What is fiscal policy?
Fiscal policy means the government's decisions about spending and taxes, used to influence the whole economy.
- Government spending (G): on health, education, roads, defence, pensions and benefits.
- Taxes (T): direct taxes on income and profit (income tax, corporation tax) and indirect taxes on spending (VAT, GST, excise duty).
- Borrowing: when spending is more than revenue, the government sells bonds and borrows.
The plan for a year is the government budget, usually presented by the finance minister. Fiscal policy is decided by the government; monetary policy (interest rates, money supply) is run by the central bank, such as the RBI, the Bank of England or the European Central Bank.
Budget deficit, surplus and public debt
- Budget deficit: G > T in a year. Deficit = G − T.
- Budget surplus: T > G. Surplus = T − G.
- Balanced budget: G = T.
A deficit is the gap in one year. Public (national) debt is the total borrowing built up over many years. Every deficit adds to the debt; a surplus can pay part of it back.
Economists often compare debt and deficit with the size of the economy (GDP), for example "deficit = 4% of GDP", because a big economy can carry a bigger debt.
Expansionary and contractionary fiscal policy
The economy moves in a business cycle: boom, slowdown, recession, recovery. Fiscal policy tries to smooth it.
Expansionary (loose) policy
Used in a recession. Raise G and/or cut T. People and firms have more to spend, so total (aggregate) demand rises, firms produce more and hire more. Usually the deficit grows.
Contractionary (tight) policy
Used when demand is too strong and inflation is high. Cut G and/or raise T. Demand cools and prices rise more slowly, but growth and jobs may suffer.
Supply-side fiscal policy
Some spending and tax choices aim at long-run growth: spending on education, training and infrastructure, or tax rules that reward investment.
The multiplier, automatic stabilisers and limits
Multiplier: spending becomes someone's income, and part of it is spent again. If people spend half of each extra income (MPC = 0.5), multiplier k = 1 ÷ (1 − MPC) = 2. So 100 of new G can raise total demand by about 200.
Automatic stabilisers act without any new decision: in a recession incomes fall, so tax receipts fall and unemployment benefits rise, which supports demand. In a boom the opposite happens. Discretionary policy is a deliberate new decision, such as a stimulus package.
Limits:
- Time lags: noticing the problem, passing the budget and building projects takes months or years.
- Debt: big deficits raise debt and interest payments.
- Crowding out: heavy government borrowing can push up interest rates and reduce private investment.
- Politics: tax cuts are popular, tax rises are not, so policy may not be reversed in good times.
Try it: classify policies
For each idea, decide: expansionary or contractionary? (1) A cut in GST on cars. (2) A freeze on public-sector pay. (3) A new rail project. (4) A higher top rate of income tax. Check: 1 and 3 expand demand; 2 and 4 contract it.
Key formulas and definitions
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Worked examples
1. A government spends 480 billion and collects 450 billion in tax. Find the budget balance.
Balance = T − G = 450 − 480 = −30 billion. It is a deficit of 30 billion, which must be borrowed.
2. MPC is 0.8. The government spends an extra 50 billion on roads. Find the multiplier and the total rise in demand.
k = 1 ÷ (1 − 0.8) = 1 ÷ 0.2 = 5. Rise in demand = 5 × 50 = 250 billion.
3. Debt is 1,000 at the start. Deficits for three years are 60, 40 and −20 (a surplus of 20). What is the debt at the end?
1,000 + 60 = 1,060; + 40 = 1,100; − 20 = 1,080.
4. Inflation is 9% and unemployment is low. Suggest a fiscal policy and one risk.
Contractionary policy: cut spending or raise taxes to cool demand. Risk: growth may slow too much and some people may lose jobs.
Common mistakes
- Mixing up deficit and debt: deficit is one year's gap; debt is the total built up over years.
- Thinking fiscal policy sets interest rates. That is monetary policy, run by the central bank.
- Forgetting the multiplier: the final change in demand is usually bigger than the first change in spending.
- Thinking a deficit is always bad. In a recession a deficit can protect jobs; the problem is very large deficits for many years.