250 GOVERNMENT

ANDTHEECONOMY 31 FISCALPOLICY

31 FISCALPOLICY
LEARNING
OBJECTIVES

Understandhow to definefiscal policy

Understandthe natureof governmentrevenue:directand indirecttaxes
Understandthe natureof governmentexpenditure:main areasof focus
Understandfiscal deficitsand fiscal surpluses
Understandthe impactof a fiscal deficit and fiscal surplus
Understandthe impactof fiscal policyon macroeconomic
objectives

GETTING
STARTED
A governmenthasa numberof measuresit can useto achieve
its macroeconomic objectives.Thesemeasuresmightbe usedto
controlinflation, bring downunemployment or promoteeconomic
growth, for example.Oneof the measuresit canuseis to adjust
levelsof governmentexpenditure on publicservices,suchas
defence,educationand healthcare.Eachyear,the government
hasto decidehowmuchwill be spenton eachserviceandhow
muchwill be spentin total.Thegovernmentalsohasto decide
howthe moneywill be raisedthroughtaxationandhow muchwill
be borrowed.Lookat the informationbelow.

CASESTUDY:
CANADIAN
PUBLIC
FINANCES
2015
In 2015, the Canadian government planned to spend CAD3 688 OOOmillion on a range of government services.
Figures 31.1 and 31.2 show the spend ing and revenue plans for the year.
295 OOO D Health D Persona l income tax
1 062 OOO
D Social secur ity D Corporate taxes
D Defence 1 541 000
D Social insurance taxes
509000 D Income secur ity D Other taxes
D Interest D Deficit
D Educat ion
• Others 344000
• Figure31.1Canadianplannedgovernmentexpenditure • Figure31.2Canadianplannedincome2015(CADmillion)
2015(CADmillion)

1 What is meant by government expenditure? Use examp les from this case to support your answer.
2 Which item of government expenditure in Canada is the most expensive?
3 Which is the most important source of income for the Canadian government?
GOVERNMENT
ANDTHEECONOMY 31 FISCALPOLICY 251

POLICY
INSTRUMENTS
The government can use a number of tools to help achieve its macroeconom ic
objectives. These are called policy instruments . Policy instruments are
SUBJECT
VOCABULARY
economic variables such as the rate of interest, rates of taxation and levels of
policy instruments tools governments government expenditure . The government can adjust them directly or indirectly.
use to implement their policies, such Changes in policy instruments can affect other variables in the economy, such
as interest rates, rates of taxation, as aggregate demand, inflation, unemployment and GDP. For example, if the
levels of government spending
government increases income tax rates, there is likely to be a fall in aggregate
demand because peop le will have less disposab le income to spend .

FISCALPOLICY One important policy instrument is fiscal policy. This involves adjusting levels
of government expenditure and taxation to influence aggregate demand in the
SUBJECT
VOCABULARY economy. Fiscal policy can be used to influence the behaviour of firms and
budget government's spending and individuals. For example , many governments place heavy taxes on cigarettes
revenue plans for the next year to discourage consumption of this harmful product.
fiscal policy decisions about
Every year, the government plans how much it is going to spend on each
government spending, taxation
and levels of borrowing that affect
category of expenditure . The government also shows how the money is going to
aggregate demand in the economy be raised and states how much it plans to borrow. These plans are published in
the government's budget. In 'Getting started ', Figures 31.1 and 31.2 showed the
spending and revenue plans for the Canadian government in 2015.

GOVERNMENT
REVENUE The main source of revenue for a government is taxation . Governments all over
the wor ld impose taxat ion for the following reasons.
• To pay for public sector services.
• To discourage certain activities . For example, in some countries, taxes are
imposed on cigarettes to discourage smoking because it is dangerous .
There is also a tax on dump ing rubb ish in landfi ll sites . This is to encourage
everyone to reduce waste .
• Taxes can be used to help to contro l aggregate demand in the economy .
This is discussed in more detail later.
• The distribution of wealth in the economy can be made fa irer. Taxing the
wealthy more heavily than the poor achieves th is. This is discussed in
Chapter 30 (pages 240-249) .

