Fiscal Policy

Economists know the state to affect for whom goods are produced mainly through its taxes and transfers, which take income away from some people and give it to others.

Besides these direct effects, the state also affects the allocation of resources indirectly through taxes (and subsidies which economists think to be negative taxes).

When state levies a tax on a good, such as cigarettes, we believe it to reduce the quantity of that good produced; whereas when it subsidizes a good, such as milk, the quantity of that good produced increases as a result.

Economists consider the power to tax to be the power to affect the allocation of the economy's resources, or to distribute what is produced. Through taxing cigarettes the state can reduce the amount of cigarettes smoked so that health of the nation improved.

Taxing income earned from work, the state affects the amount of time people want to work.

Fiscal policy is an instrument of demand management which is used to influence the level of economic activity in an economy through the control of taxation and government expenditure.

The government can use a number of taxation measures to control aggregate demand or spending: direct taxes on individuals (income tax) and companies (corporation tax) can be increased if spending has to be reduced, for example, to control inflation. Spending can also be reduced by increasing indirect taxes: an increase in the VAT on all products or excise duties on particular products such as petrol and cigarettes will result in lower purchasing power.

The government can change its own expenditure to affect spending levels as well: a cut in purchases of products or capital investment by the government can reduce total spending in the economy.

If the government is to increase spending, it creates a budget deficit, reducing taxation and increasing its expenditure.

A decrease in government spending and an increase in taxes (a withdrawal from the circular flow of national income) reduces aggregate demand to avoid (избегать) inflation. By contrast, an increase in government spending and/ or decrease in taxes — an injection (денежное вливание) into the circular flow of national income stimulates aggregate demand and creates additional jobs to avoid unemployment.

In practice, however, the effectiveness of fiscal policy can be reduced by a number of problems. Taxation rate changes, particularly changes in income tax, take time to make; considerable proportion of government expenditure on, for example, schools, roads, hospitals and defense cannot easily be changed without lengthy political lobbying.