Fiscal Policy, Taxation, Budget Balance and Public Debt
This section covers fiscal policy, taxation, the budget balance and public debt. The exam tests how government revenue and spending affect demand, equity and sustainability.
Core rules
- Fiscal policy uses government expenditure and taxation to influence aggregate demand. Expansionary policy raises spending or cuts taxes; contractionary policy does the opposite.
- Automatic stabilisers, such as unemployment benefits and progressive taxes, dampen the cycle without new legislation. Discretionary policy requires deliberate decisions.
- Direct taxes fall on income and profits; indirect taxes fall on spending. Progressive taxes take a higher share from higher incomes; proportional taxes take a constant share; regressive taxes take a higher share from lower incomes.
- The budget balance = revenue minus expenditure. A deficit means spending exceeds revenue; a surplus is the reverse. The structural balance adjusts for the cycle; the cyclical balance reflects the cycle.
- Public debt is accumulated borrowing. Debt/GDP is a sustainability indicator. EU fiscal rules include reference values of 3% of GDP for deficits and 60% for debt, with reformed surveillance.
Worked example
Government revenue is €90bn and expenditure is €105bn, so the deficit is €15bn. With GDP of €300bn, the deficit is 5% of GDP, above the 3% reference value. If debt is €270bn, debt/GDP is 90%, above the 60% reference.
Traps
Do not confuse the deficit with the debt. Do not call a cyclical deficit a structural problem. Do not assume higher tax rates always raise revenue. Do not treat progressive taxation as automatically reducing inequality.