Fiscal Policy: When Governments Play Money Games

Fiscal Policy: When Governments Play Money Games

How do governments try to fix the economy when things go pear-shaped? They don't just cross their fingers and hope for the best (though sometimes it might seem that way). Let's cover some basic notions of fiscal policy – where taxes and government spending become the ultimate economic chess pieces.

What Even IS Fiscal Policy? (Besides a Boring-Sounding Term)

Imagine the following situation: the economy is like your favourite HBO series that's gone off the rails. Unemployment is skyrocketing faster than Taylor Swift concert tickets, growth is slower than your internet during a family Zoom call, and inflation is making your pocket money worth less than your old Pokémon cards.

Fiscal policy – the government's way of saying, "We've got this" (or at least, "We're going to try").

Simply put, fiscal policy is when the government messes about with taxes and their own spending to influence the economy. It's like your parents adjusting your allowance and household chores to influence your behaviour – but on a national scale with billions of pounds at stake.

Why Should You Care? (Besides getting a 6 or a 7 in Your IB Economics Exam)

1. It affects your future wallet – Taxation redistributes income and wealth, potentially making society more equal and improving living standards for everyone.

2. It's the ultimate mood-setter for the economy – By directly influencing aggregate demand (AD), the government can either pump up the economic party (expansionary policy) or calm things down when the party's getting out of hand (contractionary policy).

How Governments Fill Their Piggy Banks

Taxation: The Not-So-Optional Contribution System

There are two main flavours of taxes:

Direct taxes – These hit your income and wealth directly. Think income tax that makes your first pay check so disappointing, inheritance tax, or the profits tax that makes companies grumble.

Indirect taxes – These sneaky taxes are added when you spend money. That extra £2 on your petrol, the painful addition to your festival cider, or the tax that makes vaping cost a small fortune.

Real-world example: In April 2022, the UK slapped a Plastic Packaging Tax on packaging with less than 30% recycled plastic. Companies now pay £200 per tonne for non-compliant packaging – pushing businesses toward sustainability while filling government coffers.

State-Owned Enterprises: The Government Business Empire

Revenue also comes from state-owned enterprises – think Royal Mail before privatisation, the BBC, or Network Rail. Unlike private businesses that are all about the profits, these typically aim to break even and provide services.

Real-world example: Transport for London (TfL) generates revenue through tube, bus and train fares, which then gets reinvested into running and improving London's transport system.

Selling Off the Family Silver: Privatisation

When governments need a quick cash injection, they sometimes sell off state-owned assets to private shareholders. It's like having a national garage sale!

Real-world example: When the UK government privatised Royal Mail in 2013, it raised £3.3 billion. The catch? It's a one-time deal – you can only sell the postal service once (unless you nationalise it again, but that's an issue for a whole separate blog post).

Where Does All That Money Go?

Governments spend money for two big reasons:

1. To make society more equal by redistributing wealth

2. To boost the economy by increasing aggregate demand

They do this through:

Current Expenditures: The Day-to-Day Stuff

This is like your everyday spending – the economic equivalent of your Netflix subscription, lunch money, and phone bill.

Real-world example: In 2023/24, the UK government spent about £267 billion on health services alone – paying NHS staff, buying medical supplies, and keeping the lights on in hospitals. This is currently a major source for debate in the UK, whether or not this amount should be reduced to the absolute bare minimum.

Capital Expenditures: The Big Investment Projects

This is like saving up for a laptop that will help you study better – but on a massive scale. These are investments in the nation's future productivity.

Real-world example: HS2, despite its controversies and budget cuts, represents a classic capital expenditure aimed at improving UK infrastructure for decades to come. The current estimated cost? A whopping £67 billion for just the London to Birmingham section!

Transfer Payments: The Robin Hood Mechanism

These payments move money from the general tax pot to specific groups who need support – without the government getting any goods or services in return.

Real-world example: In the UK, Universal Credit supports about 5.8 million people as of early 2023, with standard allowances ranging from £292.11 to £578.82 monthly depending on age and relationship status.

