Fiscal policy – 2.6.2 Part 2 Edexcel Economics A notes

What is fiscal policy?

Fiscal policy includes changes to government spending and taxes.

What does the UK Government spend money on?

• Welfare payments and retirement pensions.
• Healthcare and state education.
• Other public services, including paying the public sector workforce.
• National defence and foreign aid.
• Debt interest.
• Economic interventions such as subsidies.

The UK Government runs a budget deficit in most years. This is when government spending exceeds tax revenues.

In terms of taxation, the UK Government uses several types of taxes to raise revenue.

• Direct taxes.
  • These taxes are taken directly from earnings (income or profit).
  • Income tax is a tax based on a person’s income.
  • Similarly National Insurance contributions (NICs) are a tax on earnings paid by employers and employees.
    • One difference between income tax and NICs is that income taxes are paid on savings or pension earnings, while NICs are not.
    • Similarly NIC payments allow individuals to qualify for a state pension.
    • For most purposes, NICs can be viewed as a second type of income tax.
  • Corporation tax (tax on profits).
  • Capital gains tax (tax on income from selling an asset).
  • Council tax is a tax linked to domestic properties. The revenue from council tax goes to local councils.
• Indirect taxes:
  • These are taxes on expenditure, usually paid by firms but can be passed onto consumers indirectly with higher prices.
  • For example value added taxes (VAT) is a particular type of tax on expenditure. VAT is levied on the value added at each stage of the chain of production and distribution.
  • There are also alcohol duties and cigarette duties.

For the UK Government, income taxes provide the greatest source of revenue. Specifically income taxes are forecast to raise £470 billion for the UK Government’s tax revenue in 2024-25 (source). After income tax, the other taxes that bring in the most revenue are National Insurance, VAT and corporation tax.

What are the effects of increases in government spending?

What are the effects of increasing government spending?

