Fiscal Policy

Fiscal policy is an instrument of demand management which is used to influence the level of economic activity in an economy through the control of taxation and government expenditure.

The government can use a number of taxation measures to control aggregate demand or spending: direct taxes on individuals (income tax) and companies (corporation tax) can be increased if spending has to be reduced by increasing indirect taxes: an increase in the VAT on all products or excise duties on particular products such as petrol and cigarettes will result in lower purchasing power.

The government can change its own expenditure to affect spending level as well: a cut in purchases of products or capital investment by the government can reduce total spending in the economy.

If the government is to increase spending, it creates a budget deficit, reducing taxation and increasing its expenditure.

A decrease in government spending and an increase in taxes (a withdrawal from the circular flow of national income) reduce aggregate demand to avoid inflation. By contrast, an increase in government spending and/or decrease in taxes – an injection into the circular flow of national income stimulates aggregate demand and creates additional jobs to avoid unemployment.

In practice, however, the effectiveness of fiscal policy can be reduced by a number of problems. Taxation rate changes, particularly changes in income tax, take time to make; considerable proportion of government expenditure on, for example, schools, roads, hospitals and defense cannot easily be changed without lengthy political lobbying.

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