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2.5 Fiscal policy and supply-
side policies
2.5.1 Fiscal Policy
Fiscal policy involves the use of government spending, direct and indirect
taxation and government borrowing to affect aggregate demand, output and jobs
Fiscal policy is also used to change the pattern of spending on goods and
services e.g. spending on health care and scarce resources allocated to
renewable energy
Fiscal policy is also a means by which a redistribution of income & wealth can be
achieved for example by changing tax rates on different levels of income or
wealth
It is an instrument of micro-economic government intervention to correct for
market failures such as pollution or the sub-optimal provision of public and merit
goods
Changes in fiscal policy affect both aggregate demand (AD) and aggregate
supply (AS).
Evaluations
fall in income tax may not guarantee a rise in disposable income if consumer
confidence is low - households may save rather than spend - MPC low so may
not have a significant impact on C or AD
worsens budget deficit, worsens national debt, worsens UK credit rating and
ability too get loans - higher debt repayments
time lag between change in corp tax and actual investment
increase in investment may lead to rise in structural unemployment / capital-
labour substitution
effect depends on scale of tax cut
high income tax rates may not lead to increase in tax revenue - Laffer curve
will cause higher tax burdens in the future
2.5 Fiscal policy and supply-side policies 1
, opportunity cost
crowding out
Taxation
Direct and indirect taxes
Direct taxes
Direct taxation is levied on income, wealth and profit
Direct taxes include income tax, inheritance tax, national insurance
contributions, capital gains tax, and corporation tax (a tax on business profits)
The burden of a direct tax cannot be passed on to someone else
Indirect taxes
Indirect taxes are usually taxes on spending
Examples of indirect taxes include excise duties on fuel, cigarettes and alcohol
and Value Added Tax (VAT) on many different goods and services together with
the sugar tax
Producers may be able to pass on an indirect tax – depending on price elasticity
of demand and supply
Tax and duty
Ad valorem - these are charged as a
Specific tax (unit tax) - government
percentage of price, eg. VAT at 20% on
levies a duty of 57p per litre on petrol,
2.5 Fiscal policy and supply-side policies 2
, regardless of price being charged by most items.
the petrol station
Tax systems
Progressive taxation - when the proportion of income paid in tax rises as income
rises e.g. income tax.
Proportional taxation - when the proportion of income paid in tax remains the same
as income increases.
Regressive taxation - when the proportion of income paid in tax falls as income
increases e.g. VAT, tobacco tax(sin tax).
Taxes should be equitable
Purposes of taxation
Two key purposes of taxation (and government spending) are allocation and
distribution.
Allocation in this context means the role that taxes and subsidies have in improving
resources allocation: promoting consumption of merit goods and disincentivising
demerit goods.
Distribution here means redistribution of wealth and income: reducing the income of
a rich person through tax and increasing the income of a poor person through
welfare payments.
Average and marginal tax rates
Average tax rate = tax paid / income
Marginal tax rate = change in tax paid / change in income
In a progressive tax system, the marginal tax rate will be higher than the average tax
rate. In a regressive tax system, the opposite will be true.
The Laffer Curve
Why might total tax revenues fall if the tax rate increases?
Increased rates of tax avoidance – greater incentive to seek out tax relief, make
max use of
tax allowances
2.5 Fiscal policy and supply-side policies 3
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