Budget: a financial statement showing the forecasted government revenue and expenditure in the coming fiscal year. It lays out the amount the government expects to receive as revenue in taxes and other incomes and how and where it will use this revenue to finance its various spending endeavours. Governments aim for its budgets to be balanced.

Government spending

Governments spend on all kinds of public goods and services, not just out of political and social responsibility, but also out of economic responsibility. Government spending is a part of the aggregate demand in the economy and influences its well-being. The main areas of government spending includes defence and arms, road and transport, electricity, water, education, health, food stocks, government salaries, pensions, subsidies, grants etc.

Reasons governments spend:

  • To supply goods and services that the private sector would fail to do, such as public goods, including defence, roads and streetlights; merit goods, such as hospitals and schools; and welfare payments and benefits, including unemployment and child benefits.
  • To achieve supply-side improvements in the economy, such as spending on education and training to improve labour productivity.
  • To spend on policies to reduce negative externalities, such as pollution controls.
  • To subsidise industries which may need financial support, and which is not available from the private sector, usually agriculture and related industries.
  • To help redistribute income and improve income inequality.
  • To inject spending into the economy to aid economic growth.

Effects of government spending

  • Increased government spending will lead to higher demand in the economy and thus aid economic growth, but it can also lead to inflation if the increasing demand causes prices to rise faster than output.
  • Increased government spending on public goods and merit goods, especially in infrastructure, can lead to increased productivity and growth in the long run.
  • Increased government spending on welfare schemes and benefits will increase living standards, and help reduce inequality.
  • However too much government spending can also cause ‘crowding out’ of private sector investments – private investments will reduce if the increase in government spending is financed by increased taxes and borrowing (large government borrowing will drive up interest rates and discourage private investment).


Governments earn revenue through interests on government bonds and loans, incomes from fines, penalties, escheats, grants in aid, income from public property, dividends and profits on government establishments, printing of currency etc;  but its major source of revenue comes from taxation. Taxes are a compulsory payment made to the government by all people in an economy. There are many reasons for levying taxes from the economy:

  • It is a source of government revenue: if the government has to spend on public goods and services it needs money that is funded from the economy itself. People pay taxes knowing that it is required to fund their collective welfare.
  • To redistribute income: governments levy taxes from those who earn higher incomes and have a lot of wealth. This is then used to fund welfare schemes for the poor.
  • To reduce consumption and production of demerit goods: a much higher tax is levied on demerit goods like alcohol and tobacco than other goods to drive up its prices and costs in order to discourage its consumption and production. Such a tax on a specific good is called excise duty.
  • To protect home industries: taxes are also levied on foreign goods entering the domestic market. This makes foreign goods relatively more expensive in the domestic market, enabling domestic products to compete with them. Such a tax on foreign goods and services is called customs duty.
  • To manage the economy: as we will discuss shortly, taxation is also a tool for demand and supply side management. Lowering taxes increase aggregate demand and supply in the economy, thereby facilitating growth. Similarly, during high inflation, the government will increase taxes to reduce demand and thus bring down prices. More on this below.

Classification of Taxes

Taxes can be classifies into direct or indirect and progressive, regressive or proportional.

Direct Taxes are taxes on incomes. The burden of tax payment falls directly on the person or individual responsible for paying it.

  • Income tax: paid from an individual’s income. Disposable income is the income left after deducting income tax from it. When income tax rise, there is little disposable income to spend on goods and services, so firms will face lower demand and sales, and will cut production, increasing unemployment. Lower income taxes will encourage more spending and thus higher production.
  • Corporate Tax: tax paid on a company’s profits. When the corporate tax rate is increased, businesses will have lower profits left over to put back into the business and will thus find it hard to expand and produce more. It will also cause shareholders/owners to receive lower dividends/returns for their investments. This will discourage people from investing in businesses and economic growth could slow down. Reducing corporate tax will encourage more production and investment.
  • Capital gains tax: taxes on any profits or gains that arise from the sale of assets held for more than a year.
  • Inheritance tax: tax levied on inherited wealth.
  • Property tax: tax levied on property/land.


  • High revenue: as all people above a certain income level have to pay income taxes, the revenue from this tax is very high.
  • Can reduce inequalities in income and wealth: as they are progressive in nature – heavier taxes on the rich than the poor- they help in reducing income inequality.


  • Reduces work incentives: people may rather stay unemployed (and receive govt. unemployment benefits) rather than be employed if it means they would have to pay a high amount of tax. Those already employed may not work productively, since for any extra income they make, the more tax they will have to pay.
  • Reduces enterprise incentives: corporate taxes may demotivate entrepreneurs to set up new firms, as a good part of the profits they make will have to be given as tax.
  • Tax evasion: a lot of people find legal loopholes and escape having to pay any tax. Thus tax revenue falls and the govt. has to use more resources to catch those who evade taxes.

Indirect Taxes are taxes on goods and services sold. It is added to the prices of goods and services and it is paid while purchasing the good or service. It is called indirect because it indirectly takes money as tax from consumer expenditure. Some examples are:

  • GST/VAT: these are included in the price of goods and services. Increasing these indirect taxes will increase the prices of goods and services and reduce demand and in turn profits. Reducing these taxes will increase demand.
  • Customs duty: includes import and export tariffs on goods and services flowing between countries. Increasing tariffs will reduce demand for the products.
  • Excise Duty: tax on demerit goods like alcohol and tobacco, to reduce its demand.


