‘Discuss the ways in which the government may use Fiscal policy to help the economy grow out of a recession. Reference must be made to some policies that the current government has actually use’ Fiscal policy involves the use of government spending, taxation and borrowing to affect the level and growth of aggregate demand, output and jobs. Fiscal policy is also used to change the pattern of spending on goods and services. It is also a means by which a redistribution of income & wealth can be achieved. It is an instrument of intervention to correct for free-market failures.

Changes in fiscal policy affect aggregate demand (AD) and aggregate supply (AS). In the UK, the Treasury (pictured right) is in charge of fiscal policy decisions Traditionally fiscal policy has been seen as an instrument of demand management. This means that changes in government spending, direct and indirect taxation and the budget balance can be used “counter-cyclically” to help smooth out some of the volatility of national output particularly when the economy has experienced an external shock and is in a recession.

The Keynesian school argues that fiscal policy can have powerful effects on demand, output and employment when the economy is operating below full capacity national output, and where there is a need to provide a demand-stimulus. Monetarist economists believe that government spending and tax changes only have a temporary effect on aggregate demand, output and jobs and that the tools of monetary policy are a more effective instrument in controlling inflation and maintaining macroeconomic stability.

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Government Spending

Government spending (or public spending) and in Britain, it takes up over 45% of GDP. Spending by the public sector can be broken down into three main areas: These are welfare payments made available through the social security system including the Jobseekers’ Allowance, Child Benefit, State Pension, Student Grants, Housing Benefit, Income Support and the Working Families Tax Credit The main aim of transfer payments is to provide a basic floor of income or minimum standard of living for low income households. And they allow the government to change the final distribution of income.

In 2010-11 the UK government spent ?196bn on welfare benefits, equivalent to 13. 4% of GDP Current Government Spending: i. e. spending on state-provided goods & services that are provided on a recurrent basis – for example salaries paid to people working in the NHS and resources for state education and defence. The NHS is the country’s biggest employer with over one million people working within the system! Capital Spending: Capital spending includes infrastructure spending such as new motorways and roads, hospitals, schools and prisons.

This investment spending adds to the economy’s capital stock and can have important demand and supply side effects in the long term. The main items of UK government spending are shown in the pie chart below- the data is taken from the March 2011 UK Budget Statement available from the HM Treasury website. Social protection is the biggest single component of departmental spending and includes the many welfare benefits paid to recipients including the state pension, the jobseekers’ allowance, income support and housing benefit. Taxation There are two types of taxes, indirect and direct taxation.

Direct taxation is levied on income, wealth and profit. Direct taxes include income tax, inheritance tax, national insurance contributions, capital gains tax, and corporation tax. Indirect taxes are taxes on spending – such as excise duties on fuel, cigarettes and alcohol and Value Added Tax (VAT) on many different goods and services. Furthermore there are 3 different characteristics of taxes, these being a progressive tax, a proportional tax and a regressive tax. A progressive tax is when the marginal rate of tax rises as income rises. I. e. s people earn more income, the rate of tax on each extra pound goes up. This causes a rise in the average rate of tax. A proportional tax is the marginal rate of tax is constant. National insurance contributions are the closest example in the UK of a proportional tax, although low-income earners do not pay NICs below an income threshold. A regressive tax is the rate of tax falls as incomes rise – I. e. the average rate of tax is lower for people of higher incomes. In the UK, regressive taxes come from excise duties of items of spending such as cigarettes and alcohol.

Indirect taxes forma larger percentage of the disposable income of those who earn less, even though they may also spend less. How the current government is using fiscal policy. The current collation government are using fiscal policy to attempt to cut down borrowing and the budget deficit from previous borrowing of the recent labour governments to be in power. The Coalition Government wants to halve the budget deficit over a five year period, they have launched a programme of fiscal austerity amounting to ?126 billion a year of combined spending cuts and tax rises.

Most of the fiscal austerity is coming through planned reductions in the real level of government spending. 80% will come from spending reductions, 20% is forecast to come from higher taxes. The “fiscal squeeze” is highly controversial and has led to an impassioned debate among economists about the best way to control a budget deficit as an economy struggles to lift itself out of recession and sustain a recovery. Keynesian economists argue that deficit-reduction policies risk driving the economy into a second recession – known as a double-dip.

Reducing spending or raising taxes could hurt an already fragile economy and make the fiscal deficit problem even worse. They doubt whether new job creation in the private sector is likely to be able to compensate for job losses in the public sector. Keynesians believe that economic growth will help bring down the deficit and that maintaining a sufficiently high level of demand is crucial to achieving this – public expenditure is a component of aggregate demand and hence if public expenditure falls so will aggregate demand C+I+G+X-M).

Many private sector jobs depend on public sector spending, for example workers in the construction industry who build new roads or social housing. The government believes that reducing the budget deficit is possible without causing another downturn and that cutting the budget deficit is important to maintain their economic credibility in financial markets. Cuts in public spending are unavoidable given the size of the budget deficit. Their strategy relies less heavily on tax increases; indeed some taxes have been cut in a bid to stimulate private sector investment.

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