Fiscal policy

Government spending and taxation to manage AD: expansionary and contractionary policy, deficit and debt, automatic stabilisers, the multiplier and the limits of fiscal policy.

UK debt passes £3 trillion.

At the end of September 2026, UK public sector net debt was £3,005 billion, about 94% of GDP. In the first half of the 2026 to 2027 financial year the government borrowed £97.8 billion, and in September alone it paid £10.9 billion in debt interest, a record for that month.

How does government spending and taxation affect the economy, and what limits what the government can do?

Source: Office for National Statistics, Public sector finances, UK: September 2026.

Fiscal policy.

Fiscal policy is the use of government spending and taxation to influence the economy, mainly through aggregate demand.

• Expansionary (loose): more spending or lower taxes, to raise AD.
• Contractionary (tight): less spending or higher taxes, to reduce AD.
• A budget deficit is when spending is greater than tax revenue in a year. A surplus is the reverse.
• The national debt is the total owed from past borrowing. Each year’s deficit adds to it.
• Direct taxes are on income and wealth, such as income tax. Indirect taxes are on spending, such as VAT.

Automatic or chosen? Cyclical or structural?

• Automatic stabilisers change spending and tax without any decision: in a downturn tax revenue falls and benefit spending rises. Discretionary policy is a deliberate choice, announced in a Budget.
• The cyclical deficit is the part caused by the economic cycle; it disappears when the economy recovers. The structural deficit is the part that remains even when the economy is at full capacity, and can only be closed by higher taxes or lower spending.
• The Laffer curve shows that raising a tax rate does not always raise more revenue. Beyond some rate, people work less, avoid or evade the tax, so revenue falls. Cutting a very high rate could even raise revenue, though economists disagree about where that point is.

Why it may not work as planned.

• Time lags: it takes time to spot a problem, agree a Budget and carry out projects. By then the economy may have recovered.
• The size of the multiplier: if people save extra income or spend it on imports, AD rises less.
• Crowding out: government borrowing may push up interest rates, reducing private investment.
• Debt: higher borrowing raises the national debt and debt interest, which must be paid for later with higher taxes or less spending.
• Confidence: if households expect tax rises later, they may save rather than spend.

Think first

In a recession, tax revenue falls and spending on benefits rises, without any new decisions by the government.

What does this do to aggregate demand?

These are <b>automatic stabilisers</b>. As incomes fall, people pay less tax and more receive benefits, so disposable income and spending fall by less than they otherwise would. They work without any new policy decision.

Step by step

1. The economy is in a downturn: AD1 meets SRAS below LRAS. Real GDP is below potential, a negative output gap, with cyclical unemployment.

   Check: The budget deficit is:

   Deficit is a yearly flow; debt is the stock built up over time.

2. The government raises its spending, or cuts taxes. Government spending is part of AD, and lower taxes raise disposable income and consumption. AD shifts right to AD2, and the multiplier makes the shift bigger than the first injection. The gap closes.

3. But if the government pushes AD further, to AD3, the economy goes beyond its capacity. Real GDP goes beyond potential: a positive output gap, and inflationary pressure builds.

   Check: A cut in income tax increases AD mainly by raising:

   Higher disposable income means households spend more.

4. Summary: expansionary fiscal policy shifts AD right, raising real GDP and employment. Contractionary policy does the reverse, and can be used to cut inflation or reduce the deficit.

A common mistake

Higher income tax lowers disposable income, so consumption falls and AD shifts left. A rise in AD comes from more government spending or lower taxes.

Exam question

Explain how expansionary fiscal policy could reduce unemployment.

Model answer

Expansionary fiscal policy means raising government spending or cutting taxes.

Government spending is a component of aggregate demand, so more spending, for example on building schools, raises AD directly. A cut in income tax raises households’ disposable income, so consumption rises.

[Diagram: AD shifts right from AD1 to AD2; real GDP rises from Y1 towards LRAS.]

The effect is increased by the multiplier: the extra income is spent again, raising other people’s incomes.

Firms sell more, so they increase output. Since labour is a derived demand, they need more workers, so cyclical unemployment falls. This works best when the economy has a negative output gap, with spare capacity.

However, the effect depends on the size of the multiplier and on time lags: new spending projects can take years to start, and households may save a tax cut or spend it on imports. If the extra borrowing pushes up interest rates, it may also crowd out some private investment.