DIRECT
TAXES
Most government taxes fall into two categor ies. Direct taxes are taxes
SUBJECT
VOCABULARY
imposed on firms and ind ividuals . They are usually linked to income and
direct taxes taxes levied on the wealth . Some of the key direct taxes used around the world are out lined below .
income earned by firms and individuals
• Income tax is a direct tax on the amount earned by an individual. It is a
common and important tax worldwide. Both employed and self-employed
peop le have to pay this tax .
• Social insurance taxes are like income tax. They are imposed on people 's
income. However , the money co llected is used specifical ly for pensions,
benefits and health care. In 'Getting Started', Canada planned to raise
CAD1 065 OOOmillion in social insurance taxes in 2015 .
• Corporat ion taxes are levied on the prof its made by limited companies .
Other types of business, such as partnerships and sole traders, are likely to
pay income tax.
• Capital gains tax is levied on any financia l gains made when selling assets
at a profit. Assets such as shares, businesses and properties attract capital
gains tax.
252 GOVERNMENT
ANDTHEECONOMY 31 FISCALPOLICY

• Inheritance tax is paid on money that is inherited from peop le who die.
However , in most countries where this tax is used, a certa in amount of
money can be passed on to relatives, friends and other benefactors before
this tax applies.

INDIRECT
TAXES
Any tax on spend ing is an indirect tax. Some of the main indirect taxes used
SUBJECT
VOCABULARY
around the wor ld are described briefly below.
indirect taxes taxes levied on
• Sales tax es are taxes on spending . For examp le, EU countries use value-
spending, such as VAT
added tax . In Denmark , Belgium and Italy, the standard rates of VAT are 25
valued-added tax (VAn tax on some
per cent , 21 per cent and 22 per cent, respective ly. However, some goods
goods and services - businesses pay
value-added tax on most goods and such as food , books , drugs and medicines and pub lic transport may be zero
services they buy and if they are VAT rated 0/AT = 0 per cent) . Also, firms with a small turnover do not have to
registered , charge value-added tax on charge VAT.
the goods and services they sell • Dutie s are often heavy taxes on a select range of goods. In some countries,
goods such as petro l, cigarettes and alcohol attract quite heavy duties .
• Custom s dutie s are taxes levied on imports. In the UK, goods coming in
from a country that is not a member of the EU attract customs dut ies.
• Council ta x is collected by local authorit ies to help pay for local services
such as refuse co llection. It is levied according to the value of residential
property and is paid by the occupants .
• Business rates are also co llected by local author ities and contribute to
the provision of local community services. However, they are paid by
businesses and are levied according to the value of business property .
• Stamp duties are paid when buying certain assets, such as houses and shares.

ENVIRONMENTAL
TAXES
These are des igned to protect the environment. Below are some examples .
• Landfill tax is imposed on the disposal of waste in landfill sites. The charge
is usually linked to the weight of waste dumped in a landfil l site.
• Climat e change levies are used to help countri es meet their commitment
to reduc ing greenhouse gases. It is paid mainly by the supp liers of
electricity , gas and coal , for example.
• Aggregates levy is a tax on sand , gravel and rock that is dug from the
ground . The tax is designed to reduce the environmenta l damage caused by
quarrying .

ACTIVITY
1

CASESTUDY:
TAXATION
IN GHANA

In 2016 , the government of Ghana planned to raise GHS 38 OOOmillion

to help fund its spending plans. Figure 31.3 shows the main sources
of this revenue. Ghana uses both direct and ind irect taxes to generate
government revenue. Ghana's tax regime include the fol lowing features.
• A fairly progressive income tax system is used with tax rates of 0, 5,
10, 17.5 and 25 per cent on rising bands of income .
• Companies have to pay a standard rate of 25 per cent in corpo ration
tax on their profits.
GOVERNMENT
ANDTHEECONOMY 31 FISCALPOLICY 253

• Some business activities , such as mining and petroleum activities, are

taxed more heavily at 35 per cent.
• Companies exporting non-traditional goods and those involved in waste
management are taxed less at 8 per cent and 1 per cent, respectively.
• A standard rate of VAT is charged at 15 per cent. Some goods and
services, such as food, water and education services, are exempt.
• A national health insurance levy (NHIL) of 2.5 per cent is also charged
on spending.
• Other taxes used by Ghana include customs and excise duties , airport
tax, and environmental taxes on the production of plastics and a
special petroleum tax.
1900
D Taxes on incom e and property
D Taxes on domestic goods and services
D Taxes on internation al trade
D Non- tax revenue
D Social contributions and grants
113 00
A Figure31.3 Plannedsourcesof governmentrevenue,Ghana,2016(GHSmillion)

