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Fiscal Policy - the basics

A) Introduction

Fiscal policy is the use of government expenditure (G) and taxation (T) to control the
economy. It can be operated in two basic ways, demand side and supply side.

The aim of demand side fiscal policy is to influence the overall level of aggregate demand in
the economy in an attempt to stabilise the economy as a whole. When used in this fashion,
fiscal policy is sometimes known as stabilisation policy.

Supply side fiscal policy aims to improve the supply side of the economy, thereby making UK
firms more competitive on world markets. The supply side means the conditions of supply,
and therefore includes both labour markets, where the problems are generally lack of skills,
and product markets where the problems are generally lack of investment by firms.

In the UK, the fundamental supply side problem is productivity: The UK is on average 20%
less productive (output per worker) than Germany, and 40% less than the US.

There are three fundamental reasons for this supply side weakness:

1. Basic skills levels: eg 22% of adults in the UK have poor literacy, 50% more than in
Germany. This reduces productivity and increases training costs.
2. Investment in new capital equipment: This is 40% higher in Germany than in the UK,
reducing unit costs and boosting output per worker
3. R&D: The US invests 50% more as a proportion of GDP than UK firms on R&D. This
means fewer new innovative products, and fewer new techniques, again damaging

These two policies (supply side and demand side)are not mutually exclusive, and can in general
be used at the same time. In the UK economy at present however, fiscal policy is generally
aimed at the supply side, with demand management being left to the control of the Bank of
England through the manipulation of interest rates.

B) Demand Side Fiscal Policy

As noted, the aim here is to stabilise the overall level of aggregate demand, trying to
prevent the appearance of inflationary (too much demand) and deflationary (too little
demand) gaps. The policy works at two levels, automatic and discretionary.

(I) Automatic stabilisers

These work to damp down the trade cycle without any extra decisions being taken by the
government. Therefore, they should operate automatically to hold down demand in a boom
and to support it in a recession - they are part of the economic structure. Examples include
unemployment benefit, which will support demand automatically during a recession. Instead
of unemployed workers having no income to spend, instead they get unemployment benefit.
Consequently aggregate demand does not fall as low as it would otherwise have done. A
stabiliser working the other way is the UK’s progressive income tax structure. During a boom,
salaries rise, and as they do, the government takes proportionally more and more tax,
therefore reducing demand below the level that it would otherwise have reached.

Real GDP

Normal Trade Cycle

Trade Cycle with

Automatic Stabilisers


In the diagram, the stabilised cycle is a ‘damped’ version of the usual cycle. However, the
cycle cannot be completely eliminated by automatic stabilisers - before any unemployment
benefit can be paid, unemployment has to occur - therefore the stabilisation can only reduce
the effects of a recession - not prevent it from occurring.

(II) Discretionary stabilisers

These work to forestall a recession or boom, and allow the economy to grow steadily but not
too quickly. In order to work, they require up to date and accurate information, so that when
the government anticipates a fall in aggregate demand, it can increase government spending
or reduce taxes to compensate. Since this information is basically not available, discretionary
policy tends to work as a ‘patch-up, to drag the economy out of a recession or boom once it
has occurred.



National Income and Output (Y)

In the diagram, AD1 shows a situation where the economy is in equilibrium far below its full
employment capacity (YFE). It will be operating inside its PPF, and will be Pareto inefficient
due to high unemployment and lost output. Discretionary policy could be used to increase AD
to AD2, via an increase in the PSNCR.

If on the other hand, AD was at AD3, this would indicate that the economy was overheating,
creating inflationary pressures. Under these circumstances, a government using active policy
would cut government spending or increase taxes (reducing the PSNCR), with an aim of easing
the inflationary pressures, bringing AD down to AD2.

Therefore, according to classic demand management, the government can ensure that the
economy is at full employment without inflation simply by controlling the level of aggregate
demand in the economy. This is the classic ‘Keynesian’ solution to unemployment. In a
recession, the government increases G and reduces T, therefore needing to borrow money -
there is a Public Sector Borrowing Requirement (PSBR), or budget deficit. This injection of
demand moves the economy out of recession and into boom again. If the economy is
overheating, then the government increase taxes and reduces government spending creating
a budget surplus or PSDR (Public Sector Debt Repayment). Therefore in theory there is no
reason for the National Debt to increase over time. Sometimes the Debt increases (during
recession) sometimes it falls (during an economic boom), but overall, given the nature of the
trade cycle, these two tendencies should cancel out, leaving the government financially sound
in the long run.


Impact of national
income on tax revenue

Impact of national income

on Government Spending
(automatic policy only)

Budget Deficit: G>T Y1 Budget Surplus: G<T

Thus, during a recession the Budget will automatically move into deficit, and in a boom it will
automatically move back into surplus, although this will also be influenced by the
government’s discretionary policy.

