• Misconception: fiscal policy only means raising or lowering total spending. Correct: fiscal policy also includes changing which taxes are used and how progressive or regressive the overall tax system is.
• Misconception: a budget surplus is always the best outcome for a government. Correct: a surplus may help repay debt, but if it comes from cutting spending or raising taxes during a slowdown it can deepen unemployment.

Exam-style questions with model answers

Q1. Define 'government budget'. [2 marks]

1. A government budget is a statement of a government's estimated revenue and expenditure.
2. It usually covers a set period, most commonly one year, and shows whether spending and revenue are balanced.

Q2. State two main areas of government spending. [2 marks]

1. National defence and other public goods, such as roads, which the market would not otherwise provide.
2. Subsidies, such as subsidies on food, which are used to make essential goods more affordable for lower-income households.

Q3. A government's total revenue for the year is $420 million and its total spending is $500 million. Calculate the size of its budget deficit, showing your working. [2 marks]

1. Budget balance = Government revenue − Government spending = $420 million − $500 million = −$80 million.
2. The negative value shows a budget deficit of $80 million, which the government must borrow.

Q4. Explain two reasons why a government levies taxation. [4 marks]

1. To raise revenue: taxation is the main source of income a government needs to finance spending on public goods such as defence, and on services such as education and health.
2. To redistribute income: by taxing higher incomes at a higher rate through a progressive tax, and using the revenue to fund transfer payments to lower-income households, the government can narrow income inequality.

Q5. Distinguish between a direct tax and an indirect tax, using one example of each. [4 marks]

1. A direct tax is levied on, and paid directly by, the person or firm earning the income or profit, such as personal income tax.
2. It cannot easily be shifted onto someone else, so the taxpayer bears the full cost themselves.
3. An indirect tax is levied on goods and services rather than on income, such as excise duty on a product.
4. It is usually included in the price paid by the buyer, so the seller collects the tax on the government's behalf and can pass some or all of it on to consumers.

Q6. Analyse how an increase in government spending can help a government achieve two of its macroeconomic aims. [6 marks]

1. Higher government spending adds directly to total demand, so firms expand output and take on more workers, helping the government's aim of full employment.
2. The same extra demand raises national output and income, so it also helps the aim of economic growth.
3. If the economy has spare capacity, the extra output is produced without much pressure on prices, so the growth aim can be met without worsening inflation.
4. However, if the economy is already near full capacity, firms cannot raise output much and prices rise instead, so the price stability aim may be harmed.
5. Higher domestic incomes also raise spending on imports, which can worsen the current account of the balance of payments, so the external aim may conflict with the growth aim.
6. Overall, the effect on the government's aims depends on how much spare capacity exists and on how the extra spending is financed.

Q7. Discuss whether a government should raise taxes to reduce a large budget deficit. [8 marks]

1. Raising taxes increases government revenue, which directly reduces the size of the budget deficit and slows the build-up of government debt and future interest payments.
2. A smaller deficit may also reassure lenders, keeping the cost of government borrowing lower.
3. However, higher taxes reduce households' disposable income, so consumption falls, and lower after-tax profits may reduce firms' investment.
4. Lower consumption and investment reduce total demand, output and employment, so the economy may slow and unemployment may rise.
5. Lower incomes also mean less tax is collected, so part of the extra revenue is lost and the deficit falls by less than expected.
6. If the taxes are indirect, they may also be regressive, hitting lower-income households hardest, and they can push up prices.
7. Cutting spending instead, or relying on faster growth to raise revenue, may reduce the deficit with less harm to incentives, though spending cuts can also reduce welfare and demand.
8. On balance, some tax rise may be justified if the deficit is large and persistent, but a government should choose progressive taxes and time the rise for a period of strong growth rather than a slowdown.

Q8. Discuss whether an increase in government spending financed by borrowing will always raise a country's national output. [8 marks]

1. Government spending is a component of total demand, so an increase in spending tends to raise output and employment, especially when there are unused resources.
2. The effect can be larger than the initial spending because the extra income earned is partly spent again, generating further income.
3. However, if the economy is already at full capacity, firms cannot raise output much and the extra demand mainly raises prices, so real output rises little.
4. Borrowing to finance the spending may push up interest rates, which can reduce private investment and partly offset the rise in total demand.
5. Higher interest payments in future also use revenue that could otherwise fund public services or tax cuts.
6. If households expect future taxes to repay the debt, they may save more now and spend less, reducing the boost to demand.
7. The size of the effect also depends on how the money is spent: investment in infrastructure may raise productive capacity, while spending on imports may mainly benefit foreign producers.
8. Overall, higher spending financed by borrowing is likely to raise output when resources are idle, but it will not always do so, and the gain is smaller the closer the economy is to full capacity.

Key takeaways

• A government budget sets out planned revenue, mainly from taxation, and planned expenditure for a period, usually a year.
• Governments spend to provide public goods, redistribute income and stabilise the economy, since public goods are non-rivalrous and non-excludable.
• Taxation is the main source of government revenue, raised to fund spending, redistribute income and manage demand.
• Taxes are classified by their rate structure (progressive, proportional, regressive) and by collection method (direct, indirect).
• A good tax should reflect ability to pay and be certain, convenient and economical to collect.
• Taxation affects consumers' spending power, producers' costs and profits, government revenue and total demand in the economy.
• Fiscal policy is the deliberate use of spending and tax changes to influence output, employment and prices.
• The size of a budget deficit or surplus is found by subtracting government spending from government revenue, or the reverse.
• Expansionary fiscal policy can raise output and employment, but risks a larger deficit, more debt and, with little spare capacity, higher prices.

Test yourself

What is meant by a budget deficit?

A budget deficit is the situation where a government's total spending in a period exceeds its total revenue, so it must borrow to cover the gap.

Why are public goods usually provided by the government rather than by private firms?

Because public goods are non-rivalrous and non-excludable, private firms cannot easily charge non-paying users, so there is little profit incentive to supply them privately.

Give one example of a proportional tax.

Company or corporation tax, where the tax rate is a fixed proportion of a firm's profits regardless of the amount earned.

Name two qualities of a good tax.

It should be based on ability to pay and it should be certain, so the taxpayer knows how much is owed and when.

How is the size of a budget surplus calculated?

Subtract government spending from government revenue; if revenue is larger, the difference is the size of the budget surplus.

What is an automatic stabiliser?

A feature of the tax or spending system, such as a proportional income tax, that smooths fluctuations in demand without any new government decision.

Why might expansionary fiscal policy fail to raise output if the economy is already at full capacity?

If firms cannot produce more, the extra demand from higher spending or lower taxes is likely to raise prices rather than output.

How can fiscal policy affect the balance of payments?

Higher spending and lower taxes raise domestic incomes and prices, so imports rise and exports become less competitive, worsening the current account.