Chapter 3.

3 - Fiscal Policy
One of the major macroeconomic policy tools used to achieve the objectives of the welfare
society or macroeconomic objectives. The fiscal policy operated through budgetary policy,
taxation, and compensatory fiscal policy. The government may offset undesirable variations in
private consumption and investment by compensatory variations of public expenditures and
taxes. The ultimate aim of fiscal policy is the long-run stabilization of the economy, yet it can be
achieved by moderating short-run economic fluctuations.

Fiscal policy is the policy of the government in relation to public expenditure, taxation and
public debt. This policy is also called the budgetary policy. Fiscal policy is the use of taxation
and government expenditure strategies to influence the level of economic activity and
macroeconomic objectives such as employment, economic growth and the control of inflation.
For example, taxation can be used to redistribute income and wealth to benefit less wealthy
members of society. Government spending can be used to improve standards of living, such as
building schools, hospitals and transportation networks.

There are other sources of government revenue (such as government borrowing and the proceeds
from privatization, the selling of state assets) but tax revenues are by far the most significant
source. If the government manages to balance its revenues and its spending, then a balanced
budget is said to exist.

However, if the government spends more than it collects from its revenues then a budget deficit
exists. And if there is more government revenue than is spent, the government has a budget
surplus.

In the long run, governments strive to balance their budgets. This is partly because increasing
government revenues by raising taxes is highly unpopular, while government borrowing to fund
a budget deficit is hugely expensive due to the amount of interest owed on such loans.

OBJECTIVES OF FISCAL POLICY

● To maintain and achieve full employment.

● To stabilize the price level.
● To stabilize the growth rate of the economy.
● To maintain equilibrium in the balance of payments.
● To promote the economic development of underdeveloped countries.

Fiscal policy through variations in government expenditure and taxation profoundly affects
national income, employment, output and prices. An increase in public expenditure during
depression adds to the aggregate demand for goods and services and leads to a large increase in
income via the multiplier process; while a reduction in taxes has the effect of raising disposable
income thereby increasing consumption and investment expenditure of the people. On the other
hand, a reduction of public expenditure during inflation reduces aggregate demand, national
income, employment, output and prices; while an increase in taxes tends to reduce disposable
income and thereby reduces consumption and investment expenditures. Thus the government can
control deflationary and inflationary pressures in the economy by a judicious combination of
expenditure and taxation programmes.

Taxation

A tax is a government levy on income or expenditure. There are various reasons why the
government imposes taxes. For example:

● Taxes on salaries and profits raise government revenue and can be used to redistribute
income and wealth in the economy.
● Taxes on goods and services raise the costs of production and therefore can limit the
output of certain demerit products, such as alcohol and tobacco.
● Tariffs imposed on foreign goods and services help to protect domestic firms from
overseas rivals.

Before the government can spend money on the economy, it must first take the money from
taxpayers (both individuals and firms). In addition to other sources of government finance, tax
revenues are spent on several key areas, including social security, education, health care,
transport, infrastructure and national defence.

The tax burden is the amount of tax that households and firms have to pay. This can be
measured in three ways. For a country, the tax burden is measured by calculating total tax
revenues as a proportion of gross domestic product (GDP). For individuals and firms, the tax
burden can be measured by the absolute value of tax paid or by the amount of tax paid as a
proportion of their income or profits.

Types of taxation

There are various classifications of taxes, including the following:

● Direct taxes - This type of tax is paid from the income, wealth or profit of individuals
and firms. Examples are taxes on salaries, inheritance and company profits.
● Indirect taxes - These are taxes imposed on expenditure on goods and services. For
example, countries such as Australia and Singapore use a goods and services tax (GST),
whereas the European Union uses value added tax (VAT). Other examples are taxes on
petrol, alcohol and cigarettes.
● Progressive taxation - Under this tax system, those with a higher ability to pay are
charged a higher rate of tax. This means that as the income, wealth or profit of the
taxpayer rises, a higher rate of tax is imposed (see Figure 4.1). Examples of progressive
taxation are income tax, capital gains tax and stamp duty.
 Figure 4.1 Progressive taxation

● Regressive taxation - Under this tax system, those with a higher ability to pay are
actually charged a lower rate of tax: that is, the wealthier the individual, the lower the tax
paid as a percentage of income (sec Figure 4.2). For example, although a high-income
earner pays the same amount of airport tax or television licence fee as a less wealthy
person, the amount of tax paid is a smaller proportion of the wealthier person's income.

Figure 4.2 Regressive taxation

● Proportional taxation - Under this tax system, the percentage of tax paid stays the same,
irrespective of the taxpayer's level of income, wealth or profits (see Figure 4.3). An
example would be a flat rate sales tax, such as VAT or GST. Sales taxes vary considerably
from country to country: for example, Denmark has a 25 per cent GST, whereas sales
taxes in India and Japan are as low as 5 per cent. Another example is an income tax
which is 20 percent for all individuals regardless of level of income.
 Figure 4.3 Proportional taxation

● Income tax - tax levied on personal incomes (wages, interest, rent and dividends). In
most countries, this is the main source of tax revenues.
● Corporation tax - a direct tax on the profits of businesses.
● Sales tax - an indirect tax, such as VAT, charged on an individual’s spending.
● Excise duties - indirect inland taxes imposed on certain goods and services, such as
alcohol, tobacco, petrol, soft drinks and gambling.
● Custom duties - indirect cross-border taxes on foreign imports.
● Capital gains tax - a tax on the earnings made from investments such as buying shares
and private property.
● Inheritance tax - a tax on transfer of income and wealth such as property when passed
on to another person.
● Stamp duty - a progressive tax paid on the sale of commercial or residential property.
● Windfall tax - a tax charged on individuals and firms that gain an unexpected one-off
amount of money, such as a person winning the lottery or a firm gaining from a takeover
bid.