C) Problems with Demand Side Fiscal Policy

1) Information

Because the government often does not have the information it needs, this can create a
situation in which its policies are counterproductive. This is particularly likely when there is a
lead time before action can be taken, and lags before policies begin to bite. Therefore, the
government might feel that the economy is in need of extra demand to forestall a recession,
cutting taxes in the next budget. However, the information that the government was acting
on is likely to be months out of date. By the time the tax cut begins to have an impact on
consumer spending, economic conditions may have changed, meaning that the policy of
increasing demand may begin to work when the economy is already in an upswing, therefore
exacerbating the trade cycle rather than damping it down.

Real GDP

Destabilised trade cycle

Normal Trade Cycle

2) Crowding Out

If the government wishes to expand AD, and finances its PSBR through a bond issue, then
the total demand for funds in the money market will be higher. The consequence of this is
that borrowing rates on medium term debt (loans) will increase. This will be likely to reduce
the amount of Investment that firms can afford to undertake because of the higher cost of

This will have both short and long term effects. In the short term, this reduction in
Investment will work against the increase in government spending, therefore lessening the
impact of the policy. The private sector has been 'crowded out' by the increased role of the
government.. In the longer term, the reduction in the level of investment may reduce the
growth rate of the UK economy. Most studies suggest that there is a strong positive
correlation between Investment and economic growth. In addition, UK firms will be investing
less in R&D and new equipment than international rivals, reducing competitiveness.

3) Precommited spending

In many cases, it may be difficult for the government to alter government spending in a
downward direction, due to commitments from previous year. Many major capital investment
projects run for more than one fiscal year - if the government has built half of the M40, it
would be very difficult to cut spending the next year - half a motorway is of no use to

4) Increased debt repayments

One consequence of fiscal stabilisation has been the tendency for the National Debt to rise.
This has happened because governments are generally much keener to borrow money than
they are to increase taxes to pay it back, and pre-commited spending may make it difficult
to reduce government spending quickly. As a result government funds are diverted to the
money market rather than being spent on education, health, training and so on, which may
undermine the supply side performance of the economy.

5) Poverty/Unemployment trap

As fiscal policy has been used more and more to create 'automatic' stabilisers, there has
been an increasing danger that for a substantial proportion of the workforce, accepting a job
may not be worthwhile. This is because until recently, accepting a job generally meant losing
all benefits (income support etc.) at the same time as becoming liable for tax. This meant
that it was possible to end up with less money in a job than you would have received on

benefit. This therefore created a major imperfection in the labour market, increasing
frictional/voluntary unemployment.

In recent budgets budget, the government has sought to tackle this by guaranteeing all
families with a full time employee £240 per week. The previous objection to this is that
employers would just use this to pay workers less, but this is more difficult now that the
minimum wage has been introduced.

6) Difficulty with control

Whereas monetary policy, under control of the monetary policy committee can be altered
every month, fiscal policy is generally set through the budget, which is annual. Therefore it
may be very difficult to fine tune the economy using fiscal policy. If a major increase in AD
is needed, especially when confidence is low, then fiscal policy may be appropriate (Japan
1998), but otherwise governments have tended to rely increasingly on monetary policy as
their primary method of demand management.

D) Supply Side Fiscal Policy

Since the UK government has controlled demand through monetary policy throughout the 80s
and 90s, fiscal policy has generally had a different role to play. This has been to enhance the
supply side of the economy. As noted previously, this means improving the functioning of
both labour and product markets to increase the capacity of the UK economy, and to
increase the competitiveness of UK firms.

In recent budgets, to improve labour markets, the government has:

• Introduced individual learning accounts offering big discounts to firms and

individuals on training, helping to close the skills/productivity gap with other countries.
• Extended the welfare to work program, encouraging/coercing the young
unemployed into getting training.
• Guaranteeing a minimum income of well over £200 per week for working families
with a full time earner (therefore helping to tackle the poverty trap).
• A new 10% bottom tax rate to encourage people to work, increasing the flexibility
of the labour market.

Therefore the tax and spending structure has been used not to alter the level of demand
overall, but to create incentives and opportunities.

Similarly, in product markets, the government has acted to raise both Capital Investment
and R&D spending.:

• The introduction of a research and development tax credit which will reduce the
real cost of R&D, making it more worthwhile.
• A 10p corporation tax band for small firms, to encourage their start-up and to give
more funds for reinvestment
• The creation of a new small business service to support growing firms, and 40%
capital allowances to encourage investment and growth by small firms.

In theoretical terms, the impact of these policies will be to shift the AS curve to the right,
therefore making it easier for the economy to expand without the build-up of inflationary

Agg Price

S side policies


Real National output

In this case, supply side policies shift the AS curve from AS1 to AS2. Consequently, when
AD rises from AD1 to AD2, there is far less upward pressure on prices due to the increase in
the capacity/flexibility of the economy. Therefore the main effect of the extra demand is
to raise output rather than prices, resulting in a new equilibrium at 'B' rather than 'C'.