2.1.2 - Fiscal policy, taxation and budgets

Fiscal policy and tax revenue

Governments influence economic activity through what they tax and what they spend.

Fiscal policy is the use of government expenditure and taxation to influence the economy. It can change total spending, the distribution of income and the economy's future ability to produce. A central bank changing its policy interest rate is monetary policy, rather than fiscal policy.

Direct taxes are charged on income or wealth, such as personal income tax and tax on business profits. Indirect taxes are charged on expenditure on goods and services, such as a sales tax or a tax on fuel. A business may collect an indirect tax when it sells a product; who ultimately bears its cost depends on how prices and behaviour change. Taxes are government revenue, not free resources: paying them reduces the private income available for spending or saving.

Suppose an illustrative worker earns £2,400 monthly and pays income tax of £300 and another compulsory deduction of £120. Net pay is £2,400 − £300 − £120 = £1,980. A £60 cut in income tax, with other items unchanged, raises net pay to £2,040. If the worker spends part of that increase, businesses receive more orders. A tax cut is not a promise that every extra pound will be spent: some households save it or repay debt.

The design of taxes matters for distribution. A progressive income tax takes a higher proportion as income rises and can help finance benefits for low-income households. An indirect tax on a necessity can take a larger share of a poor household's income because it spends a greater proportion on that necessity. A tax on pollution can instead influence behaviour by making a harmful activity more expensive. Fiscal policy therefore concerns both revenue totals and incentives.

Spending and budget balances

A government budget compares flows of revenue and expenditure over the same period.

Major spending areas include education, healthcare, infrastructure such as roads, defence and security, benefits and pensions, public administration and interest on existing government debt. Education and health can improve opportunities and productivity; transport can reduce business costs; benefits support household incomes. Their opportunity costs differ: an additional hospital cannot be built using the same workers and funds already committed to another project.

The following annual budget is illustrative. All entries are in billions of pounds.

Sum the categories first. Expenditure exceeds revenue by £20 billion, so this is a fiscal deficit. If revenue exceeded expenditure there would be a fiscal surplus; equal totals form a balanced budget. State which convention you use: revenue minus expenditure is −£20 billion, while the deficit's size is positive £20 billion.

Deficits usually require borrowing, for example by selling government bonds. Government debt is the accumulated outstanding borrowing, a stock at a date. A deficit is a shortfall over a period. They are not the same quantity. A surplus can help repay debt; it does not imply that the outstanding debt has already disappeared. Debt interest is expenditure and can restrict the money available for future services.

Deficits, surpluses and economic activity

The budget balance gives useful information, but its cause determines how it affects the economy.