Fiscal and supply side policies

You will have to review your AS notes, 2.11 Fiscal Policies and 2.12 Supply Side Policies, before starting this unit.  You will also be tested on this knowledge in the Unit 4 exam.

Many of the topics covered there are essential knowledge at A2.


Fiscal Policies

Fiscal policies attempt to achieve economic targets through the use of government spending and taxation.  Fiscal policy can have both macroeconomic and microeconomic objectives.  Macroeconomic objectives are likely to be the influence of aggregate demand and aggregate supply, whilst government spending and taxation can be used to alter the pattern of economic activity, thus pursuing microeconomic objectives.


Budget Balance

There are three possible budgetary scenarios for the government:

Government spending = Taxation (balanced budget)

Government spending > Taxation (budget deficit)

Government spending < Taxation (budget surplus)


Public sector net cash requirement

The public sector net cash requirement (PSNCR) is the amount the public sector borrows from other sectors of the economy and overseas. There will be a PSNCR when there is a budget deficit.
The PSNCR is the sum of three components: the Central Government Borrowing on its Own Account (CGBR(O)), the Public Corporation Borrowing Requirement (PCBR) and the Local Authority Borrowing Requirement (LABR).


The government is able to borrow from either from the banking sector, for example, high street banks or the Bank of England, or the non-bank private sector, for example, insurance companies and individuals.  The government sells Treasury bonds and National Savings certificates.


Gilt-edged securities, otherwise known as gilts, is the name for Treasury bonds sold by the UK government.  Selling gilts is the main method used the UK government for raising finance.  About two-thirds of all gilts are held by insurance companies and pension funds.  The holder of the gilt receives a fixed cash payment (or coupon) every six months until maturity, at which point the holder receives their final coupon payment plus the return of the principal (the initial amount paid for the gilt).


Gilts are identified by their coupon rate and maturity year, for example, 1¼% Treasury Gilt 2055. The coupon paid on the gilt typically reflects the market rate of interest at the time of issue of the gilt, and indicates the cash payment per £100 that the holder will receive each year in two semi-annual payments.


In March 2009 the UK Government failed to sell all its government bonds in an auction for the first time since 2002.  It had wanted to sell £1.75bn of 40-year bonds, but investors only bid for £1.63bn of the debt.  The bid-to-cover ratio, this is how many bonds were offered versus how many were sold, was 0.93 at the auction.

What is the implication of having a negative PSNCR?  What will happen to the overall level of government debt?







Disadvantages of a budget deficit

If a government has a budget deficit over a number of years it can lead to problems for the economy:

  • Crowding-out can occur if the government has to borrow a lot of money in order to finance the budget deficit.

On the diagram below demonstrate the impact upon the rate of interest of an increase in demand for money by the government.


What will be the impact of this higher rate of interest upon the investment carried out by private firms?  Explain your answer.




This reduction is a result of private firms being crowded out of the market due to high levels of government borrowing.

  • The government has to pay back the money it has borrowed.  This will eventually have to be done out of taxation; higher tax rates will reduce the level of growth within an economy as incentives are reduced.
  • As the national debt increases a growing proportion of government spending will be used simply to pay the interest on past debt; money has an opportunity cost and could be used to build schools and hospitals.


Advantages of a budget deficit

By operating a budget deficit the government may have a positive impact upon the economy.  Increasing government spending, otherwise known as a discretionary expansionary fiscal policy, will act as a stimulus to economic growth.


The diagram above demonstrates how a stimulating AD through government spending will lead to an initial increase in national income from A to B.  If the additional spending increases the long run supply side potential of the economy, for example spending on new roads or the telecommunications infrastructure, then the AS and LRAS will also shift to the right – the economy will now move from B to C and national income will be at Y2.


Keynesian economists believe in using demand management and building up a budget deficit in order to increase aggregate demand and reduce the negative output gap.

Given the present state of the economy, do you think the government should operate at a surplus, deficit, or neutral spending?






The main reasons the UK government undertake taxation is to:

  • Fund government spending.
  • Manage the economy.

What has the government recently done to taxation to encourage economic growth?




  • Correct market failure by encouraging the consumption of merit goods and discouraging the consumption of demerit goods.

How can the government do this?





  • Redistribute income from the relatively well off to those on lower incomes.
  • To control imports through the use of tariffs; this will help a country’s balance of payments and protect industries from overseas competition.

