- To improve macroeconomic performance- fiscal policy is used to achieve lower employment, lower inflation, higher economic growth and an improved balance of payments situation. It does this either by influencing the demand side of the economy, which is subject of this unit; or by influencing the supply side of the economy.
- To achieve a more desirable distribution of income and wealth- taxes and government spending are important ways in which government can affect the distribution of income and wealth. It can use fiscal policy to reduce or increase inequality.
- To correct market failure at the microeconomic level- government spending and taxes are used to correct a wide range of market failures including the provision of public and merit goods, discouraging the consumption of demerit goods, improving the mobility of labor and increasing competition in product market.
Fiscal policy can be used to manipulate the level of aggregate demand. A larger budget deficit or a smaller budget surplus will increase the government injection into a circular flow of money. There will be a multiplier impact according to Keynesian economists, where every $1 of extra deficit or reduced surplus will lead to a more tha $1 increase in final GDP. Because of this increase in GDP, policy which leads to larger budget deficit or smaller budget surpluses is known as expansionary fiscal policy.
In contrast, there is deflationary fiscal policy when the government decides to reduce a budget deficit or increase a budget surplus. This reduces the level of aggregate demand by reducing the government injection into the circular flow.
Expansionary fiscal policy should be used when there is a negative output gap and the economy is in recession. In this situation, the level of GDP is below what the long term trend growth of GDP would predict. Unemployment is likely to be above average whilst inflation is low. The rate of growth of GDP may be below average. On the other hand, the current account position may be better than would be the case if the economy were at full employment, a level of employment where there is neither a negative or positive output gap. This is because in a recession, imports will be reduced due to lack of spending both by consumers and firms. Conversely, deflationary fiscal policy should be used when there is a positive output gap and the economy is in boom. GDP is above its long term trend rate, unemployment is below average, inflation is above average whilst the current account position is deteriorating.
In the 1930s, large falls in export earnings and investment spending led to the Great Depression. Today, any reduction in export earnings or investment would have less impact on the economy become automatic or built-in stabilisers are greater. Automatic stabilisers are expenditures which automatically increase when the economy is going into a recession. Conversely, they automatically fall when national income begin to rise.
Government spending and taxation are both automatic stabilisers. When the economy goes into recession and unemployment rises, the government automatically increases its social security spending, paying out more in unemployment benefits and other related benefits. The fall in aggregate demand is therefore less than it would otherwise have been. Tax revenues fall too at a faster rate than the fall in income. This is because tax rates tend to be higher on marginal income than on average income.For instance, a worker paid on commission may sell less in a recession. Her tax rate might then fall from the higher rate of 40 percent to the basic rate of 20 percent.If household spending has to be cut, then it is likely that consumption items such as consumer durables taxed at 17.5 percent VAT will see falls rather than zero rated food. With the government collecting less tax, disposable incomes are higher than they would be the case without this automatic stabiliser.
When the economy goes into a boom, government spending falls as the benefit budget falls automatically. Tax revenue increases at a faster rate than the increase in income. An unemployed person will pay very little tax. Once unemployed person get jobs, they start to pay substantial amounts of direct and indirect tax> so aggregate demand is lower than it would otherwise be with these economic stabilisers.