1 What is the difference between direct taxes and indirect taxes?

2 What is meant by (a) VAT and (b) customs duties?
3 Discuss which of Ghana's taxes might help protect the environment.

GOVERNMENT
EXPENDITURE Total planned expenditure and the amount to be spent on each category is
announced every year in the budget. Figure 31.1 in 'Getting started ' shows
the amount of money the Canadian government planned to spend in 2015.
Some countries divide government spending into mandatory spending and
discretionary spending. The levels of mandatory spending are determined
by current systems. For example, when someone is made redundant they
are entitled to claim Jobseeker's Allowance. These payments are made
automatically. The government is legally obliged to meet them. Discretionary
spending is 'extra' or 'new' spending. An example would be money provided
for a new motorway. The main areas of focus for government spending in most
countries are outlined in Table 31.1.

CATEGORIES MAINEXAMPLES
Socialprotection Statebenefits,pensions , child benefits,jobseekersallowancesanddisability
allowances
Healthcare Salariesof nurses, doctorsandadminstaff;drugsand medicines;equipment
andcareprogrammes
Education Teachers
' salaries,equipmentfor schoolsand studentgrants
Defence Maintenance of the armedforces(anny, navyandair force)
Interest Theinterestpaidon governmentborrowingssuchas the nationaldebt
Publicorder/safety Spendingon the policeforce,fire service,prisonservice, the justicesystem
and healthand safety
Socialservices Spendingonthe careof children,theelderlyandpeoplewith learningdisabilities
Other Transport,housingandthe environment,
industry, agriculture,training,and
recreation
A Table31.1 Government
expenditure- mainfocusareas
254 GOVERNMENT
ANDTHEECONOMY 31 FISCALPOLICY

FISCALDEFICITS
ANDFISCAL
In most years , many governments plan to spend more than they receive in tax
SURPLUSES
revenue. This results in a fiscal deficit and means that the government must
borrow money to fund the deficit. For example , in 'Gett ing started', Figure
SUBJECT
VOCABULARY
31.2 showed that Canada planned to borrow CAD439 OOOmillion. This money
might be borrowed from both domestic and foreign banks and possibly other
fiscal deficit amount by which
governments .
government spending exceeds
government revenue If the government were to spend less than it received in tax revenues, there
fiscal surplus amount by which would be a fiscal surplus . This may be used to repay government debts.
government revenue exceeds Figure 31.4 shows the pattern of fiscal deficits and surpluses for Sweden
government spending between 2008 and 2015. At the beginning of the period , Sweden enjoyed
a number of fiscal surpluses . However, from 2009 to 2014, the government
spent more than it received in revenues. Finally, in 2015, the Swedish
government managed to generate another surp lus.

15 000 -en
<.O
10000 - fg
'°

ea
1;l -1 0000
u::
Year

• Figure31.4 Fiscalbalancesfor Sweden

, 2005--15(€ million)

FISCALDEFICITS
Over a long period of time , most governments would prefer to avoid running
a fiscal deficit. In a year when the government plans to overspend, it will have
SUBJECT
VOCABULARY to borrow money to fund the deficit. Consequently, if deficits build up over
national debt tota l amount of money a period of time , the national debt gets bigger and bigger. This means that
owed by a country the government has to spend more and more of its revenue on paying off the
debt. Many would argue that money spent on interest payments has a high
opportunity cost. For example, the money cou ld be spent on lower taxes or
extra spending on social provision or infrastructure development.
Another problem with persistent fiscal defic its and rising national debt is that
future generations may be burdened with the debt of 'today '. Many wou ld
argue that this is not really fair on those people that have not even been born
yet. They will be paying for the excesses of previous generations .

FISCAL
SURPLUSES
The impact of a fiscal surplus is likely to be positive . If a government co llects
more revenue than it spends in a year, the surplus could be used in a number
of ways . For examp le, it cou ld be used to spend on the future provision
of publ ic services or used to lower taxes in the economy . However, most
governments would use it to pay off some of the national debt. This wou ld
reduce future interest payments and strengthen the nation 's finances.
Finally, when analysing the size of fiscal deficits, it is more important to focus
on the size of the deficit in relation to the nation 's GDP. This is because
GOVERNMENT
ANDTHEECONOMY 31 FISCALPOLICY 255

th e amount that needs to be borrowed to cove r the deficit is only a serious

problem if it is a large percentage of the GDP. It is like an individual taking out
a loan. If an individual has an income of US$80 OOO,a US$5000 loan is fa irly
easy to pay back over a few years. However, someone earning just US$15 OOO
a year may struggle to meet t he interest and loan repayments on US$5000.
This is because the loan is equal to one-th ird of t he person's annual income .
It might be quite a burden . Therefo re, when analysing fiscal deficits and
making international compar isons, it is best to express the deficit as a
percentage of GDP.

