AQA A-level Economics: Fiscal policy: spending, taxation and the policy tools (7136) – Revision Notes

These notes condense the AQA A-level Economics specification (version 1.3, 29 June 2022) sub-section Fiscal policy, numbered 3.2.5.1 on the AQA website (4.2.5.1 in the combined PDF), covering the tools of fiscal policy, public expenditure, taxation and how to assess them. None of this content is labelled AS-only or A-level-only. All countries and figures are invented for illustration. If a point is unclear, go back to the study guide, then try the practice questions. Also useful: the AQA A-level Economics hub, the printable checklist and the free 10-minute diagnostics. Budget balance, national debt and supply-side policies are on separate pages.

Definitions

Term	Meaning
Fiscal policy	Manipulating government spending, taxation and the budget balance
Macro function	Influencing AD, growth, jobs, inflation, the external balance
Micro function	Changing outcomes in particular markets or for particular groups
Current spending	Day-to-day running costs of services
Capital spending	Spending on lasting assets
Transfer payment	Income moved without buying output (pensions, benefits)
Direct tax	On income, profit or wealth; the person taxed bears it
Indirect tax	On spending; collected by sellers and passed on
Average rate	Tax paid divided by income
Marginal rate	Rate on the next unit of income
Crowding out	Public activity reducing private activity

Fiscal policy and aggregate demand

• G is a component of AD, so more G shifts AD right.
• Tax cuts raise disposable income (consumption) or profits (investment).
• Multiplier = 1 / MPW, with MPW = MPS + MPT + MPM.

Method in steps for a multiplier question

1. Add the three withdrawal propensities to get MPW.
2. Divide 1 by MPW.
3. Multiply by the initial injection.
4. For a tax cut, first find the part spent at home. That part is the injection.

Reminder (Country B, illustrative). MPW = 0.40, so the multiplier is 1 / 0.40 = 2.5. A spending rise of 8bn raises income by 8 × 2.5 = 20bn. A tax cut of 10bn, of which 60% is spent at home, gives a first-round injection of 6bn and a rise in income of 6 × 2.5 = 15bn.

Evaluation points: spare capacity (output or prices?), size of the multiplier, time lags, confidence, how the policy is financed, whether the spending is on imports.

Fiscal policy and aggregate supply

• Capital spending on infrastructure lowers costs.
• Education, training and health spending raise labour quality.
• Tax incentives raise the supply of labour, investment and research.
• Successful policy shifts LRAS to the right, raising potential output.
• Evaluate with lags, uncertainty over incentive responses, and project quality.

Pattern of economic activity

Taxes and spending change what is produced, where and by whom. Examples: regional transport spending, a fuel duty shifting demand to rail, subsidies for one industry, a larger public sector crowding out private investment.

Public expenditure

Type	Example
Current	Pay of public sector staff
Capital	New hospital
Transfer	State pension

Reasons: public goods, merit goods, redistribution, externalities, stabilisation, investment in growth.

Level versus share. Country B spends 560bn and GDP is 1,400bn, so public spending is 560 / 1,400 = 40% of GDP. If nominal spending grows 6% and prices rise 2.5%, real growth is 1.06 / 1.025 − 1 = 3.4%.

Taxation

Why tax: revenue, redistribution, behaviour change, demand management, shaping activity.

Classification	Test
Progressive	Average rate rises as income rises
Proportional	Average rate constant
Regressive	Average rate falls as income rises

Method in steps for tax calculations

1. Strip off the allowance.
2. Apply each band’s rate to the slice of income in that band.
3. Add the bands to get total tax.
4. Divide by total income to get the average rate.

Reminder (Country B). Allowance 12,000; 25% on income from 12,000 to 40,000; 45% above 40,000. For income of 50,000, tax = 28,000 × 0.25 + 10,000 × 0.45 = 7,000 + 4,500 = 11,500. Average rate = 11,500 / 50,000 = 23%. Marginal rate = 45%. At 40,000 the average rate is 7,000 / 40,000 = 17.5%, so the average rises with income and the tax is progressive.

A flat charge is regressive. A charge of 200 is 1.25% of an income of 16,000 but 0.25% of 80,000. A proportional tax of 15% takes 3,000 from 20,000 and 12,000 from 80,000, always 15%.