The labour government identified a number of objectives for its tax system:

  • To keep the overall tax burden as low as possible.
  • To reduce income tax rates to increase incentives to work.
  • To have a broad range of taxes which helps to keep each separate tax rate low.
  • To shift the balance of taxation away from taxes on income towards taxes on expenditure.
  • To ensure all taxes are applied equally and fairly to everyone.
  • To use taxes to reduce market failure.


The Canons of taxation

Nobody enjoys paying taxes; Benjamin Franklin said, “The only things certain in life are death and taxes.”


Economists use the canons of taxation which were developed by Adam Smith; he stated that taxes should be economical, equitable, convenient and certain.

  • Economical.  The cost of collecting the tax should be cheap to collect, otherwise the cost of collection may make it uneconomical.
  • Equitable.  The tax should be based on the taxpayer’s ability to pay.
  • Convenient.  The payment method and timing should be convenient to the taxpayer.
  • Certain.  It is important that taxpayers understand how the system works and what, when and how to pay. All taxes should be difficult to evade.


In addition to these canons, modern economists have added:

  • Efficient.  The tax system should reduce the efficiency of the economy.
  • Flexible.  The structure and rates of taxation must be capable of easy alteration in response to changing economic conditions.
  • Compatible.  In today’s world of globalisation it important that tax systems are internationally compatible, particularly with the EU for the UK.



Hypothecation of tax revenues means that the money raised from a tax is for a specific purpose, for example, the government stated that a large proportion of tobacco duty would be used by the NHS for tackling smoking-related diseases.  Hypothecation can also be sued to provide compensation to those that are affected from the consumption or production of goods and services with negative externalities.


An argument against the hypothecation of taxes is that if an organisation is reliant upon a tax for revenue then it may reduce the incentive to become more efficient.  One-sixth of all the national lottery money earmarked for good causes is being spent on bureaucracy, including one quango that has more staff than the Treasury.  This £200m a year that is being swallowed up in administration and staffing costs is up to six times the proportion spent on overheads by some leading charities.

Do you think people will be happier to pay taxes if there is hypothecation of tax revenues for specific causes?




Direct Taxes in the UK

Direct taxes are paid on income by the individual taxpayer.  The tax liability cannot be passed onto someone else.  Direct taxes include income tax, inheritance tax, capital gains tax and corporation tax.



Income tax is a direct tax on all incomes received by private individuals after certain allowances are made. Everyone has a non-taxable allowance.  Income tax is a progressive tax, this means that as income rises the percentage of income paid in tax also rises.  The table below shoes the current rates of income tax in the UK.


The marginal rate is zero for the personal allowance – this is how much you can earn without paying nay tax.  Above £34,600 the marginal rate of tax is 40%; you only pay the higher tax rate on any money above the threshold.


The higher rate of income tax has fallen over the years; from 83% in 1978, to 60% in 1987 to 40% in 1988.

What is the disadvantage to an economy of having a very high top rate of tax?





The government will usually increase the income tax boundaries in line with inflation.  If the increases in tax bands don’t rise as quickly as wages then people will find themselves entering a higher tax bracket – this is known as fiscal drag.



National Insurance contributions are a direct tax that leads to an entitlement to certain social security benefits, including contribution based Jobseeker’s Allowance, Incapacity Benefit and the State Pension; it is therefore, to some degree, an example of the hypothecation of taxation.


The type and level of NIC you pay depends on how much you earn and whether you’re employed or self employed. You stop paying NICs when you reach State Pension age.

Who pays National Insurance?


National Insurance contributions are made by employees and the self-employed who are between 16 and 65.  11% of wages between £110 and £844 and 1% of earnings above £844 are paid to the government.



This is a tax on the profits of firms, the rate charged depends upon the size of the business.  The table below outlines the different corporation tax rates.


The rates of income and corporation tax vary around the world, as seen in the chart below




This tax is levied on the income from exploiting North Sea oil and gas; it is paid in addition to corporation tax.



The Inheritance Tax threshold (or ‘nil rate band’) is the amount up to which an estate will have no Inheritance Tax to pay; at present this is £312,000.  If the estate – including any assets held in trust and gifts made within seven years of death – is more than the threshold, Inheritance Tax will be paid at 40% on the amount over the nil rate band.