The impact of taxation

Taxation has varying impacts depending on the type of tax in question. The impact of taxation on
economic agents and the economy are considered below.

● Impact on price and quantity - The imposition of a sales tax will shift the supply curve
of a product to the left due to the higher costs of production. This will increase the price
charged to customers and reduce the quantity produced and sold.
● Impact on economic growth - Taxation tends to reduce incentives to work and to
produce. By contrast, tax cuts can boost domestic spending, thus benefiting businesses
and helping to create jobs. Nevertheless, tax revenues are essential to fund government
spending (for the construction of schools, hospitals, railways, airports, roads and so on),
which fuels economic growth.
 ● Impact on inflation - As taxation tends to reduce the spending ability of individuals and
the profits of firms, it helps to lessen the impact of inflation. By contrast, a cut in taxes
boosts the disposable income of households and firms, thus fuelling inflationary pressures
on the economy.
● Impact on business location - The rate of corporation tax and income tax will affect
where multinational businesses choose to locate.
● Impact on social behavior - Taxation can be used to alter social behavior with the
intention of reducing the consumption of demerit goods. For example, taxing tobacco and
alcohol should, in theory, reduce the demand for such products. Taxes are also used to
protect the natural environment by charging those who pollute or damage it. For example,
countries such as the UK and China tax cars based on the engine size because vehicles
with larger engines tend to cause more pollution.
● Impact on incentives to work - If taxes are too high, this can create disincentives to
work. For example, France tried to introduce a 75 per cent income tax rate in 2012 for
individuals earning incomes in excess of €1 million ($1.28 million per year). However,
the proposals were overturned, with some economists arguing that the government would
actually receive more tax revenues by cutting tax rates. This is because lower rates of tax
can create incentives to work and also help to reduce tax avoidance and tax evasion.
● Impact on tax avoidance and tax evasion - Some taxes are preventable. Tax avoidance
is the legal act of not paying taxes: for example, non-smokers do not pay tobacco tax and
non-overseas travelers do not pay air passenger departure taxes.

However, tax evasion is illegal as it refers to non -payment of taxes due, perhaps by a
business under-declaring its level of profits. High levels of taxation will tend to
encourage both tax avoidance and tax evasion. By contrast, low rates of taxation create
far fewer incentives for households and firms to defraud the government.

● Impact on the distribution of wealth - The use of taxes can help to redistribute income
and wealth from the relatively rich to the poorer members of society. For example,
wealthier individuals will pay more income tax, sales taxes and stamp duty on their
private properties. These funds can be used by the government to support education,
health care and social benefits for less affluent individuals in the economy.

The incidence of taxation

The incidence of taxation refers to the final money burden on a person who ultimately bears it.
Whenever the money burden of a tax finally settles to rest on an ultimate tax payer, it is called
the incidence of a tax.

Impact of taxation refers to the immediate burden of the tax. The impact and incidence of a tax
may not fall on the same person. The impact of taxation is on the producer while incidence of
taxation is on the consumer. The impact does not reduce the income of the producer, though it
puts pressure on him for a short period whereas the incidence is durable and it ends in
diminishing the monetary income of the taxpayers.

● Elasticity of demand of the commodity - if the demand of a commodity is perfectly

elastic, the entire tax burden will be upon the seller, because an increase in the price due
to tax will make the demand of the commodity zero. On the contrary, if the demand for
the commodity is perfectly inelastic, the entire tax burden will be passed on to the buyers,
because an increase in price due to tax will not affect the demand. When it is relatively
elastic, a greater part of the tax burden will be on the seller and vice versa.

Figure 4.4 The influence of the price elasticity of demand on the incidence of taxation

● Elasticity of supply of the commodity - if the supply of a commodity is perfectly

elastic, the total tax burden is shifted to the buyers. As with the imposition of tax, the cost
of production will rise. Hence the price will rise, which may affect the demand of the
commodity and bring loss to the seller. Therefore, the seller would curtail the supply of
the commodity, increase the price of the commodity by the amount of tax and will shift
the entire burden of the tax on the buyers. On the other hand, if supply is perfectly
inelastic, the entire tax burden will be on the seller.

Use of fiscal policy

Fiscal policy can be used either to expand or to contract economic activity in order to achieve
macroeconomic objectives and to promote economic stability.

Expansionary fiscal policy is used to stimulate the economy, by increasing government

spending and/ or lowering taxes. For example, by increasing social security payments (such as
unemployment benefits or state pensions), domestic consumption should increase. This type of
fiscal policy is used to reduce the effects of an economic recession, by boosting gross domestic
product and reducing unemployment.
By contrast, contractionary fiscal policy is used to reduce the level of economic activity by
decreasing government spending and/ or raising taxes. For example, countries such as China and
the USA have used property taxes to slow down escalating house prices. Contractionary fiscal
policies are used to reduce inflationary pressures during an economic boom.

Fiscal policy is also used to redistribute income and wealth in the economy. Some countries have
quite high rates of income tax to reallocate resources from wealthier individuals to the poorer
members of society. Examples include Austria, Belgium, Cuba and Senegal, which all have a top
tax rate of 50 per cent. High income tax rates can, however, cause severe distortions to the labor
market.

Fiscal policy can also be used in conjunction with supply-side policies to affect the productive
capacity of the economy, thus contributing to long-term economic growth.