Fiscal Policy Tools

Fiscal Policy Tools: Spending and Taxes | CFA Level I Economics

In this lesson, we will explore the fiscal policy tools that governments use to achieve their macroeconomic goals. These tools can be classified as spending tools and revenue tools.

Spending Tools

Spending tools include:

  • Transfer payments: These are payments like social security and unemployment benefits that provide a minimum level of income for low-income households. They can also be used to redistribute income from the rich to the poor. Note that transfer payments are not included in GDP calculations.
  • Current spending: This refers to government spending on an ongoing basis, such as health, education, and defense. This type of spending can impact a country’s skill level and overall labor productivity.
  • Capital spending: This includes government spending on infrastructure, such as schools, public transport, and hospitals. Capital spending is expected to boost future productivity.

Government spending can be justified on both economic and social grounds, including providing basic services, ensuring a minimum standard of living, building infrastructure, supporting growth and unemployment targets, and subsidizing innovative and high-risk new products.

Government Revenues: Direct and Indirect Taxes

Government revenues can take the form of:

  • Direct taxes: These are levied on income and wealth, including personal and corporate income taxes, national insurance taxes, capital gains taxes, property tax, and inheritance tax.
  • Indirect taxes: These are levied on goods and services, including sales taxes, value-added taxes, and excise taxes like tobacco and alcohol tax. Excise taxes can be used to reduce consumption of some goods and services like alcohol, tobacco, and gambling.

Taxes can be justified in terms of raising revenues to finance expenditures and for income and wealth redistribution. Economists consider four desirable attributes of tax policy: simplicity, efficiency, fairness, and sufficiency.

Advantages and Disadvantages of Fiscal Policy Tools

Using fiscal policy tools has its advantages and disadvantages:

  • Advantages include the quick implementation of indirect taxes and the ability to implement social policies quickly through excise taxes.
  • Disadvantages include the time it takes to implement direct taxes and transfer payments, as well as the long implementation time for capital spending projects.

Announcing changes in fiscal policy can also have significant effects on expectations, such as an announcement of future increases in personal income tax reducing current consumption.

Effectiveness of Fiscal Policy Tools on Aggregate Demand

Not all fiscal policy tools affect aggregate demand equally. Spending tools are more effective in increasing aggregate demand, while tax reductions are somewhat less effective due to the marginal propensity to consume (MPC) effect.

Understanding the fiscal multiplier is crucial. The fiscal multiplier measures the net effect on aggregate demand when the government spends money. The total amount of spending in the economy extends beyond just the initial government spending, and the fiscal multiplier can be calculated using the formula:

Fiscal Multiplier = 1 / 1 – MPC(1-T)

When the government maintains a balanced budget and increases spending, the net change in aggregate demand is positive due to the different impacts of spending and tax increases on the marginal propensity to consume. This is known as the balanced budget multiplier.

Debate on National Debt

Expansionary fiscal policy often involves increasing the budget deficit, which grows the national debt. The size of national debt is usually measured relative to the annual GDP, known as the debt ratio. A high debt ratio can be of concern due to higher future taxes, disincentives to work and innovate, loss of investor confidence, and the crowding-out effect.

However, some argue that high national debt is not a significant concern if:

  • Debt is primarily held by domestic citizens.
  • Debt is used to finance productive capital investment.
  • Governments are motivated to push for needed tax reform.
  • Ricardian equivalence holds, meaning private sector savings can offset the government deficit.

Example: Balanced Budget Approach to Stimulating the Economy


Tinyland wishes to take a balanced budget approach to stimulating the local economy. The government is proposing an increased fiscal spending of $1 to boost aggregate demand. What is the potential net increase in aggregate demand if the MPC is 70%, and the tax rate is 40%?

The answer is as follows:

  1. Calculate the fiscal multiplier of the economy: with an MPC of 70% and a tax rate of 40%, the multiplier is 1/(1-0.7×0.6) = 1.724.
  2. The increase in aggregate demand from the increased spending is $1 times the fiscal multiplier, which is $1.724.
  3. Since the government wants to balance the budget, it has to increase tax collection by $1. This results in a $0.70 decrease ($1 x MPC) in consumer spending.
  4. Multiply the decrease in consumer spending by the fiscal multiplier: the decrease in aggregate demand is $0.70 x 1.724 = $1.207.
  5. Find the net increase in aggregate demand: subtract the decrease in aggregate demand from the increase in aggregate demand, which is $1.724 – $1.207 = $0.517.

In essence, the balanced budget multiplier for Tinyland is 0.517. This means that for every $1 increase in spending and tax collected, the aggregate demand increases by 51.7 cents.

Key Takeaways

  1. Spending tools include transfer payments, current spending, and capital spending, which can impact a country’s skill level, labor productivity, and future economic growth.
  2. Government revenues can be in the form of direct taxes (levied on income and wealth) and indirect taxes (levied on goods and services).
  3. Desirable attributes of tax policy include simplicity, efficiency, fairness, and sufficiency.
  4. Spending tools are generally more effective at increasing aggregate demand than tax reductions due to the marginal propensity to consume (MPC) effect.
  5. The fiscal multiplier measures the overall impact of government spending on aggregate demand, taking into account the MPC and other factors.
  6. The balanced budget multiplier shows the net impact on aggregate demand when the government increases spending and tax collection by an equal amount.
  7. Expansionary fiscal policy often involves increasing the budget deficit, which can lead to concerns about national debt and its long-term consequences.
  8. Economists debate whether a large national debt is a significant concern, considering factors such as debt composition, productive capital investment, and the potential for tax reform.

With these fiscal policy tools and concepts in mind, CFA candidates will be better equipped to analyze and understand the role of fiscal policy in shaping economic conditions and achieving macroeconomic objectives.

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