Lesson preview · The government's budget
Fiscal policy and the tax system
~8 min · Free to read
Imagine a recession: a period when the economy shrinks and jobs disappear. A factory closes and Sam loses his job. His pay stops, so he stops paying income tax, and he starts receiving unemployment benefits. Nobody voted for these changes: the rules were already written. Picture 50,000 people like Sam. The government collects less and pays out more, so its budget falls short. But the benefits keep money flowing to shops, which softens the slump.
Key Term
Fiscal policy, deficits and debt
Fiscal policy is how the government uses its spending and taxes to steer the economy.
- Expansionary policy means spending more or cutting taxes. It adds spending in a recession.
- Contractionary policy means spending less or raising taxes. It holds spending back in a boom, when spending races ahead and prices rise fast.
- A budget deficit is one year’s gap when spending is bigger than revenue (money coming in, mostly taxes). Spend 500 billion dollars, collect 470 billion, and the deficit is 30 billion. The government borrows to cover it. Revenue above spending is a surplus.
- Government debt is the total still owed from all past borrowing. Each deficit adds to it.
Sam’s story shows an automatic stabiliser: a tax or benefit that changes with the economy by itself, under rules already in place.
Tip
Automatic or discretionary?
Ask one question: did anyone have to decide? More people claiming unemployment benefits under the existing rules is automatic. A vote to send every household a new payment is discretionary: a choice, even if the money arrives quickly.
Check yourself · no marks
A boom arrives: incomes rise and unemployment falls. Without any new law, what happens to the government’s budget, and how does that affect spending?
Commit to one first. Guessing and being wrong beats reading the answer cold.
Discretionary policy, such as a tax cut or a new railway, faces time lags (delays). Lawmakers must spot the problem, agree a plan and put it into effect. By then, the economy may have recovered. Automatic stabilisers skip these delays: they start as soon as incomes and jobs change.
A government’s budget isn’t like a family’s. When a family spends less, its income stays the same. When a government cuts spending in a recession, it cuts other people’s incomes, so it collects less tax.
A government can also keep borrowing, paying off old loans with new ones, and a growing economy shrinks the debt compared with its tax income. But debt costs interest, and lenders charge more if they doubt they’ll be repaid.
The budget also decides who pays, and two taxes with the same 20% rate can land differently. Economists class a tax as progressive, proportional or regressive by the share of income it takes, not by the rate written in the law. That share is the average tax rate: total tax ÷ total income.
- Progressive: the share rises as income rises.
- Proportional: the share is the same at every income.
- Regressive: the share falls as income rises.
The sales tax charges everyone 20% of every dollar they spend. Yet it takes 19% of the lower-income household’s income, and only 10% of the higher-income household’s. The lower-income household spends almost all it earns; the higher-income one saves half. The richer household still pays more dollars, 15,000 against 3,800, but taxes are classed by share. So, measured against a year’s income, the sales tax is regressive. Over a whole lifetime, as people spend their savings, some economists find it roughly proportional.
Trap · Common Misconception
"It's regressive because everyone pays the same rate"
The flat income tax also charges everyone 20%, yet it is proportional. So the rate alone can’t make a tax regressive. What matters is what the rate is charged on. A tax on spending takes the biggest share of income from people who spend almost all they earn.
Countries tax food differently. In 2026, the UK’s VAT (value added tax, a tax on spending) is 20% on most things but 0% on most food. New Zealand’s 15% GST (goods and services tax) covers food. In 2018, New Zealand’s Inland Revenue and Treasury officials found that exempting food would help poorer households most as a share of income. But richer households, who spend more on food, would gain more dollars, and benefits could help poorer households more for the same cost.
Worked Example
The widget’s income tax comes in brackets: slices of income, each taxed at its own rate. It charges nothing on the first 10,000 dollars, 20% on income from 10,000 to 40,000, and 40% on income above 40,000. How much tax does the middle-income household pay on its 50,000 dollars? Find its average and marginal tax rates.
Trap · Common Misconception
"A higher tax bracket can leave me poorer"
Each bracket’s rate applies only to the income inside that slice. A pay rise from 40,000 to 41,000 dollars puts just the extra 1,000 in the 40% bracket: 400 dollars of tax, 600 kept. The brackets alone never cut take-home pay.
Benefits can. Imagine a 3,000-dollar benefit that stops once a family earns over 30,000 dollars. A pay rise from 29,000 to 31,000 adds 1,600 dollars after 20% tax. But the family loses the 3,000 benefit, so it ends up 1,400 dollars worse off. Look for these “cliffs” when you evaluate a tax and benefit system.
Practice · 1 / 6
A government starts the year owing 900 billion dollars. This year it collects 150 billion dollars in revenue and spends 220 billion. Which statement is right?
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