Topic 3.5

Fiscal Policy

Master the art of the government budget and unlock the secrets of fiscal policy to dominate your exams. Dive into essential concepts like crowding in, crowding out, and the AD multiplier. Use these high-level economic insights to transform your essays from basic to brilliant and secure the top marks you deserve now.

The Government Budget

A budget shows an individual’s income and spending. A balanced government budget occurs when government spending is equal to government revenue, and this is generally the long-term goal. However, governments may choose to run a deficit or a surplus in order to influence economic activity. A budget deficit happens when government spending exceeds government revenue, while a budget surplus occurs when government spending is less than government revenue.

How does the government make its money?

The government makes most of its revenue from taxes, either direct or indirect:

Direct tax - a tax on income or wealth, such as income tax, cooporation tax, and national insurance contributions
Indirect Tax - a tax on spending, or a tax on goods and services, such as VAT or excise duties

What does the government spend on?

Government spending makes up a component of AD. The government spends on:

Healthcare
Education
Defence
Law and Order
Wages (e.g. NHS/police)

Crowding In and Crowding Out

Crowding In

Crowding in occurs when government spending actually encourages an increase in private sector investment.

When the government invests in public infrastructure such as transport, roads, education, and healthcare, firms can benefit from external economies of scale, while workers may also build greater human capital.
This kind of spending can raise aggregate demand and create a more favourable climate for private investment, especially because it increases the likelihood of future growth and profits. This is known as the crowding-in effect.
In addition, improved infrastructure can attract more firms to locate in the area so they can take advantage of those external economies of scale, which helps create more jobs as aggregate demand shifts to the right.

Crowding Out

Crowding out refers to the situation where increased government involvement in a sector of the market economy substantially affects the remainder of the market, primarily through higher interest rates reducing private investment.

However, if the government finances this increased spending by borrowing money, the demand for loanable funds increase (money available for borrowing) which pushes up interest rates.
This means that private investment is more expensive and investment decreases.
In a fully employed economy with low spare capacity, the government spending competes for scarce resources with private firms, so more public sector action reduces private sector investment. This is known as the crowding out effect.

The AD Multiplier

AD shifts right

Production of goods and services increases which increases derived demand for labour

There are more jobs in the economy so more people have more disposable income

There is more consumption so producers make more revenue

Production and wages increase further, so consumption increases

Strategies to redistribute wealth

Progressive Taxation

Progressive taxation is a type of tax where the percentage of money taxed increases with income, such as income tax. Higher earners are taxed more than those who earn less, helping even out income, while reducing crime, poverty and healthcare issues

Improving Human Capital

The government can spend more on education and training to improve the human capital of workers and increase productive capacities of the economy in the long-run. People who earn less income will be more skilled and can find better paying jobs.

Drawbacks of this strategy

Higher taxes means that people have less disposable income which decreases consumption and AD in economies. This slows economic growth and reduces derived demand for labour, so there are less jobs available, so people of lower income will have less opportunities to find jobs, further perpetuating income disparities.
Progressive taxation can also cause higher-income workers to increase tax avoidance/evasion, so governments make less revenue. Some higher-skilled workers will also leave the country (causing brain drain)

Drawbacks of this strategy

Severe time lags as it requires a long time for training to have an effect
Doesn't always work
Opportunity costs: the money spent on this could be spent on something else, like healthcare, or infrastructure development.

What is Fiscal Policy?

Fiscal Policy

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.

Contractionary Fiscal Policy

Contractionary fiscal policy is the use of decreased government spending and increased taxation to achieve economic objectives, mainly price stability and a healthier balance of payments

Expansionary Fiscal Policy

Expansionary fiscal policy is the use of increased government spending and decreased taxation to achieve economic objectives, mainly economic growth and low unemployment.

How can fiscal policy be used to achieve economic objectives?

Fiscal policy involves adjusting tax rates and government spending levels to steer the economy toward stability and growth. By strategically manipulating the budget, governments can address issues such as inflation, unemployment, and wealth inequality.

Economic Growth & Low Unemployment

Expansionary Fiscal Policy:

Lower taxes increases consumption, which boosts AD along with government spending, causing economic growth. As a byproduct, unemployment falls as there are more jobs due to greater derived demand for labour

Price Stability

Contractionary Fiscal Policy:

By reducing spending or increasing income tax, the government can cool curb inflationary pressures, by decreasing domestic consumption and shifting AD left.

NB: Monetary policy is more commonly used for price stability [topic 3.6]

Healthy Balance of Payments

If the BoP is in deficit, then exports need to rise and imports need to fall, so contractionary fiscal policy cools consumption so less is spent on imports. Conversely, if the BoP is in surplus, expansionary fiscal policy is used. [Topic 4.2 covers this in more detail]

Evaluating the use of fiscal policy

Points

Helps in achieving economic objectives
Improves productive capacity of economy by increasing quality and/or quantity of the factors of production
Causes more investment
Causes a crowding in effect
Creates an AD multipler effect
Contractionary fiscal policy reduces inflation, and expansionary fiscal policy reduces unemployment
Causes more investment

Evaluations

Expansionary fiscal policy causes inflation and creates a budget deficit
Potential for a crowding out effect
Increases in consumption depends on PED and MPC (covered in topic 4.3)
Increased taxation can cause brain drain and decrease government revenue (due to tax avoidance and evasion)
Depends on interest rates: Investment might not increase because of high interest rates (saving might be more profitable and also borrowing for the investment is more expensive) and also low confidence in the economy.

Evaluating the use of increased taxation to redistribute income

Points

Evaluations

Increased taxes is effective because the rich will have less disposable income, and the tax revenue will be redistributed by the government through investment into education, training, healthcare and even social benefits which will improve their quality of life, and also increase their human capital in the longer-run
Might encourage foreign investment - foreign companies might see the fairer distribution of income as a signal of a more cohesive society, so it is a good area for investment. This means that there will be a crowding in effect of resources, while also improving infrastructure, and creating many more jobs and causing economic growth - good for the poorer

Increased taxes on the rich might lead to increased tax avoidance, and tax evasion, which would mean that actually less tax revenue is collected, so less can be spent than it already is on education training etc. so their quality of life + human capital could actually decrease
The increased taxes could cause decreased setting up of businesses or less production or productivity. This is because many high-skilled workers will leave causing brain drain, and they also have less disposable income, so this causes a decrease in productivity which will lead to a fall in output and hence slowed economic growth. This will lead to a decreased derived demand for labour which will cause unemployment so the poor will have less jobs and make less income.

💡

Key Tip: Most 6-markers in Module 3 can be answered using the AD multiplier, so ensure that you understand it properly and memorise it.

⬅️ Return to Module 3 Hub

Test Yourself!

▶️ Next Lesson: 3.6 - Monetary Policy