0455 · 4.2Fiscal policy

Fiscal policy and government budgets

0:00A government builds a hospital, pays nurses and collects taxes from households. These decisions affect more than public services. They also influence how much people spend, how many workers firms employ and how quickly prices rise. By the end of this video, you will understand how government spending and taxation connect to the whole economy. Total demand is all the spending on goods and services in an economy. Households buy products, firms purchase equipment, and governments pay for services and construction.

0:28When this spending increases, businesses receive more orders. Firms with unused equipment and available workers can respond by increasing production. Fiscal policy means changes in taxes and government spending to influence the economy. A government can use these measures to pursue economic growth, lower unemployment and stable prices. Other aims include balance of payments stability and redistributing income. The effects depend on which measure changes, who is affected and how they respond.

0:55A government budget is a government's planned revenue and spending for a year. Revenue is the income it receives, mainly through taxation. Spending includes payments for public services, infrastructure and benefits. The budget brings these plans together, so we can compare the money expected to come in with the amount allocated to spending. When government spending is greater than revenue, the result is a budget deficit. The opposite position, with revenue greater than spending, is a government budget surplus.

1:23When both amounts are equal, the budget is balanced. Each of these positions describes the gap between two flows of money over one year. For example, planned government spending is eighty-four billion dollars, while expected revenue is seventy-one billion dollars. Spending is the larger amount, so the deficit equals spending minus revenue. Eighty-four billion minus seventy-one billion equals thirteen billion dollars. The government therefore has a budget deficit of thirteen billion dollars, and it must borrow to finance it.

1:53A second government expects revenue of ninety-six billion dollars and plans to spend eighty-nine billion dollars. Here revenue is larger, so the surplus equals revenue minus spending. Taking eighty-nine billion away from ninety-six billion leaves seven billion dollars. This budget surplus of seven billion dollars could help repay earlier borrowing. Governments commonly borrow to finance a deficit. Government debt is the accumulated amount of outstanding borrowing. A deficit measures a shortfall during a particular year, while debt records borrowing still owed.

2:24Interest payments on that borrowing use revenue that could otherwise support public services, so persistent deficits can create difficult spending choices.

Why governments spend

2:33Education is a merit good, which is more beneficial to consumers than they realise, so it would be underconsumed if left to the market. Government spending on schools, teachers and training helps more people develop useful skills. Better qualifications can improve employment opportunities and raise workers' output. Public funding also helps children from lower-income households access education, which can reduce inequality in future earnings. Healthcare is another merit good, and government spending pays for hospitals, treatment and disease prevention.

3:03Healthier workers lose fewer working days through illness, so firms can produce more reliably. Access to treatment also improves the wellbeing of people who cannot afford private care. These benefits explain why a government may fund healthcare even when patients make no direct payment. Defence is a public good, which is non-excludable and non-rival. Private firms would not supply it, because people could benefit without paying, so the government pays for national security.

3:29A secure country also gives firms the confidence to invest. Infrastructure includes facilities such as roads, bridges, electricity networks and water systems. A reliable road network reduces delivery times and transport costs for firms. Investment in clean public transport can also reduce pollution while improving access to workplaces and schools. Domestic construction firms usually carry out these projects, so the spending also adds to total demand and employment. Welfare benefits are payments that support people such as unemployed workers, pensioners and households on low incomes.

4:04They help recipients afford essentials and can reduce poverty. Because these households often spend much of their income, benefits can also support demand for local businesses. However, governments must consider affordability and how benefit rules affect incentives to work. Every spending decision uses scarce resources, so it has an opportunity cost: the next best alternative forgone. More funding for defence may leave less available for healthcare if total spending is unchanged.

4:32Borrowing can allow additional expenditure now, but creates future repayment obligations. The effects therefore depend on both the benefits of spending and how it is financed.

Purposes of taxation

4:41Taxation pays for these activities, but raising revenue is only one reason for collecting it. Governments also use taxes to influence behaviour and redistribute income. A charge on a particular product can affect its price and purchases. Taxes on earnings alter the income households have available to spend after compulsory payments. Demerit goods are products that are more harmful to consumers than they realise, so they tend to be overconsumed.