The Grand Goals of Fiscal Policy

1. Keeping Inflation Under Control

When prices are rising faster than your OnlyFans follower count, the government might step in with contractionary fiscal policy – raising taxes or cutting spending to cool things down.

Real-world example: After inflation hit a 41-year high of 11.1% in October 2022, the UK government and Bank of England had to coordinate policies to bring it down, with inflation finally falling to around 4% by early 2024.

Imagine it like this: If the economy is a bathtub about to overflow (inflation), contractionary fiscal policy is turning down the taps (reducing AD) to bring the water level down to something reasonable.

Economists we like to imagine it like this: Contractionary fiscal policy e.g., the use of higher tax rates and / or deliberate use of a budget surplus, reduces consumption (C), investment (I) and government spending (G), shifting the AD curve from AD1 to AD2. This shrinks real GDP from Y1 to YF (which closes the inflationary gap} and reduces the average price level from PL1 to PL2.

2. Fighting Unemployment

When jobs are disappearing faster than free food at a university event (yep, some of us used these events to stockpile food for future emergencies!), expansionary fiscal policy can save the day.

Real-world example: During the COVID-19 pandemic, the UK government introduced the furlough scheme, spending £70 billion to support 11.6 million jobs and prevent mass unemployment when the economy essentially shut down.

It works like this: Tax cuts mean people and businesses have more money to spend (increasing C and I), while government spending (G) directly creates economic activity. Together, they shift the AD curve right, creating more jobs.

We economists, like to imagine this situation like this: Tax cuts help to increase the level of consumption (C) and investment expenditure (I), along with increased government spending (G) help to increase the level of AD from AD1 to AD2. This raises real GDP from Y1 to Y2 which leads to more employment opportunities and lowers unemployment.

3. Creating Stable Vibes for Long-Term Growth

Thoughtful tax policies can make or break an economy's long-term prospects.

Real-world example: Ireland's 12.5% corporate tax rate has attracted massive investment from tech giants like Apple, Google, and Meta, creating a tech hub that employs thousands. In contrast, when France introduced a 75% super-tax on high earners in 2012, it prompted some wealthy citizens to leave the country before the policy was eventually scrapped in 2015.

4. Smoothing Out the Economic Rollercoaster

Fiscal policy can make the business cycle less extreme – like economic shock absorbers.

Real-world example: During recessions, UK spending on Universal Credit automatically rises while tax revenues fall. This automatic stabiliser helps maintain some spending in the economy without requiring new legislation each time.

5. Making Society More Equal

Progressive taxation can reduce the gap between the haves and have-nots.

Real-world example: In the UK, the top 1% of income tax payers contribute about 29% of all income tax receipts, with the money helping fund public services used by everyone – a major redistributive effect.

6. Balancing International Trade

Keeping exports and imports in harmony is crucial for long-term economic health.

Real-world example: The UK has consistently run a trade deficit (importing more than it exports) for decades. In February 2024, this deficit widened to £14.3 billion, creating long-term challenges that fiscal policy might need to address through export incentives or import taxes.

Economists imagine this situation like this: The external balance is the value of a nation’s exports (X) being equal to its imports (M), that is, X = M. Indirect taxes levied on imports and / or government subsidies paid to domestic exporters will generally increase the external balance as X > M but leads to inflationary pressures as more money flows into the economy. If M > X, the economy experiences a negative external balance, spending more than it earns from international trade, which is not sustainable in the long run. Fiscal policies can be used to achieve an external balance, which is considered essential for the country’s long-term economic growth.

The Bottom Line

Fiscal policy is basically the government's economic Swiss Army knife – incredibly versatile but also complicated to use effectively. When you see headlines about the Budget, tax changes, or new government spending programs, you're watching fiscal policy in action!

Next time: We'll dive into how economists measure whether fiscal policy is actually working (spoiler: believe it or not, it's not just "vibes").

Stay well