Fiscal policy: taxation and spending

Fiscal policy is the use of government spending and taxation to influence AD (and, at the margin, AS). It is set by the Treasury in the Budget.

Taxation:

• Direct taxes are levied on income and wealth and cannot be passed on (income tax, NI, corporation tax, inheritance tax). Indirect taxes are levied on expenditure and can be (VAT, excise duties).
• Progressive → the average tax rate rises with income (UK income tax). Proportional (flat) → the same percentage at every income. Regressive → the average rate falls as income rises (VAT, duties).

Government spending: current spending is day-to-day (salaries, medicines); capital spending is investment in assets (roads, hospitals, schools) and is the kind that raises LRAS as well as AD. Transfer payments (pensions, benefits) are not payment for output, so they are not part of G in AD — they reappear as consumption.

The budget: surplus (T > G), deficit (G > T), or balanced. The deficit is the annual shortfall; the national debt is the accumulated stock of all past deficits. A falling deficit still adds to the debt.

• Cyclical deficit — the part caused by the economic cycle; it disappears automatically as the economy recovers.
• Structural deficit — the part that remains even at full employment. This is the one that requires real tax rises or spending cuts.
• Automatic stabilisers — in a recession, tax receipts fall and benefit payments rise without any decision being taken, cushioning the fall in AD. In a boom they do the reverse. They are why the deficit widens in every recession.
• Discretionary fiscal policy — deliberate changes in tax or spending.

Your turn — the average tax rate

Your turn — the marginal tax rate

Your turn — the budget deficit

Your turn — the debt-to-GDP ratio

Deficit or debt?

Crowding out and the Laffer curve

Crowding out — the classical objection to fiscal expansion. If the government borrows heavily, it competes with the private sector for a limited pool of loanable funds, pushing up interest rates and reducing private investment and consumption. In the extreme case the private fall exactly offsets the public rise, and AD does not move at all.

• The Keynesian reply: in a deep recession there are idle savings and idle resources. Government borrowing does not compete for scarce funds; it puts unused resources to work and, via the multiplier, crowds IN private investment by raising expected demand. Crowding out bites when the economy is near full capacity — not when it is on its knees.

The Laffer curve plots tax revenue against the tax rate. At a 0% rate revenue is zero. At a 100% rate revenue is also zero — nobody works if the state takes everything. Somewhere between lies a revenue-maximising rate T*.

• Beyond T*, raising the rate REDUCES revenue, because higher rates blunt work incentives, encourage avoidance and evasion, and drive activity into the shadow economy or abroad.
• The catch: nobody knows where T* is, and the empirical estimates for the top rate of income tax vary enormously. The curve is a genuine insight that has been used to justify tax cuts that produced neither the growth nor the revenue promised. Use it — but evaluate it.

Evaluating fiscal policy: it is powerful (it acts directly on AD, and capital spending shifts LRAS too) and it can be targeted at particular regions or groups. But it suffers from long time lags (recognition, decision, implementation), it is politically distorted (spending is easy to start and impossible to stop), it worsens the deficit, and its potency depends on the multiplier, on crowding out, and on where the economy sits on the AS curve.

The Laffer curve

Monetary policy: interest rates and QE

Monetary policy is controlled by the Bank of England's Monetary Policy Committee (MPC), which is operationally independent and targets CPI inflation at 2%. Independence matters: it removes the temptation for a government to cut rates before an election, and so it anchors inflation expectations — which is half the battle in controlling inflation.

The main instrument is Bank Rate. The transmission mechanism of a rate rise:

• Cost of borrowing rises → mortgages and business loans cost more → C and I fall.
• Reward for saving rises → saving up, consumption down.
• Disposable income of mortgage holders falls → C falls further.
• Asset prices (houses, shares) fall → negative wealth effect → C falls.
• Exchange rate: higher rates attract "hot money" inflows → the pound appreciates → exports dearer, imports cheaper → (X − M) falls AND imported inflation falls.
• Confidence falls.

All of these reduce AD, easing demand-pull inflation — but at the cost of lower growth and higher unemployment. Note the lag: monetary policy takes an estimated 18 months to 2 years to have its full effect, so the MPC must set policy on a forecast, not on today's data.

Quantitative easing (QE) — used when Bank Rate is already near the zero lower bound and cannot be cut further. The Bank creates new electronic money and uses it to buy government bonds (gilts) from financial institutions.

• Buying bonds raises their price and therefore lowers their yield (the two always move inversely) → long-term interest rates fall across the economy.
• It floods banks with reserves, encouraging lending; it raises asset prices (a wealth effect); and it tends to depreciate the currency, helping exports.
• Criticisms: it inflated asset prices, which are held overwhelmingly by the already wealthy — so QE worsened inequality; much of the money stayed on bank balance sheets rather than reaching firms; and the ultimate inflationary consequences of a huge monetary expansion are contested.

The transmission mechanism

Quantitative easing

Supply-side policy

Supply-side policies aim to raise the economy's productive potential — shifting LRAS to the right. This is the only policy family that can deliver higher output AND a lower price level simultaneously, resolving rather than trading off the growth-inflation conflict. It also cuts structural unemployment and the NAIRU, and improves international competitiveness and the current account.

Market-based (free-market) supply-side policies — reduce the role of the state and sharpen incentives:

• Cutting income tax and corporation tax → stronger incentives to work, invest and take risk.
• Benefit reform → sharpen the incentive to take a job (but risks deepening poverty).
• Privatisation → the profit motive is claimed to raise efficiency (but a privatised natural monopoly must be regulated, or it simply exploits consumers).
• Deregulation → lower barriers to entry, more competition, more contestability (but this is exactly what preceded the 2008 financial crisis).
• Labour market flexibility → weaker union power, easier hiring and firing (but greater insecurity and in-work poverty).
• Trade liberalisation and immigration to expand the labour force.

Interventionist supply-side policies — the state fixes market failures directly:

• Education and training → raises human capital, productivity and MRP. The single most powerful long-run policy — and it takes a generation.
• Infrastructure → transport, energy, broadband: lowers firms' costs across the whole economy.
• Subsidies and tax credits for R&D → corrects the positive externality of innovation.
• Regional and industrial policy, competition policy, and childcare provision to raise labour force participation.

Evaluating supply-side policy: the effects are slow (years, not quarters — useless in a recession, where only AD policy works fast); expensive (education and infrastructure carry a huge opportunity cost); uncertain (there is no guarantee a tax cut is spent on investment rather than dividends); and many market-based policies carry a direct equity cost — greater inequality and insecurity. The strongest exam answers pair a supply-side policy with a demand-side one and specify which problem each solves.

Why supply-side policy is special

The right tool for the job

Fiscal, monetary or supply-side?

Tap a policy, then tap the family it belongs to.

Match the concept to its meaning

Tap an item on the left, then its partner on the right.

The big ideas to know

You've now covered the implementation of fiscal, monetary and supply-side policy from the OCR A-level Economics (H460) specification. Press Finish to see your score.