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CIE IGCSE Economics Your notes
4.3 Fiscal Policy
Contents
4.3.1 The Government Budget
4.3.2 Taxation
4.3.3 Fiscal Policy Measures
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4.3.1 The Government Budget
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Definition of the Government Budget
The Government Budget (Fiscal policy) is presented each year as a balanced budget, a budget deficit,
or a budget surplus
A balanced budget means that government revenue = government expenditure
A budget deficit means that government revenue < government expenditure
A budget surplus means that government revenue > government expenditure
A budget deficit has to be financed through public sector borrowing
This borrowing gets added to the public debt
Reasons for Government Spending
Public expenditure (government spending) represents a significant portion of the total (aggregate)
demand in many economies. The expenditure can be broken down into three categories
1. Current Expenditures: These include the daily payments required to run the government & public
sector. E.g. The wages & salaries of public employees such as teachers, police, members of
parliament, military personnel, judges, dentists etc. It also includes payments for goods/services such
as medicines for government hospitals
2. Capital Expenditures: These are investments in infrastructure & capital equipment. E.g. High speed
rail projects; new hospitals & schools; new aircraft carriers
3. Transfer payments: Payments made by the government for which no goods/services are exchanged.
E.g. Unemployment benefits, disability payments, subsidies to producers & consumers etc. This type
of government spending does not contribute to GDP as income is only transferred from one group of
people to another
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Reasons for Taxation
Nearly every economy in the world is a mixed economy & has varying degrees of government Your notes
intervention
One of the main forms of government intervention is taxation & there are many reasons why it is
necessary
A diagram showing several reasons for government taxation in mixed economic systems
Correct market failure: in many markets there is a less than optimal allocation of resources from
society's point of view
The government aims to subsidise merit goods & tax demerit goods to address this market failure
Earn government revenue: governments need money to provide essential services, public & merit
goods
Revenue to fund this is raised through taxation
Promote equity: the wealthy are taxed to provide funds that can be utilised in reducing the
opportunity gap between the rich & poor
Support firms: in a global economy, governments choose to support key industries so as to help them
remain competitive & taxation provides the funds to do this
Support poorer households: poverty has multiple impacts on both the individual & the economy
Intervention seeks to redistribute income (tax the rich and give to the poor) so as to reduce the
impact of poverty
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4.3.2 Taxation
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The Classification of Taxes
The main source of government revenue is taxation
Direct taxes are taxes imposed on income and profits
They are paid directly to the government by the individual or firm
E.g. Income tax, corporation tax, capital gains tax, national insurance contributions,
inheritance tax
Indirect taxes are imposed on spending
The less a consumer spends the less indirect tax they pay
Examples of indirect tax include Value Added Tax (19% VAT rate in the European Union in 2022),
taxes on demerit goods, excise duties on fuel etc.
Progressive, Regressive & Proportional Tax Systems
Tax systems can be classified as progressive, regressive or proportional
Most countries have a mix of progressive (direct taxation) & regressive (indirect taxation) taxes in
place
An Explanation Of Tax Systems
System Explanation Diagram
Progressive As income rises, a larger percentage
of income is paid in tax
In the diagram, when personal income
rises from Y1 to Y2, the tax rate rises
from TR1 to TR2
Regressive As income rises, a smaller percentage
of income is paid in tax
In the diagram, when personal income
rises from Y1 to Y2, the tax rate falls
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from TR1 to TR2
All indirect taxes are regressive
In the USA, Federal income tax is Your notes
progressive but almost all State taxes
are regressive (the bottom 20% of
income earners pay as much as 6x the
% of their income than the top 20%)
Proportional As income rises, the same percentage
of income is paid in tax
In the diagram, when personal income
rises from Y1 to Y2, the tax rate remains
constant at 20%
In 2022, Bolivia was using this system
with a proportional tax rate of 13%
Progressive tax systems are built around the idea of marginal tax rates
The calculation of an individual's personal income tax requires several calculations
Using this system, a salary of £60,000 would attract a tax bill of £11,499.80, calculated as follows:
Calculation Using UK Progressive Tax Rates - June 2022
Tax Paid on
Tax Band Taxable Income Tax Rate
£60,000
Personal Allowance Up to £12,500 0% 0
£12,501 to £50,000 20% £37, 499 at 20% =
Basic Rate
£7499.80
£50,001 to £150,000 40% £10,001 at 40% =
Higher Rate
£4,000
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Additional Rate Over £150,000 45% 0
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£7499.80 + £4,000
Total Tax Paid on £60,000
= £11,499.80
Exam Tip
MCQ frequently test your knowledge of the different tax systems by presenting you with a table &
asking you to identify the type of tax system illustrated
Identify the type of tax system illustrated below:
Weekly Income ($) 100 150 200 250
Weekly Tax ($) 20 30 40 50
It is a proportional tax system with a constant tax rate of 20%
Principles of Taxation
In order for the population to accept a tax system & pay into it, the taxes imposed need to be
considered to be 'good'
There are several principles which should be applied when developing a 'good' tax system
1. Simple: taxpayers should know what, when, where & how to pay the tax
2. Fair (equity): taxes should reflect a taxpayer’s ability to pay - progressive taxation aims to achieve this
as the wealthy can afford to pay more than the poor do
3. Convenient: systems to collect payment should be easy & provide choice for taxpayers e.g. monthly
payments spread over 12 months or tax collected by the employer each month before the salary is paid
4. Efficient: the management of the tax system by the government should not be overly expensive or
wasteful
5. Fit for purpose: there should not be any unintended side effects of the system e.g. disincentivising
workers from working
6. Flexible: it should be easy to adjust/change as required by changes in the economy
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The Impact of Taxation
Changes in direct & indirect tax rates influence a range of economic variables Your notes
