2.3 Fiscal policy: government spending and taxation, the budget balance and the national debt, direct and indirect and progressive and regressive taxes, automatic stabilisers, and the strengths and weaknesses of fiscal policy.

What this dot point is asking

OCR wants you to explain fiscal policy (government spending and taxation), the budget balance and national debt, the classification of taxes (direct or indirect, progressive or regressive), automatic stabilisers, and the strengths and weaknesses of fiscal policy in managing aggregate demand.

Government spending and taxation

Because government spending (G) is a direct component of AD, and taxation affects consumption and investment, fiscal policy shifts the AD curve, with the effect amplified by the multiplier. It can also be used to achieve microeconomic and distributional goals (redistribution, correcting market failure).

The budget balance and the national debt

A rising national debt raises debt-interest costs and can crowd out other spending, but borrowing to fund productive investment can also raise long-run growth, so the sustainability of the debt (relative to GDP) matters more than its level alone.

Types of tax

• Direct taxes are levied on income and wealth (income tax, corporation tax, national insurance). Indirect taxes are levied on spending (VAT, excise duties).
• A progressive tax takes a rising proportion of income as income rises (UK income tax). A proportional tax takes a constant proportion. A regressive tax takes a falling proportion as income rises, so it bears more heavily on the poor (many indirect taxes, such as VAT, are regressive because the poor spend a larger share of income).

The mix of taxes shapes both incentives and the distribution of income, linking fiscal policy to the equity-efficiency trade-off.

Automatic stabilisers and discretionary policy

Strengths and weaknesses of fiscal policy

• Strengths. It directly affects AD; it can be targeted at specific regions, sectors or groups; it can address both demand and supply (infrastructure, education); and automatic stabilisers work without delay.
• Weaknesses. Time lags (recognition, implementation through the Budget, and impact); the risk of crowding out (government borrowing raising interest rates and squeezing private investment); a worsening budget deficit and national debt; and political constraints (spending is hard to reverse). Its effect is weak against structural unemployment, which needs supply-side measures.

Examples in context

• Pandemic support. The furlough scheme and business grants were large discretionary fiscal expansions to prevent a demand collapse, sharply raising borrowing.
• Austerity. Post-2010 spending restraint aimed to cut the structural deficit, illustrating contractionary fiscal policy and its growth costs.
• Progressive income tax. UK income-tax bands and the personal allowance are the textbook progressive tax and a key automatic stabiliser.

Try this

Q1. Distinguish between a budget deficit and the national debt. [3 marks]

• Cue. Deficit is the annual gap between spending and revenue; national debt is the accumulated total owed.

Q2. Explain why VAT is often described as a regressive tax. [4 marks]

• Cue. The poor spend a larger share of income, so VAT takes a larger proportion of their income than of the rich's.