Fiscal Policy

Budget: a financial statement showing the forecasted government revenue and

expenditure in the coming fiscal year. It lays out the amount the government expects to
receive as revenue in taxes and other incomes and how and where it will use this
revenue to finance its various spending endeavours. Governments aim for its budgets to
be balanced.

Government spending
Governments spend on all kinds of public goods and services, not just out of political
and social responsibility, but also out of economic responsibility. Government spending
is a part of the aggregate demand in the economy and influences its well-being. The
main areas of government spending includes defence and arms, road and transport,
electricity, water, education, health, food stocks, government salaries, pensions,
subsidies, grants etc.

Reasons governments spend:

• To supply goods and services that the private sector would fail to do, such
as public goods, including defence, roads and streetlights; merit goods, such as
hospitals and schools; and welfare payments and benefits, including
unemployment and child benefits.
• To achieve supply-side improvements in the economy, such as spending on
education and training to improve labour productivity.
• To spend on policies to reduce negative externalities, such as pollution
controls.
• To subsidise industries which may need financial support, and which is not
available from the private sector, usually agriculture and related industries.
• To help redistribute income and improve income inequality.
• To inject spending into the economy to aid economic growth.
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Effects of government spending

• Increased government spending will lead to higher demand in the economy and
thus aid economic growth, but it can also lead to inflation if the increasing
demand causes prices to rise faster than output.
• Increased government spending on public goods and merit goods, especially in
infrastructure, can lead to increased productivity and growth in the long run.
• Increased government spending on welfare schemes and benefits will increase
living standards, and help reduce inequality.
• However too much government spending can also cause ‘crowding out’ of
private sector investments – private investments will reduce if the increase in
government spending is financed by increased taxes and borrowing (large
government borrowing will drive up interest rates and discourage private
investment).
Tax
Governments earn revenue through interests on government bonds and loans, incomes
from fines, penalties, escheats, grants in aid, income from public property, dividends
and profits on government establishments, printing of currency etc; but its major
source of revenue comes from taxation. Taxes are a compulsory payment made to the
government by all people in an economy. There are many reasons for levying taxes
from the economy:
• It is a source of government revenue: if the government has to spend on public
goods and services it needs money that is funded from the economy itself. People
pay taxes knowing that it is required to fund their collective welfare.
• To redistribute income: governments levy taxes from those who earn higher
incomes and have a lot of wealth. This is then used to fund welfare schemes for
the poor.
• To reduce consumption and production of demerit goods: a much higher tax
is levied on demerit goods like alcohol and tobacco than other goods to drive up
its prices and costs in order to discourage its consumption and production. Such
a tax on a specific good is called excise duty.
• To protect home industries: taxes are also levied on foreign goods entering the
domestic market. This makes foreign goods relatively more expensive in the
domestic market, enabling domestic products to compete with them. Such a tax
on foreign goods and services is called customs duty.
• To manage the economy: as we will discuss shortly, taxation is also a tool for
demand and supply side management. Lowering taxes increase aggregate
demand and supply in the economy, thereby facilitating growth. Similarly, during
high inflation, the government will increase taxes to reduce demand and thus
bring down prices. More on this below.
Classification of Taxes
Taxes can be classifies into direct or indirect and progressive, regressive or
proportional.

Direct Taxes are taxes on incomes. The burden of tax payment falls directly on the
person or individual responsible for paying it.
• Income tax: paid from an individual’s income. Disposable income is the income
left after deducting income tax from it. When income tax rise, there is little
disposable income to spend on goods and services, so firms will face lower
demand and sales, and will cut production, increasing unemployment. Lower
income taxes will encourage more spending and thus higher production.
• Corporate Tax: tax paid on a company’s profits. When the corporate tax rate is
increased, businesses will have lower profits left over to put back into the
business and will thus find it hard to expand and produce more. It will also cause
shareholders/owners to receive lower dividends/returns for their investments.
This will discourage people from investing in businesses and economic growth
could slow down. Reducing corporate tax will encourage more production and
investment.
• Capital gains tax: taxes on any profits or gains that arise from the sale of assets
held for more than a year.
• Inheritance tax: tax levied on inherited wealth.
• Property tax: tax levied on property/land.
Advantages:

• High revenue: as all people above a certain income level have to pay income
taxes, the revenue from this tax is very high.
• Can reduce inequalities in income and wealth: as they are progressive in
nature – heavier taxes on the rich than the poor- they help in reducing income
inequality.

Disadvantages:

• Reduces work incentives: people may rather stay unemployed (and receive
govt. unemployment benefits) rather than be employed if it means they would
have to pay a high amount of tax. Those already employed may not work
productively, since for any extra income they make, the more tax they will have
to pay.
• Reduces enterprise incentives: corporate taxes may demotivate entrepreneurs
to set up new firms, as a good part of the profits they make will have to be given
as tax.
• Tax evasion: a lot of people find legal loopholes and escape having to pay any
tax. Thus tax revenue falls and the govt. has to use more resources to catch those
who evade taxes.

Indirect Taxes are taxes on goods and services sold. It is added to the prices of goods
and services and it is paid while purchasing the good or service. It is called indirect
because it indirectly takes money as tax from consumer expenditure. Some examples
are:
• GST/VAT: these are included in the price of goods and services. Increasing these
indirect taxes will increase the prices of goods and services and reduce demand
and in turn profits. Reducing these taxes will increase demand.
• Customs duty: includes import and export tariffs on goods and services flowing
between countries. Increasing tariffs will reduce demand for the products.
• Excise Duty: tax on demerit goods like alcohol and tobacco, to reduce its
demand.

