Fiscal policy

Fiscal policy is the use of government spending and taxation to achieve economic targets.  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.

Government Expenditure and Income

During the Budget, which takes place each March, the Chancellor, in 2008 Alistair Darling, stands before parliament and presents the government spending and income plans and the economic forecasts for the coming year.

In addition to the budget the Chancellor delivers a Pre-Budget Report in November or December (although it was in October in 2007) that updates the economic forecast, outline the plans of the Government and reports on the progress since the budget.

The state of the economy, for example during a boom or recession, would alter the size of total spending on the individual components.  Spending on social protection, such as job seekers allowance and housing benefits, would rise during a recession.

 Again the size of GDP will impact upon the level of tax receipts; you would expect the government to receive less money during a recession due to lower spending and earnings.

Government spending can be divided into three sections:

• Current spending – the day to day running of public services, e.g. school supplies and salaries for NHS workers and police.
• Capital spending – this spending will increase the productive capacity of the economy, e.g. building motorways and schools.
• Transfer payments – are the payments made that are not in return for labour or goods, e.g. Job Seekers’ Allowance.

Demand-Side Fiscal Policy: Discretionary Fiscal Policy

Discretionary fiscal policy involves attempting to affect the level of aggregate demand by changing the level of government spending or taxation.

Expansionary Fiscal Policy

These policies are undertaken in an attempt to try and increase the level of aggregate demand.  They will often be utilised when there is a threat of recession or growth is below target, examples of these policies are:

• Government Spending – increase spending.
• Direct taxes – reduce income or corporation tax.
• Indirect taxes – reduce VAT.

Contractionary Fiscal Policy

Contractionary fiscal policies are used to in an attempt to slow the economy down.  These policies are more likely to be used when the economy is overheating and there are inflationary pressures.

The Multiplier

If the government increases aggregate demand by spending £1 billion building a bypass road it will increase employment and profits at Steve’s Tarmac Company.  This will lead to a further rise in aggregate demand as consumption increases when the new workers spend their wages and the owners spend their profits.

As each pound spent by the government increases aggregate demand by a greater amount, we state that government spending has a multiplier effect.

Supply-Side Fiscal Policy

Supply-side fiscal policies aim to shift the long run aggregate supply curve to the right.

There are a number of different ways the government can use supply-side fiscal policies, including:

Labour Market Incentives

The government could reduce income tax and benefits to encourage people to seek jobs.

Capital Spending

The government could increase levels of capital spending and therefore long run aggregate supply to the right.  It might also choose to offer tax breaks or subsidies to businesses that invest.

Entrepreneurship

In order to encourage entrepreneurial activity and small business start-ups the government could provide tax breaks to small businesses.  It is also possible to introduce small business advisors, improve enterprise education or offer low rent business premises to start-ups.

Research and Development and Innovation

In order to benefit the UK economy the government may provide tax incentives to businesses that undertake research and development.

Improvements in Human Capital

Increased education and training will raise the level of an economy’s human capital.

Other Objectives of Government Spending

The government will use its spending to achieve a variety of other objectives.

The provision of public and merit goods

The government will provide goods and services that it believes are either under-produced or not produced at all (see the earlier topic ‘government and intervention in the market’).

Reducing Inequalities in income and wealth

The government provides a safety net to ensure those on the lowest incomes are able to enjoy a minimum standard of living.  This is funded through the taxation of those on higher incomes.  Progressive taxes (higher marginal tax rates for those on higher incomes) will reduce the gap between the highest and lowest paid.

Regulation of businesses and economic activity

The government funds a number of bodies who are charged with ensuring businesses behave in the public interest, for example, the Office of Fair Trading and the Competition Commission.  A number of industries, mainly the privatised former monopolies, are also overseen by regulatory groups, for example, Ofgem (Office of Gas and Electricity Markets), Ofrail (Office of the Rail Regulator) and Ofwat (Office of Water Services).

Labour’s Golden Rule for Government Borrowing

Government borrowing called the Public Sector Net Cash Requirement (PSNCR).  It is sometimes expressed as a percentage of GDP as members of the Euro are not allowed to have a PSNCR higher than 3% of GDP, although France, Germany, Portugal and Greece has all broken this rule, known as the growth and stability pact.

Labour’s Golden Rule states that the government will only borrow money for investment and not to fund current spending over an economic cycle.  The government has achieved this, but it has been criticised for changing the length of the economic cycle and adding some parts of its spending to investment that were previously part of current spending.

The government’s second rule, the Sustainable Investment Rule, states that net public debt as a proportion of GDP will be maintained below 40 per cent of GDP over the economic cycle.  This is being met, but public sector debt is rising and there is a risk this may be broken by 2010.