5.2 Fiscal policy

A government budget sets out expected public revenue and expenditure for a period. Current spending covers items such as wages and transfers; capital spending creates or improves assets; revenue mainly comes from taxes and other receipts.

The budget position is a flow over the period, not the stock of debt already accumulated. A budget balance compares revenue with expenditure before financing decisions are considered.

If revenue is 500 and total spending is 540, the government must finance a 40 budget shortfall, usually by borrowing or using reserves.

A budget is not the same as the national debt, and a budgeted figure is not necessarily the final outturn.

A budget deficit occurs when government expenditure exceeds revenue during a period. A budget surplus occurs when revenue exceeds expenditure; a balanced budget has equal flows.

The sign describes the current period’s balance, not the accumulated debt. A deficit may be deliberate fiscal stimulus or the result of weak tax receipts and higher welfare payments during a downturn.

Revenue of 700 and spending of 760 give a deficit of 60. If next year’s revenue is 780 and spending 750, that year has a surplus, but the earlier debt need not disappear.

A surplus does not automatically mean debt fell: interest, refinancing and asset transactions also affect the debt stock.

National debt is the outstanding stock of government borrowing. Persistent deficits add to it; surpluses can reduce it, although interest and refinancing also matter.

Debt is often judged relative to GDP because a larger economy has a larger potential tax base. The burden depends on interest rates, growth, maturity, currency, and what the borrowing financed—not simply on the headline amount.

A government can run a deficit of 5 this year and add roughly that flow to debt, while debt-to-GDP still falls if nominal GDP grows faster than the debt stock.

Debt is not the same as the annual deficit, and borrowing for productive investment need not have the same consequences as borrowing for persistent current spending.

Taxation is a compulsory payment to government. Direct taxes are charged on income or wealth; indirect taxes are charged on spending or transactions. Taxes can raise revenue, redistribute income and change incentives.

The legal payer is not always the person bearing the economic burden: tax incidence depends on the relative elasticities of demand and supply. A tax can also create deadweight loss if it prevents mutually beneficial trades.

A per-unit tax on a product shifts supply upward; if demand is relatively inelastic, consumers bear more of the price increase, while the government receives the tax revenue.

A progressive tax schedule is not the same as an indirect tax, and raising a tax rate does not guarantee proportionally higher revenue if behaviour changes or the tax base shrinks.

Government spending includes current spending on services and transfers, and capital spending on assets such as infrastructure. It affects aggregate demand directly when the government buys goods and services.

Spending on transfers changes household disposable income and may alter consumption; spending on education, health or infrastructure can also affect long-run productivity. Classify the channel before predicting the macroeconomic effect.

Building a rail link is a direct demand injection and may later raise productive capacity. A benefit payment mainly affects demand through the recipient’s consumption decision.

All government spending is not equally productive, and a larger budget does not automatically mean a larger AD shift if taxes, imports or saving offset it.

An expansionary fiscal stance raises aggregate demand through higher spending, lower taxes or larger transfers. A contractionary stance restrains demand through lower spending or higher taxes; a neutral stance broadly leaves the demand impulse unchanged.

Judge the stance by its effect relative to the existing position, not just by whether the budget is in deficit. Automatic stabilisers can make the balance move without a new discretionary decision.

A tax cut during a recession is expansionary even if the government still reports a deficit. A spending cut that reduces an existing deficit is contractionary, although debt may remain high.

A deficit is not synonymous with expansionary policy: a deficit can widen automatically in a downturn while discretionary policy is tightening.

A change in government spending, taxation or transfers can shift aggregate demand. The final effect on real output and prices depends on the marginal propensity to consume, spare capacity, imports and the response of interest rates and supply.

The multiplier is larger when extra income creates repeated domestic spending and smaller when saving, taxation and imports leak out. Public investment may also shift long-run aggregate supply after a delay.

A road-building programme raises demand for construction inputs; workers’ extra income can support further spending, but imported materials and saving reduce the domestic multiplier.

The initial spending change is not the final GDP change, and fiscal expansion near capacity is more inflationary than expansion with substantial spare resources.