Fiscal Policy

Author: Geoff Riley  Last updated: Sunday 23 September, 2012

Government Spending

Government spending can be broken down into three main categories:

1. General government final consumption - spending on current goods and services excluding transfer payments – the main item of spending is on pay for public sector workers.
2. Transfer payments – from taxpayers to benefit claimants through the social security system.

Government Spending Objectives

The Treasury has outlined the main goals of fiscal policy to be the following:

• Equity concerns: To ensure that government spending and taxation impact fairly within and across generations – fiscal policy should be equitable to current and future generations.
• Funding government spending: To meet the government’s spending and tax priorities without a damaging rise in the burden of government debt.
• The benefit-pay-principle: This principle seeks to ensure that those who benefit from public services such as state education and the NHS also meet the costs of the services they consume.
• Macroeconomic stability: Fiscal policy in the UK is designed to support monetary policy in contributing to an environment of sustainable growth and stable inflation.

The level of spending by the UK government has soared in recent years and has been criticised by those who claim that public sector spending is open to a high level of waste and lack of productive efficiency.

Successive governments have striven to improve the efficiency with which public services are provided. This has included the use of contracting-out and competitive tendering where private businesses compete with the public sector for the contracts to provide NHS catering, laundry and cleaning together with maintenance of the road network and aspects of the prison service.

 The government has also introduced value for money audits for each major government spending department together with a huge and growing number of performance targets.

As we see below, the share of national income taken up by government spending has risen from 41% when Labour came into office in 1997 to over 50%. Ultimately a state that spends such a high percentage of GDP needs to raise an equivalent amount in tax revenues to pay for the spending – otherwise public sector borrowing and the national debt rises to unsustainable levels.

The July 2010 Government Spending Review introduced by the Coalition introduced major cuts in the real value of government spending over the next three to four years.

Taxation

The current government's objectives for the British tax system are broadly as follows:

• To improve incentives  e.g. the incentive to look for work or start a new business
• Equitable taxes: To ensure taxes are applied equally and fairly to everyone. Equality is not always the same as fairness – see the notes below on the canons of taxation
• Correct for market failure: Using taxes to make markets work better including externalities.
  

Principles of a Good Tax System

Adam Smith developed one set of principles known as the canons of taxation in his famous work on the ‘Wealth of Nations’ published in the late 18th century.

• Efficiency - an efficient tax system raises sufficient revenue to pay for government spending, without reducing work-incentives for individuals and investment incentives for companies.
• Equity – taxes should be fair and based on people's ‘ability to pay’.
• The ‘benefit principle of taxation’ – this principle is that taxes paid by people have a link with the benefit that the person paying the tax actually receives from government spending. The benefit principle is mainly concerned with allocative efficiency rather than equity.
• Transparency and certainty - taxpayers should understand how the system works and should be able to plan their tax affairs with a reasonably degree of certainty. Taxes should also be difficult to evade and should not be too difficult or expensive to collect.

Progressive Taxation

• In a progressive tax system the average rate of tax rises with income – for example, income tax is progressive in its effects on disposable income
• The table above gives a flavour of how the tax burden rises with taxable income. For someone with an annual taxable income of £13,000, the tax rate is just under 12% whereas for some earning well over £100,000 the percentage taken in tax rises above 30%.
• In the 2009 Budget, Chancellor raised the rate of income tax on those earning over £150,000 to 50% from April 2010. In addition the government has announced the phasing out of tax-free personal allowances for those earning six figure sums. There will be no personal allowance at all, once someone’s income reaches about £113,000
• These decisions make the tax system a little more progressive although there are strong arguments on both sides on whether or not the decision is a sound one.

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