OCR A Level Economics: Fiscal policy 2: deficits, debt, stabilisers and rules (H460)

This guide covers the second half of the Fiscal policy topic in the OCR A Level Economics (H460) specification, version 3.0 (June 2026), for first assessment in 2021. It sits under Macroeconomics, in the application of policy instruments. The first half (the budget, taxation and budget position) is not repeated here. The specification labels no content as AS or A level only. All figures below are invented and illustrative.

Links: OCR Economics hub, printable checklist, revision notes, practice questions, the multiplier and output gaps, the macroeconomics guide and free 10-minute diagnostics.

What you must be able to do

Specification outcome	Where covered
Distinguish a budget deficit from government debt	Section 1
Explain how deficits can be financed	Section 2
Evaluate policies to correct a surplus or deficit	Section 3
Evaluate the consequences of government debt	Section 4
Explain what is meant by the national debt	Section 1
Explain how automatic stabilisers work	Section 5
Explain how discretionary fiscal policy may improve macroeconomic performance	Section 6
Explain how crowding out and crowding in can occur	Section 7
Evaluate the effectiveness of fiscal policy for the government’s objectives	Section 8
Explain how fiscal rules influence behaviour; evaluate their effectiveness	Section 9

1. Deficit versus debt, and the national debt

A budget deficit is a flow: in one year, government spending exceeds government revenue. The national debt is a stock: everything the government still owes on past borrowing, measured on one date. Each deficit adds to the debt. A surplus lets the government repay some of it.

Worked example (Country A, illustrative year). Revenue is 400 and spending is 460, which includes 30 of interest on existing debt. Opening debt is 1,200 and GDP is 1,500.

Deficit            = 460 - 400 = 60
Deficit / GDP      = 60 / 1,500 = 4.0%
Primary deficit    = 60 - 30 = 30   (the deficit before interest)
Closing debt       = 1,200 + 60 = 1,260

If GDP grows to 1,575 (nominal growth of 5%), the debt ratio is 1,260 / 1,575 = 80.0%, the same as the opening 1,200 / 1,500. So the debt can rise in money terms while the debt-to-GDP ratio is flat. The ratio is the better measure of burden because it compares debt with the income that supports it. Debt is also described as gross or net of the government’s financial assets, and as held domestically or by foreign lenders.

2. Financing a deficit

The government must find money to cover the gap. The main routes:

• Selling government bonds and bills to households, banks, pension funds and overseas investors. This is the usual method. It adds to the debt and pays interest.
• Borrowing from the central bank, which creates money to buy the debt. This avoids pressure on interest rates but risks inflation if the money supply grows faster than output.
• Selling state assets (privatisation). It raises one-off cash and does not add to debt, but it also removes future income from those assets.
• Running down cash balances or reserves, which can only be done for a limited time.

In Country A the 60 might be raised as 35 of long-term bonds bought by domestic pension funds and banks, 15 bought by overseas investors and 10 of short-term bills. Total: 60. Overseas holders mean future interest leaves the country. Short-term bills must be refinanced soon, so the government is exposed if interest rates have risen.

3. Correcting a deficit or a surplus

To cut a deficit the government can raise tax revenue, cut spending, or rely on growth to lift revenue. Evaluation points:

• Leakages from the cut. Cutting spending reduces GDP through the multiplier, which cuts tax receipts and raises benefits.
• Timing. Tightening in a recession deepens it. Tightening in a boom is easier.
• Composition. Cutting capital spending may damage long-run growth. Cutting benefits hits low incomes hardest. Raising taxes may weaken incentives.
• Size of the deficit and the debt. A small deficit with a falling debt ratio may need no correction.

Worked example. In Country A, assume a marginal propensity to save of 0.1, a marginal rate of tax of 0.25 and a marginal propensity to import of 0.15. Leakages sum to 0.5, so the multiplier is 1 / 0.5 = 2. The government cuts spending by 20.

Fall in GDP            = 20 x 2 = 40
Fall in tax revenue    = 0.25 x 40 = 10
Rise in benefits (0.05 per unit of lost GDP) = 0.05 x 40 = 2
Deficit falls by       = 20 - 10 - 2 = 8   (from 60 to 52)

Only 40% of the cut reached the deficit, while GDP fell by 40. The larger the multiplier and the weaker the economy, the bigger this gap.

A surplus can be corrected by cutting taxes, raising spending or repaying debt. It may cause a drag on demand if it arises in a weak economy, but it builds room for future borrowing.

4. Consequences of government debt

Costs and risks:

• Debt interest takes revenue that could fund health or education: an opportunity cost.
• Higher future taxes or lower spending, which shifts the burden to later taxpayers (intergenerational equity).
• Crowding out of private investment (Section 7).
• Loss of confidence. Lenders may demand a higher interest rate if they doubt repayment, and credit ratings may fall.
• Money leaving the country if foreign investors hold much of the debt.
• Inflation risk if the central bank finances the debt by creating money.

Benefits: borrowing can fund investment that raises future growth and tax revenue, and it can support demand in a recession.

Judgement depends on: the debt-to-GDP ratio, whether borrowing funds capital or current spending, who holds the debt, whether it is in the home currency, and the interest rate compared with the growth rate.