The greater the size of the change, the greater the ripple effects felt by households, firms & the
economy
Effects Of Tax Rate Changes
Impact Explanation
Incentive to work The higher the tax rate, the lower the incentive for the unemployed to
seek work - or for existing workers to work overtime
Government tax revenues There is a relationship between increasing tax rates & the level of
government revenues received
The broad idea is that as tax rates increase, a point will be reached
where disincentivized workers work less, resulting in lower incomes &
less government tax revenue
More people will actively seek to avoid paying tax (tax avoidance) or try
to move their income elsewhere
Income distribution A progressive tax system redistributes from those with higher income
to those with lower income & reduces income inequality
Sometimes the benefits of a good progressive tax system are lost by
the penalties imposed through multiple regressive (indirect) taxes
Economic growth Tax rate increases will likely cause a reduction of total (aggregate)
demand as firms & households have less disposable income
Tax rate decreases will have the opposite effect
As total demand slows down, fewer workers may be required for
production & unemployment may increase
Inflation Increasing Indirect tax rates increase costs of production for firms
possibly leading to cost-push inflation
An increase in indirect taxes reduces disposable income & so workers
may petition their employer for a salary increase
If they receive the increase the economy may face a wage-price spiral
The trade balance (X-M) An increase in taxes can reduce disposable income which is likely to
reduce the level of imports
This may improve the trade balance (exports - imports)
Business location If the rate of corporation tax increases relative to other countries, it
may result in less inward foreign direct investment by multi-national
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corporations
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4.3.3 Fiscal Policy Measures
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Fiscal Policy Defined
Fiscal Policy involves the use of government spending & taxation (revenue) to influence total
(aggregate) demand in the economy
Fiscal policy can be expansionary in order to generate further economic growth
Expansionary policies include reducing taxes or increasing government spending
Fiscal policy can be contractionary in order to slow down economic growth or reduce inflation
Contractionary policies include increasing taxes or decreasing government spending
Fiscal Policy is usually presented annually by the Government through the Government Budget
A balanced budget means that government revenue = government expenditure
A budget deficit means that government revenue < government expenditure
A budget surplus means that government revenue > government expenditure
A budget deficit has to be financed through public sector borrowing
This borrowing gets added to the public debt
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The Effects of Fiscal Policy on Government Macroeconomic Aims
To understand the effects of fiscal policy on an economy, it is useful to know how total demand (gross Your notes
domestic product) is calculated
Total (aggregate) demand = household consumption (C) + firms investment (I) + government spending
(G) + exports (X) - imports (M)
Total demand = C + I + G + (X - M)
From this, it is logical that changes to fiscal policy can influence any of these components - & often
several of them at once
Examples of The Impact of Contractionary Fiscal Policy
Example 1 The Government increases income tax levels
Effect on the economy Consumers pay more tax → discretionary income reduces → consumption
reduces → total demand reduces
Impact on macroeconomic Economic growth slows down
aims Inflation eases
Unemployment may increase as output is falling & fewer workers are
required
Current Account Improves (with less income, imports may fall)
Example 2 The Government freezes/reduces public sector workers pay
Effect on the economy Wages stagnate or reduce → Consumer confidence falls → consumption
decreases → total demand decreases
Impact on macroeconomic Economic growth slows down
aims Inflation eases
Unemployment may increase as output is falling
Current Account Improves (with less income, imports may fall)
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Example 3 The Government cuts Government spending in their Budget
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Effect on the economy Less demand for goods/services → less income for firms → output &
profits decrease → total demand decreases
Impact on macroeconomic Economic growth slows down
aims Inflation eases
Unemployment may increase as output is falling
Current Account Improves (with less income, imports may fall)
Less corporation tax available for redistribution
Examples of The Impact of Expansionary Fiscal Policy
Example 1 The Government decreases corporation tax
Effect on the economy Firms net profits increase → investment by firms increases → total demand
increases
Impact on macroeconomic Economic growth increases
aims Inflation rises
Unemployment may decrease as output is rising which requires more
workers
Current Account - unsure - exports may rise due to new investments in
the economy, but imports may rise due to higher income generated by
the investment
Example 2 The Government increases unemployment benefits
Effect on the economy Household income increases → consumption increases → total demand
increases
Economic growth increases
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Impact on macroeconomic Inflation rises
aims Unemployment may decrease as output is rising which requires more
workers (although increased unemployment benefits may discourage Your notes
some people from entering the labour market)
Current Account unlikely to change as this policy helps the poorest &
imports are unlikely to increase
Redistribution of income has increased & there is more equity in
society
Strengths of Fiscal Policy
Spending can be targeted on specific industries
Short time lag as compared with monetary policy (effects of fiscal policy are seen sooner)
Redistributes income through taxation
Reduces negative externalities through taxation
Increased consumption of merit/public goods
Short term government spending can lead to an increase in the total supply of an economy
E.g. Building a new airport immediately increases government spending and total demand, but
when it is built, the potential output will have increased (Production Possibility Curve has shifted
outward)
Weaknesses of Fiscal Policy
Policies can fluctuate significantly when new governments are elected
Long term infrastructure projects may lack follow-through
Increased government spending can create budget deficits
Repaying this debt may lead to austerity on future generations
Conflicts between objectives
E.g. Cutting taxes to increase economic growth may cause inflation
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