• Higher government spending boosts aggregate demand.
  • This is because G is a component of AD. AD = C + I + G + X – M.
  • So AD shifts right.
  • This raises the economic growth rate while reducing unemployment.
  • However higher government spending can lead to higher inflation.
    • This depends on the level of spare capacity in the economy.
    • Suppose the economy is operating at full capacity, on the vertical section of the Keynesian LRAS.
    • Then a shift right in AD only leads to higher inflation but does not increase the level of real GDP.
    • This is because, while the government can hire factors of production such as labour to produce goods and services, this reduces the amount of labour available for the production of other goods and services. There are no spare factors of production available.
    • As a result, when there is no spare capacity, real GDP does not increase overall when government spending increases.
• Higher government spending also causes a multiplier effect.
  • Consider a government-funded construction project to build a new train line.
  • The increase in government spending is spent paying construction firms, whose profits increase.
  • This may be passed down to workers in the form of higher wages.
  • With workers being richer, they may spend more money in local shops, boosting consumption.
  • This shifts aggregate demand further to the right.
    • Yet this depends on the size of the multiplier.
    • The multiplier could be small if the marginal propensity to consume (MPC) is small.
    • This could occur when there is low consumer confidence for instance.
• Productivity growth occurs if spent on supply-side projects.
  • An example of this could be government spending on worker education and training.
  • In the case of education and training, this increases the
  • This increases long-run aggregate supply, shifting the LRAS to the right.
  • For more on the supply side effects of fiscal policy, including evaluation, see the notes on supply side policies here.
    • However government spending can lower productivity if spent on welfare benefits such as unemployment benefit.
      • Yet spending on welfare benefits can reduce inequality and poverty. This may reduce spending on welfare and health in the long run.
• Government spending causes crowding out:
  • Crowding out is when an increase in government spending causes a decrease in private sector investment.
  • This occurs through input markets, in other words the markets for factors of production.
  • For example, suppose the government increases its spending on building rail lines.
  • This increases demand for the inputs for construction, such as workers or raw materials.
  • So the price of these inputs rises, increasing costs of construction for private businesses.
  • So private firms see a fall in profits, so firms may reduce investment.
  • A similar argument can be made about funds for borrowing (“loanable funds”). Government spending increases the total demand for loanable funds, increasing their price (which is the rate of interest). This makes private firms less willing to borrow to invest.
    • However government spending can also crowd-in private sector investment.
    • For example, higher government spending boosts aggregate demand, leading to higher economic growth and higher real incomes. This may boost demand for firms’ products and boost business confidence. So firms may increase investment.
• Increase in the budget deficit:
  • A budget deficit occurs when government spending exceeds tax revenue.
  • The UK Government ran a budget deficit of 4.4% of the UK’s GDP in 2023-24.
  • There are three responses to a budget deficit. A government can fund the budget deficit through borrowing, higher taxes or by cutting other sources of government spending.
  • Option 1: governments can borrow money to pay for the increase in government spending.
    • This means the government will pay more debt interest, which has an opportunity cost. Instead of spending on debt interest, the government could be spending that money on healthcare for example.
    • Higher government debt may worsen the government’s credit rating. This means investors believe the government is less likely to be able to repay debts. This may result in some lenders not being willing to lend to the government, making it harder for the government to borrow.
    • Alternatively, lenders to the government may request higher interest payments to cover a greater risk of the government failing to repay its borrowing.
    • If a government cannot make debt repayments, it may stop making debt payments (“default” on its debt). This would make it harder for the government to borrow in future.
      • This depends on the level of interest rates on government debt. Interest rates were low during the Covid-19 pandemic, which made it cheaper for governments to borrow.
  • Option 2: governments can raise tax rates to pay for the increase in government spending.
    • Raising taxes, such as income taxes, may reduce aggregate demand and long run aggregate supply.
    • This cancels out the effect of the increase in government spending, such that overall there is no net effect on economic growth.
  • Option 3: governments cut other areas of spending in response to increasing government spending in another area.
    • This demonstrates the concept of opportunity cost.
    • In other words, government spending in one area means the government has to forgo spending in another area.

What are the effects of changes to tax rates?

• Income tax cuts
  • Cutting income tax rates increases the incentive to work. So workers may work more hours. Higher pay might also increase worker motivation, leading to higher productivity.
  • Also more workers may enter the labour force, as the post-tax income from working is now more likely to exceed any welfare payments.
  • This all contributes to long-run aggregate supply shifting to the right.
  • You can also argue that the increase in labour supply, as well as the rise in labour productivity, leads to a fall in business costs per unit produced. This shifts SRAS right.
  • Cutting income tax also raises the disposable income of households. This is likely to increase consumption and also aggregate demand.
  • Also government revenue may fall. This reduces the funding available for public services such as national defence or education.
  • Alternatively tax cuts could increase the budget deficit and lead to more government borrowing. This drives up debt interest payments.
• Corporation tax cuts
  • Corporation tax cuts reduce the tax rate on firms’ profits. This gives firms more funds to reinvest, increasing investment and AD.
  • Corporation tax cuts also increase the future rate of return on any investment made today. A firm knows that any future profits made will be taxed at a lower rate. This increases the incentive to invest today, boosting AD.
  • Higher investment boosts the quantity and quality of the capital stock. This raises productive capacity, shifting the LRAS right.
  • This also increases firms’ incentive to grow or the incentive to start a business. This shifts LRAS right.
  • Investment from abroad may also increase.
  • However again government revenue may fall, reducing funding for public services such as education or national defence.
  • Cutting corporation tax may have less of an impact on firms making low profits or even losses.
  • Other countries may respond to corporation tax cuts in one country by lowering their own corporation tax rates. This could lead to a race to the bottom in corporation tax rates. As a result, cutting corporation tax rates may not attract much additional investment from abroad.
• Indirect tax cut (VAT cut)
  • VAT is a tax on expenditure, paid directly by firms but often passed on to consumers.
  • A fall in VAT reduces the tax burden for businesses, reducing production costs.
  • So SRAS shifts to the right.
  • This leads to lower inflation and higher economic growth.
  • However this reduces government revenue, increasing the size of the budget deficit.