Advantages:

• Cost-effective: the cost of collecting indirect taxes is low compared to collecting

direct taxes.
• Expanded tax-base: directs taxes are paid by those who make a good income,
but indirect taxes are paid by all people (young, old, unemployed etc.) who
consume goods and services, so there is a larger tax base.
• Can achieve specific aims: for example, excise duty (tax on demerit goods) can
discourage the consumption of harmful goods; similarly, higher and lower taxes
on particular products can influence their consumption.
• Flexible: indirect tax rates are easier and quicker to alter/change than direct tax
rates. Thus their effects are immediate in an economy.
Disadvantages:

• Inflationary: The prices of products will increase when indirect taxes are added
to it, causing inflation.
• Regressive: since all people pay the same amount of money, irrespective of their
income levels, the tax will fall heavily on the poor than the rich as it takes more
proportion of their income.
• Tax evasion: high tariffs on imported goods or excise duty on demerit goods can
encourage illegal smuggling of the good.

Progressive Taxes are those taxes which burdens the rich more than the poor, in that
the rate of taxation increases as incomes increase. An income tax is the perfect
example of progressive taxation. The more income you earn, the more proportion of the
income you have to pay in taxes, as defined by income tax brackets.
For example, a person earning above $100,000 a month will have to pay a tax rate of
20%, while a person earning above $200,000 a month will have to pay a tax rate of 25%.

Regressive Taxes are those taxes which burden the poor more than the rich, in that the
rate of taxation falls as incomes increase. An indirect tax like GST is an example of a
regressive tax because everyone has to pay the same tax when they are paying for the
product, rich or poor.
For example, suppose the GST on a kilo of rice is $1; for a person who earns $500
dollars a month, this tax will amount to 0.2% of his income, while for a richer person
who earns $50,000 a month, this tax will amount of just 0.002% of his income.
The burden on the poor is higher than on the rich, making its regressive.

Proportional Taxes are those taxes which burden the poor and rich equally, in that the
rate of taxation remains equal as incomes rise or fall. An example is corporate tax.
All companies have to pay the same proportion of their profits in tax.
For example, if the corporate tax is 30%, then whatever the profits of two companies,
they both will have to pay 30% of their profits in corporate tax.

Qualities of a good tax system (the canons of taxation):

• Equity: the tax rate should be justifiable rate based on the ability of the taxpayer.
• Certainty: information about the amount of tax to be paid, when to pay it, and
how to pay it should all be informed to the taxpayer.
 • Economy: the cost of collecting taxes must be kept to a minimum and shouldn’t
exceed the tax revenue itself.
• Convenience: the tax must be levied at a convenient time, for example, after a
person receives his salary.
• Elasticity: the tax imposition and collection system must be flexible so that tax
rates can be easily changed as the person’s income changes.
• Simplicity: the tax system must be simple so that both the collectors and payers
understand it well.

Impacts of taxation
Taxes can have various direct impacts on consumers, producers, government and thus,
the entire economy.

• The main purpose of tax is to raise income for the government which can lead to
higher spending on health care and education. The impact depends on what the
government spends the money on. For example, whether it is used to fund
infrastructure projects or to fund the government’s debt repayment.
• Consumers will have less disposable income to spend after income tax has
been deducted. This is likely to lead to lower levels of spending and saving.
However, if the government spends the tax revenue in effective ways to boost
demand, it shouldn’t affect the economy.
• Higher income tax reduces disposable income and can reduce the incentive to
work. Workers may be less willing to work overtime or might leave the labour
market altogether. However, there are two conflicting effects of higher tax:
• Substitution effect: higher tax leads to lower disposable income, and
work becomes relatively less attractive than leisure – workers will
prefer to work less.
• Income effect: if higher tax leads to lower disposable income, then a
worker may feel the need to work longer hours to maintain his
desired level of income – workers feel the need to work longer to earn
more.
• The impact of tax then depends on which effect is greater. If the
substitution effect is greater, then people will work less, but if income
effect is greater, people will work more
• Producers will have less incentive to produce if the corporate taxes are too
high. Private firm aim on making profits, and if a major chunk of their profits are
eaten away by taxes, they might not bother producing more and might decide to
close shop.

Fiscal Policy
Fiscal policy is a government policy which adjusts government spending and
taxation to influence the economy. It is the budgetary policy, because it manages the
government expenditure and revenue. Government aims for a balance budget and tries
to achieve it using fiscal policy.
A budget is in surplus, when government revenue exceed government spending. While
this is good it also means that the economy hasn’t reached its full potential. The
government is keeping more than it is spending, and if this surplus is very large, it can
trigger a slowdown of the economy.
When there is a budget surplus, the government employs an expansionary fiscal
policy where govt. spending is increased and tax rates are cut.
A budget is in deficit, when government expenditure exceeds government revenue. This
is undesirable because if there is not enough revenue to finance the expenditure, the
government will have to borrow and then be in debt.
When there is a budget deficit, the government employs contractionary fiscal
policy, where govt. spending is cut and tax rates are increased.
Fiscal policy helps the government achieve its aim of economic growth, by being able to
influence the demand and spending in the economy. It also indirectly helps maintain
price stability, via the effects of tax and spending.
Expansionary fiscal policy will stimulate growth, employment and help increase prices.
Contractionary fiscal policy will help control inflation resulting from too much growth.
But as we will see later on, controlling inflation by reducing growth can lead to
increased unemployment as output and production falls.