OCR A Level Economics: Fiscal policy 1: the budget and taxation (H460)

This guide follows the OCR A Level Economics (H460) specification, Version 3.0 (June 2026), for first assessment in 2021. It covers the first part of the topic Fiscal policy, under The application of policy instruments (Macroeconomics). The specification labels no content as AS or Extension: all of it is A Level. All countries and figures below are made up as examples, not real data, and money is in currency units (cu).

Plan revision with the OCR Economics hub, the printable checklist and the free diagnostics. Then use the revision notes and the practice questions. The macroeconomics overview and exam preparation page add context. Deficits, debt, stabilisers and fiscal rules belong to the next fiscal policy unit, so they are not taught here.

What this guide covers

Specification point	What you must be able to do
Government budget	Explain it; identify main UK sources of tax revenue and spending
Current and capital spending	Explain and distinguish them
Progressive, proportional, regressive	Explain and distinguish; calculate average and marginal tax rates
Direct and indirect taxation	Explain and distinguish them
A good tax	Explain its features
Tax rate and revenue	Evaluate the relationship, including the Laffer Curve
Flat rate tax	Evaluate advantages and disadvantages
Budget position and fiscal stance	Explain; surplus, deficit, balanced; cyclical and structural; overall and current

1. The government budget

The government budget is the account of planned receipts and spending over a period, usually a year. Receipts are mostly taxes.

In the UK the biggest tax receipts come from income tax, National Insurance contributions and VAT. Smaller sources include corporation tax, excise duties (fuel, alcohol, tobacco) and local taxes such as council tax and business rates. The largest areas of spending are social protection (including the state pension and benefits) and health. Others include education, debt interest, defence, transport and public order and safety.

Current expenditure pays for the daily running of public services and for transfers, such as wages of public sector workers, benefits and debt interest. It is used up within the year. Capital expenditure is spending on assets that last and raise future capacity, such as roads, hospital buildings and equipment.

The distinction matters because capital spending can raise long-run potential output, while current spending mainly meets present needs.

2. Progressive, proportional and regressive taxes

A tax is classified by what happens to the average tax rate as income rises.

• Progressive: the average rate climbs with income, so richer people give up a bigger share.
• Proportional: the average rate stays the same at every income.
• Regressive: the average rate drops as income climbs, so poorer people give up a bigger share.

Formulas:

• Average tax rate = (tax paid / income) × 100
• Marginal tax rate = (change in tax paid / change in income) × 100

Worked example. Country A taxes income at 0% up to 10,000 cu, 20% from 10,000 to 30,000 cu, and 40% above 30,000 cu.

Income    Working                           Tax      Average rate
20,000    (20,000 - 10,000) x 20%           2,000    10.0%
40,000    4,000 + 10,000 x 40%              8,000    20.0%
60,000    4,000 + 30,000 x 40%              16,000   26.7%
100,000   4,000 + 70,000 x 40%              32,000   32.0%

Average rates grow with income, so the system is progressive. The marginal rate is the rate on the next cu earned. A rise from 60,000 to 70,000 cu adds 10,000 x 40% = 4,000 cu of tax, so the marginal rate is 4,000 / 10,000 = 40%. A rise from 15,000 to 25,000 cu adds 2,000 cu, a marginal rate of 20%. In a progressive system the marginal rate (40% here) is above the average rate (26.7% at 60,000 cu).

Proportional. A tax of 15% on all income has an average rate of 15% and a marginal rate of 15% at every income.

Regressive. An annual licence fee of 120 cu takes 0.8% of a 15,000 cu income but only 0.2% of a 60,000 cu income. Taxes on spending can also be regressive in effect. Suppose tax equals 8% of spending. Household P has an income of 18,000 cu and spends 16,200 cu (90%): it pays 1,296 cu, which is 7.2% of income. Household R has an income of 90,000 cu and spends 45,000 cu (50%): it pays 3,600 cu, which is 4.0% of income. R pays more cu but a smaller share, because richer households save a larger proportion.

3. Direct and indirect taxation

A direct tax is charged on what people or firms earn or own, and the legal liability and the burden usually sit with the same person or firm. Examples are income tax, National Insurance contributions, corporation tax and inheritance tax.

An indirect tax is levied on spending, so the seller pays it to the government but may pass part of it on to consumers in higher prices. Examples are VAT and excise duties.

	Direct	Indirect
Based on	Income, profit, wealth	Spending
Usually	Progressive	Regressive in effect
Visible to payer?	Yes	Often hidden in prices
Can be avoided by	Earning less, avoidance	Spending less on taxed goods
Effect on incentives	Can reduce work effort	Can reduce consumption of taxed goods

Evaluation: direct taxes tend to be more equitable but may weaken work incentives. Indirect taxes are simple to collect and hard to avoid, but are regressive and raise prices.

4. Features of a good tax

The specification asks for the features of a good tax without fixing a list, so use the standard criteria and apply them to the tax in the question.

• Equity: fair between people. Vertical equity means those with a greater ability to pay contribute more. Horizontal equity means people in similar circumstances pay similar amounts.
• Certainty: the taxpayer knows how much to pay, when and how.
• Convenience: easy to pay, for example deducted at source.
• Economy: low costs of collection and compliance relative to revenue raised.
• Efficiency: the tax distorts decisions as little as possible and does not discourage work or enterprise.
• Adequate yield and flexibility: it raises enough revenue and the rate can be changed.