Principles: vertical equity, horizontal equity, benefit principle, efficiency, certainty, low administration cost, flexibility. They often conflict.

Must-know distinctions

• Average rate versus marginal rate. Progressive means a rising average rate, not a rising amount.
• Direct versus indirect. Direct taxes hit the person taxed. Indirect taxes can be passed on.
• Transfer spending versus spending on goods and services. Transfers move income and affect AD only when spent.
• Level versus distribution. Same total tax can have different effects depending on who pays.
• Macro versus micro. One tax can serve both: a tax on a harmful good corrects an externality and raises revenue.

Merits of UK taxes

Tax	Strength	Weakness
Income tax	Progressive, large revenue	Work incentives, avoidance
Corporation tax	Links to ability to pay	May deter investment
VAT	Wide base, hard to avoid	Regressive
Excise duties	Correct externalities	Regressive, evasion
Council tax	Simple local tax	Not linked to current income

Assessing level and distribution

Level: a bigger total of spending or tax shifts AD by more when there is spare capacity and a large multiplier. Distribution: poorer households spend a larger share of extra income, so transfers to them lift AD more than the same sum to richer households. Shifting from direct to indirect taxes tends to make the system less progressive, because low incomes spend more of their income.

Reminder (Country B). Income tax takes 7,000 from a 40,000 earner and 11,500 from a 50,000 earner. After tax they keep 33,000 and 38,500, a ratio of 1.17 to 1 against 1.25 to 1 before tax, so the tax narrows the gap slightly.

Chain: change in spending or tax → effect on AD or AS → effect on output, jobs, prices and equality → judgement that weighs spare capacity, lags, size of the effect and who gains or loses.

Quick self-test

1. State two microeconomic functions of fiscal policy.
2. MPS = 0.2, MPT = 0.1, MPM = 0.2. Find the multiplier.
3. With the multiplier in question 2, find the change in income from a spending rise of 5bn.
4. A tax cut of 20bn leads to 12bn spent at home and the multiplier is 2. Find the change in income.
5. Allowance 10,000 and 30% above it. Find the tax and average rate on 30,000.
6. A fixed charge of 120 is paid by two households on 12,000 and 60,000. Is it regressive?
7. Give one example each of current, capital and transfer spending.
8. Why can a tax on cigarettes be regressive?
9. State the difference between vertical and horizontal equity.
10. Give two reasons a government levies taxes other than raising revenue.

Answers

1. Any two of: correcting externalities with a tax; subsidising merit goods; redistributing income through benefits; protecting a particular industry.
2. MPW = 0.2 + 0.1 + 0.2 = 0.5, so the multiplier is 2.
3. 5 × 2 = 10bn.
4. 12 × 2 = 24bn (not 40bn, because the saved part does not enter the flow).
5. Taxable income 20,000; tax 20,000 × 0.30 = 6,000; average rate 6,000 / 30,000 = 20%.
6. 120 / 12,000 = 1.0%; 120 / 60,000 = 0.2%. The rate falls as income rises, so yes.
7. For example: teachers’ pay (current); a new bridge (capital); a state pension (transfer).
8. It is a fixed amount per pack, and poorer smokers spend a larger share of income on the product.
9. Vertical equity: those with more ability to pay contribute more. Horizontal equity: people in similar circumstances are treated alike.
10. For example: to redistribute income; to discourage a harmful activity; to manage AD.

Where marks are usually lost

• Calling a tax progressive because the amount paid rises, without comparing average rates.
• Applying the top rate to the whole income instead of only the slice in the top band.
• Forgetting the allowance when finding taxable income.
• Using the full tax cut as the injection when part is saved or spent on imports.
• Saying a policy raises output without saying whether there is spare capacity.
• Describing what a tax is but not judging it against a principle of taxation.
• Treating all government spending as the same, when current, capital and transfers differ in effect.
• Giving a one-sided answer where the question says assess or evaluate.
• Mixing up the level of spending (its size) with its distribution (who receives it).

Official syllabus

AQA AS and A-level Economics specification (7135 and 7136), version 1.3, 29 June 2022, published by AQA. Sub-section: Fiscal policy (first part).