Worked example (debt dynamics). A simple rule: next year’s ratio = (this year’s ratio x (1 + r) / (1 + g)) + the primary deficit as a share of GDP, where r is the average interest rate and g is nominal growth. For Country A: r = 2.5%, g = 5%, primary deficit = 30 / 1,575 = 1.90% of GDP.

0.80 x 1.025 / 1.05 = 0.7810
0.7810 + 0.0190     = 0.8000   (ratio stays 80.0%)

If interest costs rise to 4.5% on all debt: 0.80 x 1.045 / 1.05 + 0.0190 = 0.8152, so the ratio rises to 81.5%. When r is above g, the government must run a primary surplus to stop the ratio climbing.

5. Automatic stabilisers

Automatic stabilisers are features of the budget that offset swings in output without any new decision. Progressive income taxes and unemployment benefits are the standard examples.

• Boom: incomes rise, so tax receipts rise faster, benefit payments fall, and the budget moves towards surplus. This reduces disposable income growth and cools demand.
• Recession: receipts fall, benefits rise, the deficit widens, and demand is supported.

They work with no time lag in decision-making and no political delay. They do not remove the cycle, only soften it.

Worked example. Leakages without tax: 0.1 + 0.15 = 0.25, multiplier 4. With the 0.25 marginal tax rate: 0.5, multiplier 2. An investment fall of 10 cuts GDP by 40 without the tax system and by 20 with it. If GDP falls by 20, tax revenue falls by 0.25 x 20 = 5 and benefits rise by 0.05 x 20 = 1, so the deficit widens by 6 with no policy decision. Stabilisers are stronger where tax rates are progressive and benefits generous.

6. Discretionary fiscal policy

Discretionary policy is a deliberate change in government spending or taxes. Expansionary policy (more spending or lower taxes) raises aggregate demand, shifting AD to the right, and is used for a negative output gap or high unemployment. Contractionary policy shifts AD left, and is used to reduce inflationary pressure or a positive output gap. Spending on infrastructure or education can also shift long-run aggregate supply.

Worked example. Country A raises spending by 12 with a multiplier of 2.

Rise in GDP         = 12 x 2 = 24
Rise in tax revenue = 0.25 x 24 = 6
Net cost to budget  = 12 - 6 = 6

Half the stimulus pays for itself. The limits are time lags (recognising the problem, deciding, implementing, then the effect appearing), uncertainty about the multiplier, and political motives.

7. Crowding out and crowding in

Crowding out happens when government borrowing reduces private spending. Extra bond sales compete for savings and push up interest rates, so private investment falls (financial crowding out). Government use of scarce labour or capital near full capacity can also squeeze out private use (resource crowding out).

Continuing the example: the 12 of borrowing raises the interest rate by 0.5 percentage points, and private investment falls by 8 per percentage point, so by 4.

Net initial injection = 12 - 4 = 8
Rise in GDP           = 8 x 2 = 16   (not 24)

One third of the spending was crowded out. Crowding out is weak with spare capacity, when savings are high, or when the central bank holds rates down. In an open economy a higher rate can also raise the exchange rate and cut net exports.

Crowding in occurs when government spending raises private spending. Higher demand lifts firms’ expectations and sales, and the accelerator effect encourages investment. Public infrastructure can raise the returns on private projects. If crowding in adds 3 of private investment, the net injection is 11 and GDP rises by 22.

8. How effective is fiscal policy?

For: it targets demand directly, has a known multiplier effect, and can be aimed at particular groups or sectors. Against: time lags, the multiplier’s size is uncertain, crowding out, high debt limiting room to act, and households saving if they expect future taxes. Effectiveness depends on whether the economy has spare capacity, how big the multiplier is, whether the spending is current or capital, and whether policy helps or conflicts with other objectives, such as growth against the balance of payments. By objective: with spare capacity, stimulus can raise growth and cut unemployment; tightening restrains inflation at a cost to output and jobs; extra spending raises imports, which can worsen the trade balance. A good answer reaches a judgement.

9. Fiscal rules

A fiscal rule is a commitment that limits the budget, for instance a ceiling on the deficit or debt ratio, or a requirement to borrow only to invest (a “golden rule”).

Influence on behaviour:

• Governments must choose which spending or taxes to adjust.
• Lenders may trust the government more and ask for lower interest rates.
• Firms and households may feel more certain about future taxes, which supports investment.

Worked example. In Country A: current spending is 430, capital spending 30, revenue 400. The current deficit is 30 and the overall deficit 60. Borrowing of 60 exceeds capital spending of 30 by 30, so the golden rule is broken. A deficit limit of 3% of GDP allows 45, so 15 of correction is needed. A debt ceiling of 60% is exceeded at 80%.

Effectiveness: credibility helps if the rule is enforced and independently monitored. Weaknesses are rigidity that forces cuts in a recession, escape clauses that weaken trust, accounting tricks, and pressure on capital spending, which is easy to cut.

Common errors

• Using the word deficit for the stock of borrowing, or debt for the yearly gap.
• Forgetting that a spending cut shrinks tax revenue.
• Treating crowding out as certain.
• Describing a stabiliser as a policy decision.

Official syllabus

OCR A Level in Economics (H460) specification, version 3.0 (June 2026), for first assessment in 2021, published by OCR.