Fiscal policy

Economics AS · Government macroeconomic intervention. The idea in plain words, the rules to remember, the mistake to avoid and a worked example, written and checked by Mega Lecture.

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The idea

Fiscal policy is the use of government spending and taxation to influence aggregate demand (AD). The government budget is its plan for spending and tax revenue for a year. If spending is greater than revenue there is a budget deficit; if revenue is greater there is a surplus. The national debt is the total the government owes from all past borrowing.

Taxes may be direct (on income or profit) or indirect (on spending). They may be progressive, proportional or regressive. Spending may be capital or current.

Expansionary fiscal policy raises spending or cuts taxes, so AD shifts right. Contractionary policy does the opposite, so AD shifts left. The effect on output and prices depends on where the economy is on the AS curve.

Rules to remember

Budget deficit: government spending > tax revenue. Budget surplus: tax revenue > government spending.
National debt = total stock of government borrowing; a deficit adds to it each year and interest must be paid on it.
Direct tax: on income or wealth (income tax, corporation tax). Indirect tax: on spending (VAT, sales tax, excise duty).
Progressive: average rate rises as income rises. Proportional: average rate stays the same. Regressive: average rate falls as income rises.
Average rate of tax (art) = total tax paid ÷ total income × 100. Marginal rate of tax (mrt) = change in tax paid ÷ change in income × 100.
Capital spending: on assets that last, such as roads and schools. Current spending: day-to-day, such as wages and medicines.
Expansionary: higher spending or lower taxes, AD shifts right. Contractionary: lower spending or higher taxes, AD shifts left.

Common mistake

Do not mix up the budget deficit and the national debt. The deficit is the shortfall in one year (a flow); the debt is the total owed from all years (a stock). A smaller deficit still makes the debt bigger.

Worked example

Income tax is 0% on the first $8,000 of income, 10% on the next $12,000 and 30% on all income above $20,000. A person earns $40,000. Find the marginal and average rates of tax.

Tax on the first $8,000 = $0. Tax on the next $12,000 = 10% × 12,000 = $1,200.
Income above $20,000 = 40,000 − 20,000 = $20,000. Tax on it = 30% × 20,000 = $6,000.
Total tax = 0 + 1,200 + 6,000 = $7,200. Average rate = 7,200 ÷ 40,000 × 100 = 18%.
An extra $1 of income would be taxed at 30%, so the marginal rate is 30%.

Answer: Marginal rate = 30%, average rate = 18%. The marginal rate is above the average rate, so the tax is progressive.

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