What is Fiscal Policy?
Fiscal policy involves the use of government spending, taxation and borrowing to influence both
the pattern of economic activity and also the level and growth of aggregate demand, output and
employment. A rise in government expenditure, or a fall in the burden of taxation, should
increase aggregate demand and boost employment. The size of the resulting final change in
equilibrium national income is determined by the multiplier effect. The larger the national
income multiplier, the greater the change in national income will be.
However fiscal policy is also used to influence the supply-side performance of the economy. For
example, changes in fiscal policy can affect competitive conditions individual markets and
industries and change the incentives for people to look for work and for companies to invest and
engages in research and development. Government capital spending on transport infrastructure
and public sector investment in education and health can also have a direct but unpredictable
effect in the long run on the competitiveness and costs of businesses in every industry.
Government Spending: Government spending can be broken down into three main categories:
o General government expenditure - consists of the combined capital and current
spending of central government including debt interest payments to holders of
o General government final consumption - is government expenditure on current goods
and services excluding transfer payments
o Transfer payments – transfers are transfers from taxpayers to benefit recipients through
the working of the social security system. The total welfare bill now exceeds £140 billion
Government Spending and Fiscal Policy Objectives
The Treasury has outlined the main goals of fiscal policy to be the following: o Equity concerns: To ensure that government spending and taxation impact fairly within
and across generations – fiscal policy should be equitable to current and future
o Funding government spending: To meet the government’s spending and tax priorities
without a damaging rise in the burden of government debt
o The benefit principle: This principle seeks to ensure that those who benefit from public
services such as the benefits from education, health and transport also meet as far as
possible the costs of the services they consume
o Macroeconomic stability: Fiscal policy in the UK is now designed to support monetary
policy in ‘smoothing the path of aggregate demand over the economic cycle’ and in
contributing to an environment of sustainable growth and stable inflation – this is the
main macroeconomic objective of fiscal policy
Fiscal Policy Effects
Fiscal policy decisions have a widespread effect on the everyday decisions and behavior of
individual households and businesses – hence in this note we consider some of the
microeconomic effects of fiscal policy before considering the links between fiscal policy and
aggregate demand and key macroeconomic objectives.
The microeconomic effects of fiscal policy
1. Taxation and work incentives: Can changes in income taxes affect the incentive to work? This
remains a controversial subject in the economic literature!
Consider the impact of an increase in the basic rate of income tax or an increase in the rate of
national insurance contributions. The rise in direct tax has the effect of reducing the post-tax
income of those in work because for each hour of work taken the total net income is now lower.
This might encourage the individual to work more hours to maintain his/her target income.
Conversely, the effect might be to encourage less work since the higher tax might act as a
disincentive to work. Of course many workers have little flexibility in the hours that they work.
They will b