1. AS Macro Revision
Fiscal Policy
Spring 2014

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3. What is Fiscal Policy?
• Fiscal policy involves the use of government spending,
taxation and borrowing to affect the level and growth of
aggregate demand, output and jobs
• Fiscal policy is also used to change the pattern of spending
on goods and services e.g. Health care and renewable energy
• Fiscal policy is also a means by which a redistribution of
income & wealth can be achieved for example by changing
tax rates on different levels of income or wealth
• It is an instrument of micro-economic government
intervention to correct for market failures such as pollution
or the sub-optimal provision of public and merit goods
• Changes in fiscal policy affect both aggregate demand (AD)
and aggregate supply (AS) (build this into your analysis)

4. Some Key Roles for Fiscal Policy
Fiscal policy decisions have a large impact on millions of consumers
and businesses – in both the short and the long term
Financing government
spending
Altering distribution of
income and wealth
Providing a welfare
state safety-net
Managing the
economic cycle
Improving
competitiveness
Tackle market failures

5. The Public and the Private Sector of the Economy
Public sector businesses are owned and operated by the
government, whilst the private sector is privately owned
• The public sector is not profit-driven, while this is usually (but not
always) the case with the private sector.
• In terms September 2013, there were 5.7 million people working in the
UK public sector (18.8% of people in employment). The National Health
Service (NHS) employs over 1.5 million people
• Public sector businesses include the following:
• Met Office and Ordnance Survey
• Channel 4, National Nuclear Laboratories
• Eurostar, NATS (National Air-Traffic Control Services)
• Network Rail
• The Royal Mail was part privatised in 2013

6. Direct and Indirect Taxation
• Direct taxation is levied on income, wealth and profit
• Direct taxes include income tax, inheritance tax,
national insurance contributions, capital gains tax,
and corporation tax
• The burden of a direct tax cannot be passed on
• Indirect taxes are taxes on spending
• Examples of indirect taxes include excise duties on
fuel, cigarettes and alcohol and Value Added Tax
(VAT) on many different goods and services
• Producers may be able to pass on an indirect tax –
depending on price elasticity of demand and supply

7. Progressive, Proportional and Regressive Taxes
•
With a progressive tax, the marginal rate of tax rises as
income rises. I.e. as people earn more income, the rate
of tax on each extra pound goes up. This causes a rise
in the average rate of tax
• Examples: Income tax (basic and higher rates)
• With a proportional tax, the marginal rate of tax is
constant leading to a constant average rate of tax
• Examples: National insurance contributions
• With a regressive tax, the rate of tax falls as incomes
rise – I.e. the average rate of tax is lower for people of
higher incomes
• Examples: Excise duties on tobacco and alcohol

8. Taxation and Aggregate Demand
Changes in tax rates and tax allowances can have a direct and
indirect effect on the level of aggregate demand
Income tax and
disposable income
Corporation taxes and
business investment
Taxation of imports
National insurance and
labour demand
VAT and consumer
spending
Taxation and business
R&D spending

9. Lower Taxes and Components of Demand
Cut in personal
income tax rates
Boost to disposable
income
Adds to consumer
demand
Cut in indirect
taxes e.g. VAT
Lower prices –
leads to higher
real incomes
Adds to consumer
demand
Cut in
corporation tax
Higher “post tax”
profits for
businesses
Adds to business
capital spending
Cut in tax on
interest from
saving
Boost to disposable
income of people
with net savings
Adds to consumer
demand
Expansionary
Fiscal Policy

10. Taxation and Aggregate Supply
Changes in tax rates and tax allowances can have a direct and
indirect effect on both short-run and long-run aggregate supply
Work incentives /
active labour supply
Inward migration of
key workers
Capital investment
e.g. FDI projects
Enterprise /
Entrepreneurship
Human capital
spending
Tariffs affect import
costs

11. How Could Tax Cuts Stimulate Economic Recovery?
Consumer spending
• Cuts in VAT or income tax to boost
demand for goods and services
Business investment
• Lower corporation tax to increase
investment and tax incentives for R&D
Lower employment taxes
• Reduced national insurance so that
businesses create more jobs
Lower fuel / carbon taxes
• Lower costs for businesses, less
inflation and higher profits
Low confidence – tax
cuts likely to be saved
rather than spent
Businesses might
choose to invest
overseas instead
Skills shortages might
limit new job creation
Possible conflicts with
environmental policies

