Fiscal policy

Fiscal policy

The public sector and fiscal policy

The public sector, which involves government spending, revenue raising, and borrowing, has a crucial role to play in any mixed economy.

The purpose of government expenditure

Government spends money for a variety of reasons, including:

  1. To supply goods and services that the private sector would fail to do, such as public goods, including defence, roads and bridges; merit goods, such as hospitals and schools; and welfare payments and benefits, including unemployment and disability benefit.
  2. To achieve supply-side improvements in the macro-economy, such as spending on education and training to improve labour productivity.
  3. To reduce the negative effects of externalities, such as pollution controls.
  4. To subsidise industries which may need financial support, and which is not available from the private sector. For example, transport infrastructure projects are unlikely to attract private finance, unless the public sector provides some of the high-risk finance, as in the case of the UKs Private Finance Initiative – PFI. During 2009, the UK government provided huge subsidies to the UK banking sector to help deal with the financial crisis. Agriculture is also an industry which receives large government subsidies. See: CAP.
  5. To help redistribute income and achieve more equity.
  6. To inject extra spending into the macro-economy, to help achieve increases in aggregate demand and economic activity. Such a stimulus is part of discretionary fiscal policy.

Local government is extremely important in terms of the administration of spending. For example, spending on the NHS and on education are administered locally, though local authorities. Approximately 75% of all public spending is by central government, and 25% is by local government.

Central and local government (public sector) spending

Using public spending to stimulate economic activity has been a key option for successive governments since the 1930s when British economist, John Maynard Keynes, argued that public spending should be increased when private spending and investment were inadequate.  There are two types of spending:

  1. Current spending, which is expenditure on wages and raw materials. Current spending is short term and has to be renewed each year.
  2. Capital spending, which is spending on physical assets like roads, bridges, hospital buildings and equipment. Capital spending is long term as it does not have to be renewed each year – it is also called spending on ‘social capital’.

Where does the spending go?

The main areas of UK government spending in 2016, which totalled £761.9 bn, were:

  1. Social protection (pensions, tax credits and other benefits)
  2. Health
  3. Education
  4. Debt interest
  5. Defence

Types of fiscal policy

Fiscal policy is the deliberate adjustment of government spending, borrowing or taxation to help achieve desirable economic objectives. It works by changing the level or composition of aggregate demand (AD).

There are two types of fiscal policy, discretionary and automatic.

  1. Discretionary policy refers to policies that are implemented through one-off policy changes.
  2. Automatic stabilisation, where the economy can be stabilised by processes called fiscal drag and fiscal boost.

Central government borrowing

Government must borrow if its revenue is insufficient to pay for expenditure – a situation called a fiscal deficit. Borrowing, which can be short term or long term, involves selling government bonds or bills.  Bonds are long term securities that pay a fixed rate of return over a long period until maturity, and are bought by financial institutions looking for a safe return. Treasury bills are issued into the money markets to help raise short term cash, and last only 90 days, whereupon they are repaid.

Local government borrowing

If the revenue from the council tax and central government support is insufficient to meet spending commitments, local authorities can also borrow by issuing bonds. Only around 25% of local authority spending is financed by local revenue raising, 75% coming from central government and by borrowing. (Source: Local Government Association)

Public Sector Net Borrowing

If the borrowing requirements of both central and local government is combined, the amount of borrowing required is called the public sector net borrowing (PSNB).  The need to borrow varies considerably with the business cycle.

During periods of economic growth, tax yields rise and spending on welfare payments fall, pushing the public finances towards a surplus.  During periods of economic slowdown, tax yields fall and welfare payments rise, pushing the economy towards a fiscal deficit.

In 2009, the government introduced a new measure of public sector borrowing, called Public Sector Net Borrowing Ex (PSNBEx). This measure excludes payments to the financial sector to ease the credit crisis.


See: The 2018 Budget

Fiscal rules for spending and borrowing

It is common to set some rules to constrain borrowing, such as rules to help achieve financial sustainability.  These rules often set limits or targets in terms of spending or borrowing as a proportion of GDP. The may may be vague, such as ‘balancing the budget over the business cycle, or more specific, such as ‘keeping the growth in borrowing to 2%per year’.

Although they aim to act as a constraint, it is highly possible that they may be adjusted in the future, to reflect changing cicumstances – such as in response to a financial shock.