  • Cost-effective: the cost of collecting indirect taxes is low compared to collecting direct taxes.
  • Expanded tax-base: directs taxes are paid by those who make a good income, but indirect taxes are paid by all people (young, old, unemployed etc.) who consume goods and services, so there is a larger tax base.
  • Can achieve specific aims: for example, excise duty (tax on demerit goods) can discourage the consumption of harmful goods; similarly, higher and lower taxes on particular products can influence their consumption.
  • Flexible: indirect tax rates are easier and quicker to alter/change than direct tax rates. Thus their effects are immediate in an economy.


  • Inflationary: The prices of products will increase when indirect taxes are added to it, causing inflation.
  • Regressive: since all people pay the same amount of money, irrespective of their income levels, the tax will fall heavily on the poor than the rich as it takes more proportion of their income.
  • Tax evasion: high tariffs on imported goods or excise duty on demerit goods can encourage illegal smuggling of the good.

Progressive Taxes are those taxes which burdens the rich more than the poor, in that the rate of taxation increases as incomes increase. An income tax is the perfect example of progressive taxation. The more income you earn, the more proportion of the income you have to pay in taxes, as defined by income tax brackets.
For example, a person earning above $100,000 a month will have to pay a tax rate of 20%, while a person earning above $200,000 a month will have to pay a tax rate of 25%.

Regressive Taxes are those taxes which burden the poor more than the rich, in that the rate of taxation falls as incomes increase. An indirect tax like GST is an example of a regressive tax because everyone has to pay the same tax when they are paying for the product, rich or poor.
For example, suppose the GST on a kilo of rice is $1; for a person who earns $500 dollars a month, this tax will amount to 0.2% of his income, while for a richer person who earns $50,000 a month, this tax will amount of just 0.002% of his income. The burden on the poor is higher than on the rich, making its regressive.

Proportional Taxes are those taxes which burden the poor and rich equally, in that the rate of taxation remains equal as incomes rise or fall. An example is corporate tax. All companies have to pay the same proportion of their profits in tax.
For example, if the corporate tax is 30%, then whatever the profits of two companies, they both will have to pay 30% of their profits in corporate tax.

Types of Taxes

Qualities of a good tax system (the canons of taxation):

  • Equity: the tax rate should be justifiable rate based on the ability of the taxpayer.
  • Certainty: information about the amount of tax to be paid, when to pay it, and how to pay it should all be informed to the taxpayer.
  • Economy: the cost of collecting taxes must be kept to a minimum and shouldn’t exceed the tax revenue itself.
  • Convenience: the tax must be levied at a convenient time, for example, after a person receives his salary.
  • Elasticity: the tax imposition and collection system must be flexible so that tax rates can be easily changed as the person’s income changes.
  • Simplicity: the tax system must be simple so that both the collectors and payers understand it well.

Impacts of taxation

Taxes can have various direct impacts on consumers, producers, government and thus, the entire economy.

  • The main purpose of tax is to raise income for the government which can lead to higher spending on health care and education. The impact depends on what the government spends the money on. For example, whether it is used to fund infrastructure projects or to fund the government’s debt repayment.
  • Consumers will have less disposable income to spend after income tax has been deducted. This is likely to lead to lower levels of spending and saving. However, if the government spends the tax revenue in effective ways to boost demand, it shouldn’t affect the economy.
  • Higher income tax reduces disposable income and can reduce the incentive to work. Workers may be less willing to work overtime or might leave the labour market altogether. However, there are two conflicting effects of higher tax:
    • Substitution effect: higher tax leads to lower disposable income, and work becomes relatively less attractive than leisure – workers will prefer to work less.
    • Income effect: if higher tax leads to lower disposable income, then a worker may feel the need to work longer hours to maintain his desired level of income – workers feel the need to work longer to earn more.
    • The impact of tax then depends on which effect is greater. If the substitution effect is greater, then people will work less, but if income effect is greater, people will work more
  • Producers will have less incentive to produce if the corporate taxes are too high. Private firm aim on making profits, and if a major chunk of their profits are eaten away by taxes, they might not bother producing more and might decide to close shop.

Fiscal Policy

Fiscal policy is a government policy which adjusts government spending and taxation to influence the economy. It is the budgetary policy, because it manages the government expenditure and revenue. Government aims for a balance budget and tries to achieve it using fiscal policy.

A budget is in surplus, when government revenue exceed government spending. While this is good it also means that the economy hasn’t reached its full potential. The government is keeping more than it is spending, and if this surplus is very large, it can trigger a slowdown of the economy.
When there is a budget surplus, the government employs an expansionary fiscal policy where govt. spending is increased and tax rates are cut.

A budget is in deficit, when government expenditure exceeds government revenue. This is undesirable because if there is not enough revenue to finance the expenditure, the government will have to borrow and then be in debt.
When there is a budget deficit, the government employs contractionary fiscal policy, where govt. spending is cut and tax rates are increased.

Fiscal policy helps the government achieve its aim of economic growth, by being able to influence the demand and spending in the economy. It also indirectly helps maintain price stability, via the effects of tax and spending.
Expansionary fiscal policy will stimulate growth, employment and help increase prices. Contractionary fiscal policy will help control inflation resulting from too much growth. But as we will see later on, controlling inflation by reducing growth can lead to increased unemployment as output and production falls.

Notes submitted by Lintha

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15 thoughts on “4.3 – Fiscal Policy

    1. Hello! We haven’t made printable notes yet. You can always print these pages directly from your browser, however. We would also appreciate if you didn’t share the printed material with others though (redirect them to this website instead 🙂 )


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