What this lesson teaches
I can explain how fiscal policy can help a government meet its macroeconomic aims.
Syllabus K343, 4.2.6. Effects of fiscal policy on government macroeconomic aims: how fiscal policy measures may enable a government to achieve its macroeconomic aims
Make a guess
Unemployment is high because workers lack the skills growing industries need. Will a big tax cut solve it?
- Yes, because people will spend more on courses.
- Not much: spending does not create new skills.
- Yes. Tax cuts always reduce unemployment.
Show the answer
Not much: spending does not create new skills.
This is structural unemployment. A tax cut raises demand, but the jobs on offer still need skills the unemployed do not have. Training targets the cause.
Expansionary fiscal policy supports growth and jobs, contractionary policy fights inflation, and taxes and transfers also change the current account and income distribution.
Growth and employment. In a recession, the government raises its spending or cuts taxes. Households have more to spend and firms receive more orders, so firms produce more and need more workers. Output grows and unemployment caused by weak demand falls. Spending on schools, training and transport also helps growth in the long run, because workers become more productive.
Put these in order
Put the chain from an income tax cut to lower unemployment in order.
- Firms raise output and hire more workers
- The government cuts income tax
- Unemployment falls
- Consumer spending and total demand rise
- Households' disposable income rises
Show the answer
- The government cuts income tax A lower tax leaves households more of their pay.
- Households' disposable income rises With more income to spend, households buy more goods and services.
- Consumer spending and total demand rise Firms see more orders, so they plan to produce more.
- Firms raise output and hire more workers Every extra worker hired is one fewer person without a job.
- Unemployment falls
Low and stable inflation. When too much spending is pushing prices up, the government raises taxes or cuts its own spending. Households have less disposable income, so they buy less, and firms facing weaker demand find it harder to raise prices. Inflation slows. The cost is slower growth and possibly more unemployment.
Balance of payments and fair incomes. Higher income tax reduces spending on imports as well as on local goods, which can shrink a current account deficit. Grants for research and training can make exporters more competitive. Progressive income tax takes a larger share from high earners, and transfers give cash to poorer households, so income becomes more equal.
Limits. Fiscal policy takes time to plan and to work. A tax cut may be saved rather than spent if people are worried about their jobs. In Singapore, a large part of any extra spending goes on imports, so less of it reaches local firms. And a deficit must be paid for by borrowing or by using reserves.
- Fiscal policy and growth
- Higher spending or lower taxes raise demand, output and jobs.
- Fiscal policy and inflation
- Higher taxes or lower spending cut demand and slow price rises.
- Fiscal policy and fairness
- Progressive taxes and transfers such as GST Vouchers make incomes more equal.
Worked example: Raising GST in 2023 and 2024
Singapore raised GST from 7% to 8% in 2023 and to 9% in 2024. The government said it needed more revenue for rising healthcare spending as the population ages.
- Measure: a higher indirect tax, so most goods and services cost a little more.
- Effect on households: real incomes fall slightly, and lower-income households feel it most because they spend a larger share of their income.
- Protecting fairness: an Assurance Package and the permanent GST Voucher scheme gave cash and vouchers, mostly to lower-income households.
- Judgement: the tax rise pays for future spending, and the transfers limit the harm to the poorest. Both fair incomes and sound public finances are served.
Watch out for this
Expansionary fiscal policy always reduces unemployment.
It reduces unemployment caused by weak demand. It does little for structural unemployment, where workers lack the skills that growing industries need, unless the spending goes on training.
Check your understanding
Prices are rising fast because households and firms are spending too much. Which fiscal measure fits?
- Raise income tax so households have less to spend
- Spend more on new MRT lines to create construction jobs
- Cut income tax so households can afford higher prices
Show the answer
Raise income tax so households have less to spend
Right. Lower disposable income cuts spending, so firms find it harder to raise prices.
Check your understanding
Which fiscal measure most directly makes the distribution of income more equal?
- A higher tax rate on all food
- Cash transfers to low-income households
- A cut in the top rate of income tax
- A cut in spending on public housing
Show the answer
Cash transfers to low-income households
Right. Transfers add directly to the incomes of the poorest households.