Capital Gains tax is a tax on the increase in value of assets when they are sold compared with their value when they were bought.  The most common capital gains are made from the sale of shares, bonds, precious metals and property.  There is an annual tax-free allowance, known as the ‘Annual Exempt Amount, of £9,000.  After this amount capital gains tax of 18% is paid.


indirect taxation

Indirect taxes are taxes on spending, including VAT and a range of excise duties.  The tax can be levied on either the supplier or consumer.  If the tax is placed on the producer, the firm may be able to pass on some of the tax if the price elasticity of demand is inelastic.  There has been a shift away from direct to indirect taxation as part of discretionary fiscal policy, for example, the UK government reduced VAT from 17.5% to 15% in 2008 in an attempt to stimulate consumer spending.


This is an example of an ad valorem tax that leads to a pivotal shift in the supply curve.

Use the diagram below to demonstrate the effect of imposing VAT on a market.


The standard rate of VAT is 15%.  There are some goods and services that have VAT charged at 0%, examples of “zero-rated” goods are most food (not in a restaurant or hot takeaways), books, newspapers, public transport and children’s clothing.  Others are subject to VAT at a lower rate of 5%, examples of “the reduced rate” are domestic gas supplies, installing energy-saving materials, sanitary hygiene products and children’s car seats.  Some goods and services are exempt from VAT, for example, insurance, education, fundraising by charities and most services provided by doctors and dentists.


There has been a degree of harmonisation of VAT across the EU, rates vary from between 15 and 25%.



Excise duties are charged per unit purchased, for example:

  • Beer – 35p on a pint of 4% beer.
  • Wine – £1.57 per bottle or still wine or £2.02 per bottle of sparkling wine.
  • Petrol – 50.4p per litre.
  • Vehicle Excise Duty – up to £440 per year and £950 showroom tax which is dependant upon CO2 emissions.
  • Cigarettes – £2.24 per pack of 20 plus 22% of the retail price.


There will be VAT charged on top of these prices.

Laffer Curve

The Laffer curve demonstrates the idea that increasing the rate of taxes does not necessarily increase tax revenue, for example, a 100% rate of income tax will generate no revenue as there will be no incentive to make money.  Increasing taxes beyond the peak of the curve will decrease tax revenue.


The marginal rate of tax that leads to the highest revenue for the government is a source of great debate; it will vary from one economy to another and varies with time even in the same economy.


It is used by supply side economists who argue in favour of reducing marginal tax rates in order to increase the incentive to work.

Do you agree with the principle the principles behind the Laffer curve?  Explain your answer.




I hope your economics lesson wasn’t like this…. A classic scene from the brilliant and very funny Ferris Beuller’s Day Off



Fiscal Rules

Perhaps fearful of being labelled a tax and spend government, the labour party laid down strict rules regarding levels of national debt.  In 1998 it established the Fiscal Policy Framework, which includes a Code for Fiscal Stability.


UK Code for Fiscal Stability

The Code is based upon two main rules.  The labour party’s golden rule states that the government could only borrow money for investment over the course of an economic cycle.  This means that any borrowing during a downturn would have to be repaid during the boom years.  There has been some criticism of the labour government as the dates of the economic cycle have been changed and some spending has been reclassified as investment.


The second rule is the sustainable investment rule which states that public sector debt must be less than 40% of GDP over the economic cycle.


These rules imply that the government doesn’t intend to rely upon fiscal policy as its demand management tool.


Stability and Growth Pact

The European Monetary Union (EMU) relies upon governments not building up substantial budget deficits and amassing subsequent national debts were recognised; were this to occur there would be significant strains upon the currency.  A condition of membership that annual government borrowing could not exceed 3% of GDP and the national debt could not exceed 60% of GDP.  As the UK is not a member of the EMU it is not bound by the terms of the pact.  The table below outlines the government finances of the European economies.



Government finances

annual government deficit to GDP

gross government debt to GDP

Reference value

min. -3%

max. 60%











































United Kingdom



























Czech Republic




















Supply-Side Policies

Supply side policies are those policies that aim to shift the long run aggregate supply curve to the right.

Use the diagram below to show the effects on a successful supply side policy.


Use the long run Phillips curve to demonstrate how supply side policies will impact upon the natural rate of unemployment.




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