AQA Economics A-level: Macroeconomics

Topic 5: Fiscal and Supply Side Policies

5.1 Fiscal Policy

• Definition: Fiscal policy involves the manipulation of government spending, taxation, and the budget balance. It serves both macroeconomic and microeconomic functions.

• Instruments:

  • Government Spending and Taxation: Governments can adjust these to stimulate the economy, influencing the circular flow by altering the budget, and targeting spending and taxes in specific areas.
  • Aims: Stimulate economic growth and stabilize the economy.

• UK Context:

  • Major expenditures: Pensions, welfare benefits, health, and education.
  • Major revenue: Income tax.

Influence on Aggregate Demand (AD)

• Expansionary Fiscal Policy: Increases AD by increasing spending or decreasing taxes, often worsening the budget deficit and increasing government borrowing.

• Deflationary Fiscal Policy: Decreases AD by cutting spending or raising taxes, improving the budget deficit.

Influence on Aggregate Supply (AS)

• Tax Reductions: Lower income and corporation taxes encourage spending and investment.
• Subsidies and Education Spending: Supports firm cost reduction and improved productivity through better training and healthcare.
• Infrastructure Investment: Spending on roads and schools enhances infrastructure.

Government Budget

• Budget Deficit: Expenditure exceeds tax receipts.
• Budget Surplus: Tax receipts exceed expenditure.
• Debt vs. Deficit: Debt is accumulated deficits; deficit/surplus is the annual difference.

Taxes

• Direct Taxes: Imposed on income, paid directly (e.g., income tax, corporation tax).

• Indirect Taxes: Imposed on goods/services, raising production costs (e.g., VAT, fuel duty).

• Types of Taxes:

  • Proportional: Fixed rate for all (flat tax).
  • Progressive: Higher income pays higher rates (e.g., UK income tax).
  • Regressive: Lower income pays higher proportion (e.g., Congestion Charge).

Principles of Taxation

• Criteria developed by Adam Smith, including:

  1. Low collection cost relative to yield.
  2. Clear timing and quantity.
  3. Convenient payment methods.
  4. Based on ability to pay.

• Modern additions include efficiency, compatibility, and inflation adjustments.

Limitations of Fiscal Policy

• Imperfect Information: Can lead to inefficient spending.
• Time Lag: Effects may take months or years.
• Crowding Out: Private sector funds reduced when government borrows.
• Interest Rates: High rates can reduce effectiveness.
• Debt: Excessive spending leads to repayment difficulties.

Public Expenditure and Taxation

• Types:

  • Current Expenditure: Recurring (e.g., drugs for health service).
  • Capital Expenditure: On assets (e.g., roads, schools).
  • Transfer Payments: Welfare payments without exchange of goods/services (e.g., pensions).

• Global Context:

  • Major UK expenditures: Pensions, welfare, health, education.
  • Education spending is constant; defense spending is decreasing.

Public Expenditure Impacts

• Productivity and Growth: Investments in human capital boost growth.
• Crowding Out: Government borrowing limits private sector investments.
• Taxation Levels: High government debt might lead to increased taxes.
• Equality and Living Standards: Progressive taxes and redistributive policies reduce inequality.

Budget Balance and National Debt

• Definitions:

  • Balanced Budget: Expenditure equals revenue.
  • National Debt: Accumulated government deficit over time.

• Cyclical vs. Structural Deficits:

  • Cyclical: Temporary, linked to business cycles.
  • Structural: Persistent imbalance.

Consequences of Budget Deficits

• Inflation: Increased AD can be inflationary.
• Interest Rates: May rise due to increased government borrowing.

National Debt Significance

• Borrowing Costs: Increase with rising demand for credit.
• Interest Rates and Confidence: Loss of confidence can necessitate higher interest rates.

Office for Budget Responsibility (OBR)

• Role: Analyzes UK finances, produces forecasts, judges fiscal targets, scrutinizes spending, and assesses long-term fiscal sustainability.