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Fiscal policy refers to the use of government spending and taxation to influence the level of aggregate demand (AD) and, through it, macroeconomic objectives such as economic growth, employment, inflation control, and the balance of payments. It is one of the two main demand-side policy tools available to governments — the other being monetary policy.
Key Definition: Fiscal policy is the deliberate manipulation of government spending (G) and taxation (T) to influence aggregate demand, output, employment, and the price level.
The government budget sets out planned spending and revenue for the coming financial year. In the UK, the Chancellor of the Exchequer presents the budget to Parliament, usually in the autumn.
| Component | Description | Examples |
|---|---|---|
| Government spending (G) | Total public expenditure on goods, services, transfers | NHS, defence, education, pensions, Universal Credit |
| Taxation (T) | Revenue raised from individuals and firms | Income tax, VAT, corporation tax, fuel duty |
| Budget balance | G − T | Surplus if T > G; Deficit if G > T |
The UK government budget has been in deficit for most years since 2001, meaning the government has spent more than it has received in revenue. In 2009-10, following the Global Financial Crisis, the deficit peaked at approximately 10% of GDP — around £153 billion.
Exam Tip: Always distinguish between the budget deficit (the annual shortfall of revenue relative to spending) and the national debt (the total accumulated stock of government borrowing). Examiners frequently penalise students who confuse the two.
Government spending can be divided into three broad categories:
Current spending covers the routine costs of running public services. This includes wages for teachers, nurses, and civil servants; heating and lighting government buildings; purchasing medical supplies for the NHS. Current spending does not create new assets — it maintains existing service levels.
Capital spending creates new assets with long-term benefits. Examples include building new hospitals, schools, roads, and railway lines. Keynes (1936) argued in The General Theory of Employment, Interest and Money that capital spending has the greatest multiplier effect because it creates employment directly in construction and manufacturing, and indirectly through the increased consumption of those workers.
Transfer payments redistribute income from taxpayers to recipients without any corresponding output. Examples include the state pension, Universal Credit, Jobseeker's Allowance, and child benefit. Transfer payments are not included in the calculation of GDP because they do not represent payment for a newly produced good or service.
Automatic stabilisers are elements of fiscal policy that change automatically with the economic cycle, without any deliberate government decision. They act as a built-in counter-cyclical mechanism, dampening fluctuations in aggregate demand.
During a recession:
During a boom:
| Phase of Cycle | Tax Revenue | Welfare Spending | Budget Balance | Effect on AD |
|---|---|---|---|---|
| Recession | Falls | Rises | Deficit widens | Expansionary (supports AD) |
| Boom | Rises | Falls | Deficit narrows / surplus | Contractionary (dampens AD) |
Exam Tip: Automatic stabilisers are a strength of fiscal policy because they act immediately without the recognition, decision, and implementation lags that affect discretionary policy. Make this point explicitly in evaluation.
Discretionary fiscal policy involves deliberate, conscious decisions by the government to change tax rates or spending levels in order to influence aggregate demand. Unlike automatic stabilisers, discretionary changes require legislation and take time to implement.
An expansionary fiscal stance involves increasing government spending and/or cutting taxes to boost AD. This shifts the AD curve to the right.
Example: In the 2008-09 recession, Chancellor Alistair Darling implemented a temporary reduction in VAT from 17.5% to 15% (December 2008 to January 2010) to stimulate consumer spending. This was a classic Keynesian demand-management response.
A contractionary fiscal stance involves cutting government spending and/or raising taxes to reduce AD. This shifts the AD curve to the left.
Example: Following the 2010 general election, the Coalition government under George Osborne pursued austerity — cutting departmental spending by an average of 19% and raising VAT from 17.5% to 20% in January 2011.
Keynes (1936) argued that an initial change in government spending leads to a larger final change in national income. This is the multiplier effect.
The multiplier (k) can be expressed as:
k = 1 / (1 − MPC) or equivalently k = 1 / MPW
where MPC = marginal propensity to consume and MPW = marginal propensity to withdraw (savings + taxation + imports).
If MPC = 0.8, then k = 1 / (1 − 0.8) = 5. A £10 billion increase in government spending would lead to a £50 billion increase in national income.
However, the multiplier is likely to be smaller in practice because:
The PSBR (now more commonly referred to as Public Sector Net Borrowing, PSNB) is the amount the government needs to borrow in a given year to finance its budget deficit. The government borrows by selling gilts (government bonds) to financial markets.
| Strengths | Weaknesses |
|---|---|
| Can target specific sectors or regions | Time lags: recognition, decision, implementation |
| Automatic stabilisers act immediately | Political constraints: governments may pursue vote-winning rather than economically optimal policies |
| Multiplier can amplify the impact of spending | Crowding out: government borrowing may raise interest rates and reduce private investment |
| Effective in a liquidity trap when monetary policy is ineffective (Keynes, 1936) | Ricardian equivalence: rational consumers may save more if they expect future tax rises (Barro, 1974) |
| Can address market failure and provide public goods | Budget deficit leads to rising national debt and interest payments |
Exam Tip: A 25-mark essay on fiscal policy should balance Keynesian arguments for active demand management with monetarist/classical criticisms. Always consider the context — fiscal policy is more effective in a deep recession with spare capacity than in a boom near full employment.
| Year | Chancellor | Key Fiscal Action | Context |
|---|---|---|---|
| 2008-09 | Alistair Darling | VAT cut to 15%, bank bailouts | Global Financial Crisis |
| 2010-15 | George Osborne | Austerity: departmental cuts, VAT to 20% | Deficit reduction |
| 2020 | Rishi Sunak | Furlough scheme (CJRS), Eat Out to Help Out | COVID-19 pandemic |
| 2022 | Kwasi Kwarteng | Mini-budget: unfunded tax cuts | Cost of living crisis; reversed after market turmoil |
| 2023 | Jeremy Hunt | Fiscal tightening, windfall taxes | Restoring market credibility |
The Kwarteng mini-budget (September 2022) is a critical case study. The announcement of £45 billion in unfunded tax cuts caused gilt yields to spike, the pound to fall sharply, and the Bank of England to intervene to prevent a pension fund liquidity crisis. This demonstrated the importance of fiscal credibility — markets must believe the government's fiscal plans are sustainable.