The success of tax cuts depends on:

• The level of consumer or business confidence:
  • For example, suppose consumer confidence is low.
  • Then when income taxes are cut, consumers may save the extra disposable income rather than spend.
  • So consumption may not rise as much following the tax cut.
• How tax rates compare to other countries:
  • Suppose corporation tax rates rise, but remain lower than in competitor economies. This is broadly what has happened with the UK’s rise in corporation tax rates for businesses making larger profits.
  • Then foreign direct investment into the UK is likely to continue as the UK remains competitive on corporation tax rates.
  • As a separate point, how other countries respond to one country increasing their corporation tax rates will also matter.
• The time frame:
  • In the short run, the effect of tax cuts on AD may dominate. This could lead to higher inflation in the short run.
  • Only in the long run, when productive capacity has increased and the LRAS has shifted right, is the inflationary effect of tax cuts minimised (or tax cuts could even reduce the rate of inflation).
• Tax cuts can raise revenue:
  • Income tax cuts for example may encourage people to work more, increasing taxable incomes. This may increase overall revenue from income tax.
  • This is captured by the Laffer curve, a diagram which I will cover in theme 4 notes (to be uploaded at a later date).

Diagrams for fiscal policy

Here are some possible diagrams for expansionary fiscal policy.

Basic diagrams

1) AD shifts right

AD shifts right due to an increase in government spending or a fall in tax rates.

2) LRAS shifts right

This can occur due to an increase in government spending on supply-side projects, such as education or infrastructure. Similarly, a tax cut may increase productive potential, shifting LRAS right.

Higher level diagrams for 25 markers

• AD double shift to the right on the same diagram. The first shift right due to the initial expansionary fiscal policy (e.g. higher government spending). The second shift right is due to the multiplier effect.
• SRAS and LRAS may both shift to the right on the same diagram. This occurs where fiscal policy increases productive capacity and leads to lower business costs for firms.
• A combination of AD and LRAS shifting right on the same diagram.

I will cover two more diagrams in my forthcoming theme 4 notes on fiscal policy (crowding out and the Laffer curve). These are also appropriate diagrams to use for fiscal policy essays.

Fiscal policy case studies: The Great Depression and 2008 global financial crisis

Great Depression 1929 into 1930s

• The original response of the UK and US authorities was to cut government spending and raise taxes.
• After this did not work, the US conducted expansionary fiscal policy.
  • The New Deal, from 1933 onwards, involved an increase in government spending.
  • This Included government spending to support farmers, and spending on infrastructure such as the Tennessee dams.

Global Financial Crisis 2007-8

• Fiscal policy US:
  • 6% of GDP spent on fiscal stimulus – tax cuts for businesses, more spending on health, education, welfare and infrastructure.
• Fiscal policy UK:
  • 2.2% of GDP spent on fiscal stimulus. This included a VAT cut, spending on health, education and infrastructure as well as green energy.
  • However the UK Government moved to reduce budget deficit from 2010. Over a decade, the budget deficit fell from 10% of GDP to 2% of GDP.

Practice Exam Style Question

This is a practice 25 mark question written in the style of Edexcel Economics A. It features a short extract and the 25 mark question itself:

Taking effect from 1st April 2023, the UK Government has committed to increasing the corporation tax rate from 19% to 25% for companies with profits above £250,000 per year. For firms with profits below £50,000, there is no increase in corporation tax rates. But for firms with profits between £50,000 and £250,000 there will be a smaller increase in corporation tax rates.

Evaluate the macroeconomic effects of a rise in corporation tax rates on companies making large profits. (25 marks)

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