5:06Tobacco is a familiar example. A tax on cigarettes raises their price, so demand contracts along an unchanged curve. The contraction is small when demand for the product is price inelastic, because smokers are strongly attached to it. A tariff is a tax on imports, which are goods and services purchased from abroad. By increasing the price of imported products, it can reduce purchases and encourage consumers to choose domestic alternatives.

5:31However, households may face higher prices and less choice. Domestic firms using imported materials can also experience higher production costs. Taxes that take a larger share from higher earners help a government redistribute income, especially when the revenue funds benefits for poorer households. This narrows the gap between rich and poor. Taxation also influences total demand. A tax cut leaves households with more income to spend, while a tax rise removes spending power from the economy.

5:59Encouraging environmental sustainability is another reason for taxation. A carbon tax charges activities that release carbon dioxide, so polluting production becomes more expensive. Firms then have a financial incentive to use cleaner methods, while consumers may switch towards less polluting products. The effect is stronger when affordable alternatives are available, and revenue can help fund environmental improvements.

Tax types and economic effects

6:23Taxes can be classified in two different ways. One classification identifies whether the charge falls directly on income or wealth, or indirectly on spending. Another examines how the proportion of income paid changes as earnings rise. Keeping these questions separate helps us understand both how a tax is collected and who bears the greater relative burden. A direct tax is a tax on income or wealth, paid by the taxpayer straight to the government.

6:49Income tax on earnings and corporation tax on company profits are examples. An indirect tax is charged on spending on goods and services. Sales taxes, value added tax and excise duties on particular products fall into this category. With an indirect tax, a seller collects the payment and passes it to the government. The firm may pass some of the burden to consumers through a higher price. Its customers then pay more for the product, while sales may fall.

7:15The share of the burden that each side bears depends on the price elasticity of demand and supply. A progressive tax takes a rising proportion of income as earnings increase. Income tax with bands is the usual example, because earnings in the top bands face steeper rates. Under a regressive tax, the proportion of income paid falls as earnings rise. A proportional tax takes the same percentage at every level of earnings, as with a flat-rate income tax.

7:40The crucial word is proportion, because it compares the payment with the person's income. Suppose a flat-rate income tax is fifteen per cent. Someone earning eight hundred dollars pays one hundred and twenty dollars. A person on five thousand dollars pays seven hundred and fifty dollars. The higher earner pays more dollars, yet both give up fifteen per cent, so the tax is proportional. For example, two consumers each pay sixty dollars in sales tax on the same purchase.

8:07One has an income of six hundred dollars during the period. To find the share, divide the tax by the income and multiply by one hundred. Sixty dollars divided by six hundred, multiplied by one hundred, gives ten per cent. The other consumer earns three thousand dollars during that period. Sixty dollars divided by three thousand, multiplied by one hundred, gives two per cent. The same payment therefore absorbs a smaller share of the higher income.

8:32This illustrates why a sales tax can have a regressive effect, although the overall burden also depends on spending patterns. Taxation affects consumers in two main ways. Disposable income is the money left to spend or save after direct taxes have been paid. Higher income tax reduces it, so households buy fewer products or save less. An indirect tax raises the price of a product, so consumers can afford less even when their earnings stay unchanged.

8:58Workers also consider how taxation affects the reward from employment. Higher income tax reduces the extra take-home pay from additional hours, which may weaken incentives to work overtime. Some people instead work longer to maintain their living standards. The effect on the number of hours offered therefore varies from one worker to another. For producers and firms, corporation tax reduces the profit they keep. This can leave less money available to finance equipment or expansion.

9:24An indirect tax on producers raises production costs, so supply decreases and its curve shifts left. The price rises and sales fall, so revenue and employment can drop, especially when customers can easily choose alternatives. The government gains revenue from taxation, which helps finance spending and can reduce its budget deficit. A higher tax rate brings in less extra revenue than expected when people buy fewer of the taxed products or cut their working hours.

9:51Tax avoidance and evasion also reduce collections. Across the economy, taxes influence demand, production incentives, income distribution and environmental outcomes.