ACTIVITY
2

CASESTUDY:
FISCAL
BALANCES
IN LUXEMBOURG

The small European state of Luxembourg has a populat ion of just under
600 OOO.However , it has a high GDP per capita at just over €89 OOOper
head , a stable economy w ith low unemployment and sou nd eco nomic
growth . Abo ut one-th ird of Luxembourg 's GDP is generated from banking
services . The country had a reputat ion fo r banking secrecy unti l 2015
when the EU fo rced Luxembourg to reveal tax informat ion on savings
accounts held in Luxembourg 's banks. Other EU rulings relating to t he
way Luxembourg col lected tax revenues meant that the government had
to raise add itional levies and cut its expenditure by reducing some soc ial
benefits. Figure 31.5 shows the fiscal balances for Luxembourg between
2005 and 2015 .
'<l"

2000 - ~- <:q
c
~ '°
~
'°
<D
(\J
.E 1500 -
~
Q) 1000 '°
'j,
u <D
c('(l
ea 500 ~ (") -
.D (\J

ea
u 0
(/)
2005 2006 2007 2008
i.i: -500

Year
.&. Figure31.5 Fiscalbalancesfor Luxembourg,
2005-15(€ million)

1 In which years did the Luxembourg government overspend? Account

for your answe r.
2 Comment on the patte rn of Luxembourg 's fiscal balances over the
period .
3 Describe the poss ible impact of the balances described in (2) on
Luxembourg.

THEIMPACT
OFFISCALPOLICY
ON
Fiscal policy is also used to influence aggregate demand in the economy. In
MACROECONOMIC
OBJECTIVES some years, a government may increase the size of a budget deficit (or reduce
a surplus) , by spending more or tax ing less, to stimulate the economy . This is
GENERAL
VOCABULARY
cal led expansionary fiscal policy. In contrast , it may be necessary to reduce
stimulate to encourage an activ ity to aggregate demand . In this case, the government will plan to reduce the size
begin or develop further
of a deficit (or inc rease a surplus) by spending less or taking more in tax. This
256 GOVERNMENT
ANDTHEECONOMY 31 FISCALPOLICY

SUBJECT
VOCABULARY is called contractionary fiscal policy . Some examp les of the impact of fiscal
policy on macroeconomic objectives are outlined below .
expansionary fiscal policy fiscal
measures designed to stimu late
demand in the economy INFLATION
contractionary fiscal policy fiscal Contractionary fiscal policy can be used to reduce inflation. If it is thought that
measures designed to reduce demand inflation is being caused by aggregate demand growing too quickly, measures
in the economy can be taken to reduce demand. The government could cut its own spending
levels or raise taxat ion. Increases in taxes w ill reduce disposable income and
therefore reduce demand , relieving inflationary pressure.

ECONOMIC
GROWTH
Expansionary fiscal policy can be used to help stimulate economic growt h.
Increases in government expend iture will increase aggregate demand. For
examp le, if more civil servants and council workers are employed , t here will
be more demand for most goods and services as people who were previously
unemployed take up the new jobs . Cuts in taxes will also generate more
demand because firms and households w ill have more money to spend .
Economic growth is more likely to result from extra government expenditure
on capital projects, such as new schools, transport links and airports. This is
because money spent on investment is t he key to economic growth.

UNEMPLOYMENT
Expansionary fiscal policy can help to reduce unemployment. Again increases
in government expend iture and tax cuts can help to stimulate demand . To
meet this extra demand , firms wil l have to produce more. This means more
staff wil l be taken on and unemployment will fall. The government could help
by directing its extra spend ing on construction projects , such as building
new hospitals , motorways and rail links. The construction industry is labou r
intensive, which means that job creation w ill be higher.

CURRENT
ACCOUNT
DEFICIT
Fiscal policy might be used to help influence the balance on the current
account. For example, if t here is a large defic it on the current account,
contractiona ry fiscal policy will help reduce aggregate demand . This wil l help
to reduce the demand for imports .

