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

Written for the A-level, this guide works from the AQA AS and A-level Economics specification (version 1.3, 29 June 2022). It covers the first part of the sub-section called Fiscal policy: site-map number 3.2.5.1, printed as 4.2.5.1 in the combined PDF. You will meet the tools, their effects, the kinds of spending and tax, and how to assess them. Nothing in this content is labelled AS-only or A-level-only. All countries, households and numbers are invented.

Use the revision notes and the practice questions. Related pages are aggregate demand and supply, government intervention in markets, the AQA A-level Economics hub and the printable checklist. To find weak spots first, try the free 10-minute diagnostics. The budget balance, the national debt and supply-side policies have their own pages, so this one only touches them.

What this guide covers

Specification point	What you must be able to do
Manipulation of spending, taxation and the budget balance	Name the tools and say what each changes
Macro and micro functions	Give examples of each
Influence on aggregate demand and aggregate supply	Chain the effects, with a multiplier calculation
Pattern of economic activity	Show how spending and tax shift resources between uses
Types of and reasons for public expenditure	Classify spending and justify it
Why governments levy taxes; direct and indirect; progressive, proportional, regressive	Define, calculate and classify
Principles of taxation; merits of different UK taxes	Judge taxes against criteria
Level and distribution of spending and taxation	Assess their economic significance

The tools of fiscal policy

Fiscal policy means deliberately adjusting what the government spends, what it raises in tax and the resulting budget balance. The government can change how much it spends, what it spends on, how much it raises in tax, which taxes it uses and who pays them. Because spending and tax revenue together fix the budget balance, any change in either alters it. Whether the resulting deficit or surplus is wise is a separate question, covered elsewhere.

Fiscal policy has two kinds of function:

• Macroeconomic: influencing aggregate demand, the economy’s growth, employment, inflation and the balance of payments. Cutting taxes in a downturn is a macro use.
• Microeconomic: changing outcomes in particular markets or for particular groups. A tax on a harmful product, a subsidy for a merit good or a benefit for low-income households is a micro use.

One measure often does both. A rise in tax on tobacco corrects an externality in one market and also raises revenue.

Influencing aggregate demand

Aggregate demand is C + I + G + (X − M). Fiscal policy acts on it in two ways.

• Government spending (G) is a direct component. A rise shifts AD to the right.
• Taxation works indirectly. Lower income tax raises disposable income and so consumption. Lower corporation tax can raise investment. Higher taxes do the reverse.

A change in G or in tax causes a bigger change in income through the multiplier. The multiplier is 1 divided by the marginal propensity to withdraw (MPW), where MPW = marginal propensity to save + to pay tax + to import.

Worked example (Country A, illustrative). MPS = 0.10, MPT = 0.20, MPM = 0.20.

1. MPW = 0.10 + 0.20 + 0.20 = 0.50.
2. Multiplier = 1 / 0.50 = 2.
3. Government spending rises by 6bn. Change in income = 6 × 2 = 12bn.

Now compare a tax cut of 6bn. Households save or spend on imports 30% of it and spend 70% at home, so the first-round injection is 6 × 0.7 = 4.2bn. Income rises by 4.2 × 2 = 8.4bn. Spending gives a bigger boost than an equal tax cut because the whole sum enters the circular flow at once.

Chain of reasoning: government spending rises → AD shifts right → firms with spare capacity raise output and hire → incomes rise → further spending (multiplier) → real GDP and employment rise. If the economy is near full capacity, the same shift mainly raises the price level.

Influencing aggregate supply

Fiscal policy can also change productive capacity, mostly over the longer run.

• Capital spending on roads, rail or digital networks lowers firms’ costs and raises productivity.
• Spending on education, training and health improves the quality of labour.
• Tax incentives can raise the supply of labour (lower income tax on extra earnings), investment (lower corporation tax or allowances for equipment) or research.

A successful policy shifts long-run aggregate supply right, raising potential output and lowering inflationary pressure at any given growth rate. Evaluate with time lags, uncertainty over how far people respond to incentives, and the fact that a project may be badly chosen.

The pattern of economic activity

Spending and tax change what is produced, where and by whom.

• Spending on a new rail line moves jobs and investment to the regions it serves.
• A tax on fuel raises the relative cost of road transport, shifting demand to rail and encouraging fuel-efficient vehicles.
• Higher public spending raises the public sector’s share of output. Heavy borrowing to fund it may raise interest rates and reduce private investment (crowding out), shifting activity from private to public use.
• Subsidies shift resources towards the favoured industry at the expense of others.

Types of and reasons for public expenditure

Public expenditure falls into three types:

• Current spending on the day-to-day running of services, such as teachers’ and nurses’ pay.
• Capital spending on assets that last, such as hospitals and roads.
• Transfer payments such as pensions and unemployment benefit, which move income without buying output.

Reasons: provide public goods (private markets will not); provide or subsidise merit goods such as education and health; redistribute income; correct externalities; stabilise the economy; and invest in capacity for growth.

Country A’s spending (illustrative, billions; GDP = 1,000).