No tax scores well on all of these. A progressive income tax scores well on vertical equity but, with many bands and reliefs, less well on economy. Weigh the criteria against the government’s aim.

5. Tax rates and tax revenue: the Laffer Curve

Revenue = tax rate × tax base. Raising the rate raises revenue per unit of the base, but a higher rate can shrink the base through lower work effort, more avoidance and evasion, or emigration of workers and firms.

The Laffer Curve shows this: revenue is zero at a 0% rate, rises to a maximum at some rate, then falls, reaching zero again at a 100% rate (if nobody will earn taxable income at all). Rates above the revenue-maximising rate are on the prohibitive section.

Worked example. In Country A the taxable income base (in bn cu) is 600 - 6t, where t is the tax rate in per cent. Revenue = t × (600 - 6t) / 100.

Rate t     Base    Revenue (bn cu)
0%         600     0
20%        480     96
30%        420     126
40%        360     144
50%        300     150  <- maximum
60%        240     144
70%        180     126
100%       0       0

Revenue peaks at 50%. A 30% rate and a 70% rate raise the same revenue (126 bn cu), but the 70% rate does so with a much smaller base, which means greater damage to incentives. Cutting the rate from 70% to 50% would raise revenue by 24 bn cu; cutting from 30% to 20% would reduce it by 30 bn cu.

Evaluation.

• The shape and the peak are not known in reality. The peak depends on the tax, the country, the time horizon and the avoidance routes available.
• Responses take time, so short-run and long-run effects differ.
• Labour supply responses differ. A higher rate can encourage people to work more (income effect) or less (substitution effect).
• Most economies are probably on the rising section for most taxes, so cuts in rates are less likely to raise revenue.
• Revenue maximisation is not the only aim. Equity, incentives and growth also matter.

Indirect taxes follow the same logic. If a per-unit tax of t cu is added to a good with a constant cost of 4 cu and demand Q = 400 - 20P, then P = 4 + t, Q = 320 - 20t, and revenue = t(320 - 20t), which peaks at t = 8 with revenue 1,280 cu. Inelastic demand loses fewer sales, so the tax usually raises more revenue.

6. A flat rate tax system

A flat rate tax applies a single rate to all taxable income, usually above an allowance.

Worked example. Country A considers replacing its bands with 25% above a 10,000 cu allowance.

Income     Flat tax    Average rate    Current bands tax
20,000     2,500       12.5%           2,000
50,000     10,000      20.0%           12,000
100,000    22,500      22.5%           32,000

With an allowance, a flat tax is still progressive in its average rate, because the average rate rises towards 25%, but less steeply. At 100,000 cu the flat tax is 9,500 cu lower.

Advantages	Disadvantages
Simple, with low compliance and administration costs	Less equitable: less redistribution
Marginal rate falls for high earners, which may improve incentives	Lower revenue unless the rate is raised
Fewer reasons to avoid or evade	Low earners may pay more than before
Transparent and certain	Allowance and rate still need political agreement

Evaluation turns on the rate, the allowance, how the base responds, and the weight on equity versus incentives.

7. Budget position and fiscal stance

The budget position is the balance between government receipts and spending.

• Budget surplus: receipts exceed spending.
• Budget deficit: spending exceeds receipts.
• Balanced budget: receipts equal spending.

Fiscal stance describes how policy affects aggregate demand: expansionary (spending up or taxes cut, so the structural deficit widens), contractionary (spending down or taxes up) or neutral. A deficit is not automatically an expansionary stance, because the position moves with the economic cycle.

Overall versus current budget. Country A has receipts of 350 bn cu (all current). Current spending is 330 bn cu and capital spending is 50 bn cu, so total spending is 380 bn cu.

• Overall budget position = 350 - 380 = -30 bn cu, a deficit.
• Current budget position = 350 - 330 = +20 bn cu, a surplus.

With GDP of 2,000 bn cu, the overall deficit is 1.5% of GDP. Borrowing to fund capital spending is easier to defend than borrowing to fund wages and benefits, because the assets last.

Cyclical versus structural. The cyclical part of the balance arises because the economy is above or below trend: in a downturn, tax revenue falls and benefit spending rises without any new policy. The structural part would remain even if the economy were at trend, and only policy change or lasting economic change alters it.

Illustration, for a different economy from Country A above: a deficit is 4% of GDP and the output gap is -5%. Suppose each 1% of output gap changes the balance by 0.4% of GDP. The cyclical deficit is 5 × 0.4 = 2% of GDP, so the structural deficit is 4 - 2 = 2%. If growth closes the gap, the deficit falls to about 2% of GDP with no policy change. If the output gap were +2%, a cyclical surplus of 0.8% of GDP would flatter the position. The 0.4 is illustrative only.

A government that treats a cyclical deficit as structural may cut spending in a recession and deepen it.

Common errors

• Calling a tax progressive because the amount paid rises. Test the average rate.
• Using the average rate as the marginal rate.
• Applying the top rate to all income instead of only the slice above the threshold.
• Saying a deficit always means expansionary policy.
• Claiming the Laffer Curve proves that cutting rates raises revenue.

Official syllabus

OCR, A Level in Economics (H460), Version 3.0 (June 2026), first assessment 2021, Component 2 content: The application of policy instruments, topic Fiscal policy, the first part. Published by OCR (Oxford Cambridge and RSA).