FISCALPOLICY
ANDTHEENVIRONMENT
More recently, governments have used fiscal policy to tackle environmental
problems. For example, taxes such as landfi ll tax , the climate change levy
and the aggregates levy, have been used to help reduce environmental
damage . These are explained above. Some governments also use subsidies to
encourage activities that are environmenta lly friendly. For example, in the USA,
subsidies have been given to the produce rs of environmental ly friendly fuels.

MULTIPLE-CHOICE
QUESTIONS
.... 1 In 2016 , a government spends €654.5 million and collects €631.6 million
in revenue. As a result, the fiscal balance for the year wou ld be which of
t he following?
A €654 .5 million defic it
B €22.9 million surplus
C €1286.1 million surplus
D €22.9 million deficit
GOVERNMENT
ANDTHEECONOMY 31 FISCALPOLICY 257

..,. 2 Which of the following fisca l measures is likely to increase a fiscal

deficit?
A An increase in spending on education
B A rise in VAT
C A cut in pension payments
D A rise in corporation tax

CASESTUDY:
RECENT
FISCAL
POLICY
IN GREECE
In recent years, Greece has used contractionary fiscal policy in an effort
to achieve a specific macroeconomic object ive. The aim of Greek fiscal
policy has not been to reduce aggregate demand to reduce inflation but
to cut its huge fiscal deficit. The globa l recession in 2008 hit Greece very
hard, however, Greece also had other problems. Both private sector and
public sector debt was very high indeed . From 1999 to 2008, private
sector debt as a proportion of GDP more than doubled from 59 per cent
to 126 per cent. The ratio of public sector debt to GDP was around 100
per cent over the same period. During this period, consumers, bus inesses
and the government spent heavily. This was reflected in the booming level
of imports . However, when the financial crisis hit the world in 2008, those
with debt struggled to repay what they owed . In an effort to reduce debt,
households and businesses cut their spending and unemp loyment rose.
Greece was forced to borrow from the EU and the IMF. Figure 31.6 shows
the Greek and EU fisca l balances between 2005 and 2015 .

2 2015
2005 2006 2007 2008
0
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<.'.)
-4 "'"
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-6
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(tl
<ii -8
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.0 I I I
00
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<ii -10 a:i I
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&:-12 ci
,.... ('!
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,.... 0 Greece
I ,.... I
-14 r (\J
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,... ,.... 0 EU(28)
-16 U) I
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I

A Figure31.6Greeceand EUfiscal balances,2005-15 (%GDP)

The loans granted to Greece came with cond itions . The country had to
raise revenues and cut government spending . Greece has raised many
of its taxes many times in the last few years. Some examp les are shown
below .
• In 2013 , corporation tax rates rose from 20 per cent to 26 per cent and
a top rate of income tax of 42 per cent was to be imposed on incomes
above €42 OOO.
• In 2016 , corporation tax was increased again to 29 per cent.
• Rates of VAT increased from 19 per cent in 2010 to 24 per cent in 2016 .
• New property taxes were introduced and existing ones increased .
• A range of other taxes and duties were increased .
258 GOVERNMENT
ANDTHEECONOMY 31 FISCALPOLICY

The government also agreed to cut its spending . Figure 31.7 shows
the levels of government spending in Greece between 2007 and 2016 .
Spending was reduced from around €14 OOOmillion to just under €10 OOO
million over the period. This is qu ite a significant cut and was achieved by
making cuts to most of the various government departments . For examp le,
the government raised the retirement age to reduce pens ion payments
and made big cuts in benefits , educat ion, defence and many other areas.

g> 15 000
'6
aj 14000
a.c
w .Q 13000
c :=
~ E 12000
c~
ai 11 OOO
>
8 10000
9000 -'--~~~~~~~~~~~---+
2008 2010 20 12 20 14 20 16
Year
• Figure31.7Greekgovernmentspending,2007-16(€ million)

CHAPTER
QUESTIONS
1 Describe what fisca l defic it is.
2 Why is it important to express a fiscal deficit as a percentage of GDP?
3 Describe Greece's fiscal position between 2005 and 2015.
4 What is meant by contractionary fiscal policy? Use the example in th is case
to support your answer.
5 Consider the possible impact on Greece of a persistent fiscal deficit.