12. Get help on the AS
macroeconomics course
using twitter
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@tutor2u_econ
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13. Government Spending
Government spending is spending by the public sector on goods
and services such as education, health care and defence
Transfer Payments
Recurring spending
Investment Projects
Welfare Spending
Public Services
State Investment
Total UK government spending is forecast to be £745 billion in 2015
This is 43.1% of GDP. £50 billion or 7% will be on capital spending
Spending on public services such as education & health is 22% of GDP

14. Economic Importance of Government Spending
Key
Component
of Aggregate
Demand
Providing
Public &
Merit Goods
Regional
Economic
Impact
Achieving
greater
Equity in
Society

15. Economic Importance of Education & Health Spending
Education and health are regarded by economists as merit goods.
An increase in funding of both can affect the macro-economy
Education spending
• May increase the skills and
productivity of workers
• Improvement in human capital will
lower structural unemployment
• More innovation / competitiveness
Health care spending
• Improved health outcomes will boost
active labour supply
• Will also increase productivity
• Lessens risks of relative poverty
Evaluation Arguments
1. Effectiveness of
education spending has
been questioned
2. Money might be better
spent targeting certain
groups or ages
Evaluation Arguments
1. Better health results can
be achieved without
increase in health
funding
2. Will lower income
families get the improved
access

16. How Government Spending can affect Incomes
Welfare state transfers
• Universal child benefits / unemployment benefit
• Public (state) pensions
• Conditional welfare transfers e.g. Conditional on
attending unemployment programmes
• Targeted welfare payments- linked to income
State-provided services (in-kind benefits)
• Education - reduces inequality of market incomes
• Health care – state provided health services
• Social housing e.g. Provided by local authorities
• Employment training

17. The Fiscal (Budget) Balance
When tax revenues are insufficient to pay for state spending then a
government must borrow, this is known as a budget deficit
The last year that
the UK ran a
budget surplus
was in 2000. There
has been a deficit
in every year since
with the fiscal
deficit peaking at
11% of GDP in
2009 – which was
also a year of deep
recession. The
deficit has
gradually fallen in
recent years

18. Government Spending and Taxation as % of GDP
The scale of state spending and total tax revenues is usually
measured as a % of national GDP – data for the UK is below
The recession
from 2008-2010
caused a steep
rise in state
spending and a
fall in tax
revenues. The
government is
now seeking to
reduce
government
spending as a
share of GDP to
help cut the
fiscal deficit.

19. Government Borrowing and Bond Interest Rates
When a government borrows it issues debt in the form of bonds.
The yield on a bond is the interest rate paid on state borrowing
In recent years
there has been a
large fall in the
interest rate
paid on 10 year
UK government
loans. This is
good news for
the government
as the interest
payments on
each bond will
be lower.

20. Economic Arguments for Budget Deficits
A budget deficit is a net injection of aggregate demand into the
circular flow since G > T
1. A rise in borrowing to fund extra government spending can have
powerful effects on AD, output and employment when an
economy is operating below full capacity output
2. There is an automatic rise in the budget deficit to cushion the
fall in AD caused by an external economic shock. A higher fiscal
deficit is needed to lift AD back towards pre-recession levels
3. If a fiscal stimulus works the budget deficit will improve as a
result of higher tax revenues and reductions in welfare spending.
A growing economy helps to shrink debt as a percentage of GDP
4. It makes sense for a government to borrow money if interest
rates are low and if the deficit is being used for investment

21. Is a High Level of Public Debt Bad for the Economy?
Public debt is the total stock of debt issued by a government that
has yet to be re-paid – also known as the National Debt
• The Government may have to offer higher interest rates
on new debt – increasing the cost of servicing debt
• This interest burden has an opportunity cost for less
spent on interest payments could free up extra
spending on services such as health and education
• A sizeable increase in the national debt is likely to cause
higher taxes in the future. This will cut the disposable
incomes of tax payers and leave less money for private
sector expansion
• It might be considered unfair if the rising tax burden
falls more heavily on future generations of tax payers
rather than people who benefit from government
spending now.
UK Debt Data
UK government
debt is forecast
to reach 94% of
GDP in 2013.
This is lower
than the average
of advanced
economies
(109.3%).
Japan’s gross
debt is 245% of
GDP in
2013, while
Greece’s is
179% of GDP.

22. Supply-Side
Economic Policies

23. Get help on the AS
macroeconomics course
using twitter
#econ2
@tutor2u_econ
www.tutor2u.net