Category	Amount	Share of total	Type
Social protection	140	35.0%	Transfer
Health	100	25.0%	Current
Education	60	15.0%	Current
Defence	30	7.5%	Current
Transport infrastructure	40	10.0%	Capital
Public order and other	30	7.5%	Current
Total	400	100%	40.0% of GDP

Transfers are 35% of the total, capital spending 10%, and current spending on goods and services 55%. The model is simplified, as real health and education budgets contain some capital items.

Why governments levy taxes

• Raise revenue to pay for public expenditure.
• Redistribute income and wealth through progressive taxes and benefits.
• Change behaviour and correct market failure, for example taxing a good with negative externalities.
• Manage aggregate demand by raising or cutting tax.
• Influence the pattern of activity, for example by protecting a sector or encouraging saving.

Direct and indirect taxes

A direct tax is levied on income, wealth or profit and borne by the person or firm taxed (income tax, corporation tax). An indirect tax is levied on spending and collected by a seller who passes it on in the price, so the burden can fall on someone else (a sales tax or an excise duty).

Country A’s revenue (billions): income tax 130, social contributions 80, corporation tax 40, property tax 15, sales tax 90, excise duties 25. The total is 380, or 38% of GDP. Direct taxes are 265 (69.7%) and indirect 115 (30.3%). Direct taxes are easier to make progressive. Indirect taxes are harder to avoid but tend to take a larger share of low incomes.

Progressive, proportional and regressive taxes

Compare the tax as a share of income (the average rate) at different incomes. The marginal rate is the rate on the next unit of income.

• Progressive: the average rate rises with income.
• Proportional: the average rate is constant.
• Regressive: the average rate falls as income rises.

Worked example. Country A’s income tax has a tax-free allowance of 7,500, 16% on income from 7,500 to 32,500 and 36% above 32,500.

Income	Working	Tax	Average rate
6,000	below allowance	0	0%
24,000	(24,000 − 7,500) × 0.16	2,640	11.0%
50,000	25,000 × 0.16 + 17,500 × 0.36	10,300	20.6%
100,000	4,000 + 67,500 × 0.36	28,300	28.3%

The average rate rises, so the tax is progressive. A flat 15% on all income would be proportional.

An indirect tax can be regressive. Suppose a household pays an effective 10% on its spending. A household on 20,000 spends 95% of its income (19,000) and pays 1,900, or 9.5% of income. A household on 100,000 spends 55% (55,000) and pays 5,500, or 5.5%. The richer household pays more in total but a smaller share of income, so the tax is regressive. A flat licence fee is the extreme case.

Principles of taxation

A good tax meets agreed criteria:

• Equity (fairness): vertical equity asks that those with greater ability to pay contribute more; horizontal equity asks that people in similar circumstances pay similar amounts. The benefit principle says payment should match benefit received.
• Efficiency: the tax should distort decisions as little as possible, apart from where distortion is the aim.
• Certainty and simplicity: people should know what they owe and when.
• Low administrative and compliance costs.
• Flexibility: revenue should be able to adjust to changing needs.

Principles conflict. A highly progressive system scores well on vertical equity but may weaken the incentive to work, and complex reliefs that make a tax fairer also make it less simple.

The role and merits of UK taxes

Tax	Role	Merits	Weaknesses
Income tax	Large direct tax on earnings	Progressive, raises substantial revenue	Can weaken work incentives; avoidance
National Insurance	Contributions on earnings	Reliable revenue	Adds to labour costs
Corporation tax	Tax on company profits	Taxes ability to pay of firms	Can deter investment; profits can be shifted
VAT	Broad tax on spending	Hard to avoid, wide base	Regressive
Excise duties	Tax on fuel, alcohol, tobacco	Corrects externalities, reliable	Regressive, black-market risk
Council tax	Local tax on property	Simple to collect	Linked to property bands, not current income

Judge each tax against the principles above, and say who bears it.

Assessing level and distribution

You must assess the economic significance of changes in the level and distribution of spending and tax.

• Level: a higher overall level of spending or tax shifts AD. The effect depends on spare capacity, the multiplier, how it is financed, confidence and time lags. Country A spends 40% of GDP, so a 1% cut in its spending would remove 4bn, and with a multiplier of 2 a fall in income of up to 8bn.
• Distribution: who gets the spending and who pays the tax matters. Poorer households spend a larger share of extra income, so transfers to them raise AD more than the same sum going to rich households. A shift from direct to indirect taxes can make the system less progressive.

Worked example. Using the income tax schedule above, a 24,000 earner keeps 21,360 and a 100,000 earner keeps 71,700. The gross income ratio is 4.17 to 1, but after tax it is 3.36 to 1, so the tax narrows the gap. Add the indirect taxes and the gap narrows by less.

A strong evaluation weighs short-run against long-run effects, equity against efficiency, and whether the economy is in a recession or near full capacity.

Common errors

• Saying a tax is progressive because the amount paid rises with income. Compare the average rate.
• Using a marginal rate where the average rate is asked for.
• Writing that transfers are part of G in AD. Transfers affect AD only when recipients spend them.
• Assuming that a tax cut and a spending rise of equal size have equal effects.
• Listing taxes without judging them against a principle.

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).