Fiscal policy

Every year a government decides two numbers: how much it will spend and how much it will take in tax. Those two numbers look like accounting. They are not. Together they decide how much demand exists in the economy, who carries the burden of paying for the state, and whether the next generation inherits a debt or a surplus. Fiscal policy is the deliberate use of those two levers to steer the economy.

The government budget

The budget is simply the plan for revenue and spending over a year. Where tax revenue exceeds government spending there is a budget surplus. Where spending exceeds revenue there is a budget deficit, and the shortfall has to be borrowed. Accumulated deficits, added up over many years and net of any repayment, make up the national debt. A deficit is a flow measured over a year; the national debt is a stock measured at a point in time. Confusing the two is one of the most common errors in this topic.

Governments spend for reasons that go well beyond managing demand. They provide public goods that no firm would supply, such as defence and street lighting. They provide merit goods such as healthcare and education that would otherwise be under-consumed. They pay transfer payments such as pensions and unemployment benefit, which redistribute income rather than buy output. And they invest in infrastructure, which raises the economy's productive capacity over the long run. Recognising which type of spending a question is about matters, because transfer payments do not directly add to aggregate demand while government purchases of goods and services do.

Types of tax

A direct tax is levied on income or wealth and is paid straight to the government by the person or firm on whom it falls, as with income tax and corporation tax. An indirect tax is levied on spending and is collected by the seller, as with value added tax and excise duties on fuel and tobacco. The distinction matters because the burden of an indirect tax can be shifted onto the consumer through a higher price, whereas the burden of a direct tax cannot be passed on so easily.

Taxes are also classified by how the burden changes as income rises. A progressive tax takes a rising proportion of income as income rises, so higher earners pay a larger share of what they earn. A proportional tax takes the same proportion at every income. A regressive tax takes a falling proportion as income rises, so it falls hardest on the poor. Most indirect taxes are regressive in effect, because a low earner spends a larger fraction of their income than a high earner does.

Expansionary and contractionary fiscal policy

Expansionary fiscal policy means raising government spending, cutting taxes, or both. It increases total demand in the economy and is used when output is weak and unemployment is rising. Contractionary fiscal policy, sometimes called deflationary fiscal policy, means cutting spending or raising taxes. It reduces total demand and is used when the economy is overheating and inflation is climbing. The same instruments serve different aims depending on which direction they are pushed.

Fiscal policy is asked to do several jobs at once, and they do not always point the same way. Governments use it to promote economic growth, to reduce unemployment, to control inflation, to redistribute income from rich to poor through progressive taxes and welfare payments, and to improve the current account of the balance of payments. Cutting taxes to reduce unemployment will also raise inflationary pressure and pull in imports. That tension between objectives is where evaluation marks live.