Expansionary and contractionary fiscal policy

10:01Expansionary fiscal policy uses lower taxes, higher government spending, or both, to increase total demand. Consider a government commissioning new hospitals during a period of high unemployment. Construction firms receive additional orders and purchase materials from suppliers. These firms recruit unemployed workers because the projects need more labour. Those workers earn income and spend some of it in shops, cafés and other businesses. These purchases create further demand beyond the original construction contracts.

10:30Firms with spare capacity can increase output without large price rises. Economic growth is an increase in an economy's output of goods and services over time. The extra spending therefore supports growth and can reduce unemployment. A cut in income tax raises what households keep from their pay. People retain more of their earnings, so they can increase consumption. Businesses may respond to higher sales by expanding production and hiring workers.

10:56However, households could save the extra income or buy imports, so the increase in domestic production may be limited. Expansionary measures can also create trade-offs between government macroeconomic aims. If firms are already operating near capacity, extra demand may push prices upwards. Inflation is a sustained rise in the general price level. Tax cuts or additional expenditure also enlarge the budget deficit unless other changes offset them. Contractionary fiscal policy uses higher taxes, lower government spending, or both, to reduce total demand.

11:28A rise in income tax reduces what households have left to spend, so consumption may fall. Lower public expenditure reduces orders received by firms. Weaker demand can ease pressure on prices when inflation is being driven by excessive spending. A current account deficit occurs when a country's payments abroad for goods, services, income and transfers exceed its receipts from other countries. Expansionary policy can widen this deficit, because extra spending draws in more imports.

11:56Contractionary policy can narrow it, since lower domestic spending cuts purchases of imports when other flows remain unchanged. However, falling orders can also reduce output and employment, so improved price stability may come with economic costs. Fiscal policy also serves the aim of redistributing income. Progressive income tax and welfare benefits narrow the gap between richer and poorer households. In the longer term, spending on education improves skills, while better infrastructure lowers business costs.

12:27These changes raise productive capacity, and you will see more of them in the video on supply-side policy. Time lags limit how precisely a government can manage these effects. A hospital takes time to plan and build, and households may respond gradually to tax changes. Conditions could alter before the policy has its full impact. Expansionary policy financed by borrowing also adds to government debt, and the interest payments leave less revenue for future public services.

Exam skills and recap

12:53Common examination difficulties centre on budget direction, tax proportions and incomplete chains of reasoning. Identify which budget amount is larger before calculating the gap, then name the resulting position. For tax classification, focus on the percentage of income paid. When explaining a policy, connect the initial measure to spending, firms' decisions and the final economic outcome. In multiple-choice questions, look for the defining features in each option. Higher revenue than expenditure marks a surplus, while a rising share of income paid signals a progressive tax.

13:27Structured questions use command words to indicate the task. A define question needs a precise meaning, while state means express the point in clear terms. To explain, set out the purposes or reasons for why and how something happens. When asked to analyse, examine the topic in detail to show the relationships between a policy and its effects. A discuss answer writes about the issue in depth in a structured way and gives both sides.

13:52It ends with a conclusion that judges which outcome is more likely, and under what conditions. Consider this exam-style question: discuss whether an increase in government spending will reduce unemployment. Increased expenditure on construction raises demand for building services. Firms recruit workers to complete additional projects. Employees spend part of their earnings, which supports other businesses and can create further jobs. However, spending on imported equipment may create relatively few domestic jobs.

14:21If unemployed workers lack the required skills, firms may struggle to recruit them. Projects also take time to start, so the extra jobs may arrive only after a long delay. On balance, increased spending usually reduces unemployment when domestic suppliers have spare capacity and suitable workers are available. The central idea is that fiscal policy changes the flow of spending through an economy. Taxes influence disposable income, product prices and incentives, while public expenditure supports services and demand.

14:50A budget deficit occurs when spending exceeds revenue; the reverse produces a surplus. Their sizes come from calculating the difference between the two annual amounts. Expansionary measures can support growth and employment, especially when resources are underused. Contractionary measures can reduce pressure on prices and imports, although output may suffer. Tax design and spending priorities also influence inequality and environmental sustainability. Understanding these mechanisms lets you explain both the intended benefits and the trade-offs.