Fiscal policy means changing taxes or government spending to influence the economy. A fiscal answer explains the likely effect on revenue, the budget balance and demand, and says what must be true for that effect to happen.
This lesson follows tracing an interest-rate change and returns to the budget from reading a fictional budget, because fiscal effects are measured against it.
What are the possible effects?
A tax cut leaves households with more income to spend. Higher government spending adds directly to demand. Both may raise output when there is spare capacity, meaning unused workers and factories. If the economy is already at full capacity, extra demand is more likely to push up prices.
The budget changes too. A tax cut lowers revenue at first. Extra spending raises the deficit unless revenue grows. Name both the demand effect and the budget effect.
What assumptions should you state?
- How much of the extra income households spend rather than save.
- Whether there is spare capacity.
- Whether people and firms respond as expected.
- Whether the effect is short run or long run.
Worked example
In the fictional economy of Marlow, taxable income is MD 400 million and the income tax rate is 20%. The government cuts the rate to 15%.
Step 1, revenue before: 400 × 20% = MD 80 million.
Step 2, revenue after, with income unchanged: 400 × 15% = MD 60 million.
Step 3, change in revenue: 80 − 60 = a fall of MD 20 million. This is also the extra income left with households.
Step 4, spending response: the question states that households spend 80% of extra income. So extra spending = 20 × 80% = MD 16 million, and 20 − 16 = MD 4 million is saved.
Step 5, feedback to revenue: suppose the extra demand raises taxable income by MD 10 million. At 15%, that adds 10 × 15% = MD 1.5 million. Net fall in revenue = 20 − 1.5 = MD 18.5 million.
Conclusion: the cut may raise demand by about MD 16 million if households spend 80% of the extra income. The budget deficit is likely to widen, because revenue falls by more than the extra tax collected.
The mistake to watch for
A common slip is to state a one-way effect with no condition.
Mistaken answer: A tax cut always increases government revenue because people work harder.
The student used one assumption without saying so, and ignored the immediate fall in the tax collected.
The correction is to calculate the first-round loss, then say what extra income would have to appear to win some back, and use “may” and “if”.
Check yourself
Try these without a calculator, then open each answer.
1. Taxable income is MD 200 million. The rate falls from 25% to 20%. By how much does revenue fall, with income unchanged?
Show answer
Before: 200 × 25% = 50. After: 200 × 20% = 40. Revenue falls by MD 10 million.
2. In question 1, households spend 70% of the extra income. How much extra spending is that?
Show answer
Extra income = MD 10 million. Extra spending = 10 × 70% = MD 7 million.
3. Marlow’s revenue is MD 200 million and spending is MD 210 million. Spending then rises by MD 30 million with no change in revenue. What is the new deficit?
Show answer
New spending = 210 + 30 = 240. Deficit = 240 − 200 = MD 40 million, up from MD 10 million.
Where this leads next
The final lesson of the module shows how to write all this without taking a side, in presenting documented policy mechanisms without advocating a political choice. The ratios with interpretation limits tool helps you express a deficit as a share of revenue, and the practice set tests the whole module.
If you can calculate the effect but struggle to phrase the assumptions, our teachers can work through your answers in online one-to-one Economics tuition.