Fiscal Policy, Public Finance and the Budget
Fiscal policy is where the paper becomes most applied and most contentious. You need the classification of taxes, the structure of the budget, the difference between the deficit and the debt, and the ability to evaluate expansionary and contractionary stances. Cyprus is a rich case: a small open economy that ran large deficits, entered an adjustment programme in 2013, and still carries a substantial public debt ratio while operating a 12.5 per cent corporate tax rate and a 19 per cent standard VAT rate.
Taxation
- Direct taxes fall on income and profit; indirect taxes fall on spending, principally VAT (standard 19 per cent in Cyprus, with reduced rates) and excise duties on fuel and tobacco.
- Progressive, proportional and regressive structures; average versus marginal rate; the Laffer curve shows revenue may fall if rates are pushed too high.
- Criteria for a good tax: equity (ability to pay, horizontal and vertical), efficiency, certainty, convenience and economy of collection.
Expenditure and the budget
- Current spending on goods and services and public-sector pay; transfers and social benefits; capital investment; interest on the debt.
- Budget balance = revenue − expenditure. A deficit adds to the debt stock; the debt-to-GDP ratio also moves with growth, inflation and the interest rate.
- Automatic stabilisers (tax receipts and welfare spending that move with the cycle) versus discretionary measures.
Stance and evaluation
- Expansionary: higher spending or lower taxes, raising aggregate demand, subject to crowding out and import leakage.
- Contractionary: used to control inflation or correct a deficit.
- Supply-side measures aim at incentives rather than demand.
- EU framework: the Stability and Growth Pact with the 3 per cent deficit and 60 per cent debt reference values and the excessive deficit procedure.
Worked example
Revenue is €10.5bn and expenditure €11.2bn, so the deficit is €0.7bn. With GDP of €30bn, that is 2.3 per cent of GDP, inside the 3 per cent reference value. With an MPC of 0.8, the simple spending multiplier is 1 ÷ 0.2 = 5, so €400m of extra public investment could add €2bn to GDP in the absence of crowding out, whereas a €400m tax cut has a multiplier of −MPC ÷ (1 − MPC) = −4 and adds only €1.6bn.
Traps that cost marks
- Confusing the deficit (a flow over the year) with the debt (a stock at a point in time).
- Ignoring automatic stabilisers when judging the discretionary stance.
- Applying the full multiplier in a small open economy with high import leakage.
- Treating a regressive tax as necessarily unfair in every context; evaluation earns marks.