Fiscal policy
Key terms
Define each term.
Multiple choice
Circle the correct answer.
A government cuts income tax rates and raises spending on infrastructure. This is best described as:
Which statement correctly distinguishes a budget deficit from the national debt?
During a recession a country's budget deficit widens even though the government has announced no change to tax rates or spending plans. The most likely explanation is:
Worked problems
Show your working.
Classifying a tax system from its bands. A country taxes income at 0% on the first $10,000, 20% on income between $10,001 and $50,000, and 32% on income above $50,000. Calculate the average and marginal rates of tax for a worker earning $60,000 and state whether the system is progressive.
Chains of reasoning
The steps are in the wrong order. Write the letters in the order that makes a linked chain.
How expansionary fiscal policy reduces demand-deficient unemployment
- A Firms respond to higher orders by raising output, since inventories are being run down.
- B Higher disposable income raises consumption C, since some proportion of any extra income is spent rather than saved.
- C The government raises spending on infrastructure and cuts the basic rate of income tax.
- D Aggregate demand shifts right, because both G and C are components of AD.
- E The initial spending becomes income for construction workers and suppliers, who spend a share of it in turn, so the final rise in national income exceeds the initial injection.
- F Government spending G rises directly, and lower income tax raises households' disposable income.
- G Employment rises and demand-deficient unemployment falls, while real GDP increases.
- H Labour is a derived demand, so producing more output requires employing more workers.
Diagrams
Draw a circular flow of income diagram for an economy with a government sector. Label the flows between households and firms, then add taxation as a withdrawal and government spending as an injection. Mark clearly which arrow the government controls in each case.
Draw an AD/AS diagram showing an economy operating below full employment. Show the effect of expansionary fiscal policy, labelling the shift of AD, the change in real output and the change in the price level. Then repeat the shift on a diagram where AS is near-vertical.
Answers
Fiscal policy: The use of government spending and taxation to influence the level of economic activity and to achieve macroeconomic aims.
B. Both measures increase total demand, and both operate through the government budget rather than through interest rates or the money supply. Infrastructure spending also has supply-side effects over the long run, but the immediate classification is expansionary fiscal policy.
B. The deficit is a flow, measured over a period, and the debt is a stock, measured at a moment. A government can reduce its deficit every year and still see its national debt rise, because any deficit at all adds to the accumulated total.
B. With rates and plans unchanged, the movement is not discretionary. Falling incomes reduce income tax and expenditure tax receipts while rising unemployment increases benefit payments, so the deficit widens by itself. This is the stabiliser working as intended, cushioning the fall in disposable income and therefore in aggregate demand.
Step 1. Work out the tax paid on each band. First band: 0% of $10,000 = $0. Second band: 20% of ($50,000 - $10,000) = 20% of $40,000 = $8,000. Third band: 32% of ($60,000 - $50,000) = 32% of $10,000 = $3,200.
Step 2. Total the tax paid. $0 + $8,000 + $3,200 = $11,200.
Step 3. Calculate the average rate of tax. ($11,200 / $60,000) x 100 = 18.67%, or 18.7% to one decimal place.
Step 4. Identify the marginal rate of tax. The next dollar earned is taxed in the top band, so the marginal rate is 32%.
Step 5. Classify the system. The marginal rate of 32% exceeds the average rate of 18.7%, so a further dollar of income is taxed more heavily than income has been on average. The proportion of income paid in tax therefore rises with income, which is the definition of a progressive tax system.
Show the band-by-band working even when the question only asks for the final figure. Method marks are available and a single arithmetic slip then costs one mark rather than all of them.
C, F, B, D, A, H, G, E
- The government raises spending on infrastructure and cuts the basic rate of income tax.
- Government spending G rises directly, and lower income tax raises households' disposable income.
- Higher disposable income raises consumption C, since some proportion of any extra income is spent rather than saved.
- Aggregate demand shifts right, because both G and C are components of AD.
- Firms respond to higher orders by raising output, since inventories are being run down.
- Labour is a derived demand, so producing more output requires employing more workers.
- Employment rises and demand-deficient unemployment falls, while real GDP increases.
- The initial spending becomes income for construction workers and suppliers, who spend a share of it in turn, so the final rise in national income exceeds the initial injection.
AO2 analysis carries 40% of the marks, and it is the linking that earns them. The weakest version of this answer is 'the government spends more so unemployment falls'. Every arrow above is a separate creditable step.
The purpose of drawing it is to see why the two levers pull in opposite directions. Taxation takes money out of the flow, so raising it reduces the income circulating. Government spending puts money in, so raising it increases the income circulating. A budget deficit means injections from the government exceed withdrawals, which is why an unbalanced budget in that direction expands the economy.
The point of drawing it twice is the comparison. On the elastic section of AS most of the shift becomes extra real output with little price rise. Near full capacity the same shift is absorbed almost entirely by a higher price level, so the policy delivers inflation instead of growth. Examiners reward candidates who make the outcome depend on where the economy currently sits rather than assuming the convenient case.