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  • Varun Mittal

A government's fiscal policy


In previous articles, I covered the goals that a government aspires to achieve and how monetary policy might help them attain those goals. Fiscal policy is another option available to the government. Anything relating to government taxation and spending is known as fiscal policy. The acronym TBaGS is a fantastic way to

remember it (Taxation, Budget, and Government Spending). Taxes are a fiscal responsibility that authority imposes on a predetermined group of people. To influence the economy, the government can adjust the amount of taxation that an individual is charged. In this article, I will refer to income tax - direct taxation – whenever I reference taxation in the argument. The government can increase or decrease the amount of tax it levies. By increasing the level of tax levied, the government is reducing the level of disposable income that consumers hold. This, in turn, would lead to a decrease in consumer spending and, as a result, a decrease in the economy's consumption. Consumption is a component of aggregate demand (AD), hence there is a loss of demand in the economy as a result. As illustrated in the graph, this results in a decrease in the economy's real GDP, and, depending on the degree of the reduction, either disinflation or deflation.


The higher taxation, on the other hand, immediately contributes to the government's revenue. As a result, the government can spend the lost revenue to compensate for the decrease in consumption. As a result, the economy's AD will not be harmed, and it will instead migrate toward a more centrally controlled economy. Nonetheless, a government's additional revenue is usually used to pay down debt. During a moment of economic boom, when the economy is operating well, a government would increase taxation. Governments would primarily do this to avoid a spike in inflation, allowing them to pay off any debt that may have contributed to the boom. This is depicted in the graph above during a period of economic boom.


Taxation can also be reduced by the government. This would have the reverse effect, increasing the amount of disposable income available to consumers. As a result, consumers spend more, leading to an increase in aggregate demand (AD), as consumerism is one of its components.

As illustrated in the graph, this results in an increase in real GDP and price levels, with the magnitude of each varying depending on how close to full capacity the economy is. The closer it gets to full capacity; the less real GDP will expand, and the more price levels will rise. When the government wants to jumpstart the economy and get it out of a slump, this is the most usual method. The government, on the other hand, is wary about lowering tax rates since it will be difficult to justify raising them again if they do. Governments are voted into power, so saying they will raise taxes makes it hard for them to get re-elected.


To keep this piece from becoming too long, I will conclude it here. When I return with the next instalment in the series, I will go through indirect taxation and how the government can achieve its goals.