Key Idea: Topic 3.6 explains how governments use spending and taxation to manage AD, the multiplier effect, and the constraints of budget deficits and national debt.
✅ Core definitions
- Fiscal policy
- Government changes in spending (G) and/or taxation (T) to influence AD.
- Expansionary
- G↑ and/or T↓ → AD right (close deflationary gap, boost growth).
- Contractionary
- G↓ and/or T↑ → AD left (close inflationary gap, reduce overheating).
- Budget deficit
- G > T (spending exceeds revenue) — adds to national debt.
- National debt
- Total accumulated government borrowing over time.
📊 Types of taxes
- Direct taxes — on income/profits (income tax, corporation tax)
- Indirect taxes — on spending (VAT, excise duties)
- Progressive — rate rises with income (income tax brackets)
- Regressive — takes larger % from low earners (VAT on food)
- Proportional — flat rate regardless of income
🔁 The multiplier effect
- Initial spending creates multiple rounds of income and spending
- Leakages (savings, taxes, imports) reduce each round → multiplier is finite
- Open economies with high taxes have smaller multipliers
- Works in reverse too — spending cuts multiply downward
In practice, multipliers are typically 1–2, much smaller than formula-predicted values. State this in evaluation.
⚖️ Evaluation and constraints
- Time lags — recognition, decision, and implementation lags (slower than monetary policy)
- Crowding out — government borrowing raises interest rates → private investment↓
- Political constraints — spending is popular, tax rises are not (political bias)
- Automatic stabilisers — tax revenue↓ and welfare spending↑ in recessions → built-in fiscal response without new policy
Distinguish: discretionary fiscal policy (deliberate changes) vs automatic stabilisers (built-in mechanisms that activate without new legislation).