Borrowing, and the financial crisis

According to the Institute for Fiscal Studies (IFS), the central government net borrowing requirement in 2009, of approximately £150b, was almost double initial estimate. The main reason for this overshoot was the rescue package for the banking sector, following the global financial crisis.

The banking bailout package included:

  1. £37b for recapitalisation of the main banks, RBS, Lloyds and HBOS.

  2. £21b to the Bank of England to help refinance the financial services sector.

Source: IFS, 2009

Fiscal deficits and the National Debt

Fiscal deficits occur when the revenue received by a government is less than spending during a financial year. These deficits will create the need to borrow by selling government securities – bills and bonds.

What is the national debt?

The national debt is the cumulative amount of annual borrowing that occurs when government spending is greater than revenue.

National debt
Hypothetical example to illustrate how the national debt is calculated.

£b 2013 2014 2015 2016
500 550 600 650
Revenues 480 520 560 600
Borrowing 20 30 40 50
National Debt 20 50 90 140

What causes a rising national debt?

A rising national debt can happen when tax revenues fall and government spending rises as the economy slows down or goes into recession, or when householders and firms spend less, so less VAT is collected, and householders and firm receive less income, so revenues from income taxes fall.

UK public finances

The advantages of discretionary public spending as a fiscal tool

Public spending can stimulate the macro-economy

Public expenditure can be used to help stimulate the macro-economy at times of low and negative growth. This works by increasing the level of aggregate demand, and can compensate for failings in other components of aggregate demand, such as a fall in household spending on consumer goods and firms spending on capital goods. It can also be used to complement monetary policy or when monetary policy has proved ineffective. This could be the case when interest rates are already low, but the economy still needs stimulating, as occurred throughout the advanced economies following the financial crisis and consequent global recession.

Public spending can improve the infrastructure of an economy

If the spending is on capital items, then infrastructure can be developed, which can help improve competitiveness and economic growth. Infrastructure projects are usually far too expensive for the private sector to tackle on its own.

Public spending can generate positive externalities

Spending on infrastructure, healthcare, and education also provides an external benefit to the rest of the economy which can have long run effects in comparison with reductions in interest rates, which are often short-term.

Public spending can be targeted

Public spending can be targeted to achieve a wide range of specific economic objectives, such as reducing unemployment, achieving more equity,  road building, action against poverty, and re-building city centres.

The disadvantages of public spending

Time lags

There may be a considerable time-lag between spending and the benefits that arise. For example, a decision to increase spending on education will take many months and maybe years to implement, and many years or decades to see the full benefits. Indeed, the full benefits may never be measured and recorded because of information failure.

Public spending can be inflationary

In trying to promote growth or reduce unemployment government spending can be inflationary, especially if the government has to borrow from the financial markets or if the spending is rising too quickly, as might occur if public sector pay increases without an efficiency gains. Monetarist economists, such as Milton Friedman, are anti-fiscal in their approach to demand management, preferring to regulate aggregate demand by controlling the quantity of money in circulation. Government spending, they argue, in inherently inflationary, so the best role for government, also suggested by the New-classical economists, is to improve supply-side performance, especially labour productivity. New-classical economists, such as Robert Lucas, highlight what see as the general failure of government to influence consumer behaviour. Markets tend to clear effectively if left alone, hence a government should not interfere in the working of markets. If government does interference, say by increasing spending, and this is expected, then people will expect an inflationary effect, and will bargain for higher wages. The increase in wages shifts the AS curve to the left, with no gain in aggregate output. If people understand how policy operates, its effect on the real economy will be much weaker.

In what often appears a rather odd assertion, new-Classical economists argue that demand management only works when it is unanticipated by firms and households. The New-classical approach is highly critical of relying on past events to predict the future. If policy-makers rely exclusively on gathering and using past statistics, they are unlikely to make very accurate predictions. They argue that the only way to influence economic performance in the long run is by improving the conditions of supply rather than trying to create economic growth by increasing demand.

Public spending can generate  a debt burden

Borrowing to fund spending will add to the national debt and can create an excessive debt burden for future generations.


There is a potential trade off between unemployment and inflation, first analysed by A.W. Phillips in the 1950s. If the aim of public spending is to create jobs, there is the strong possibility that prices will be driven-up, and any growth in jobs will only be temporary as the economy quickly readjusts to the previous level of unemployment.

Crowding out

Crowding-out theory is closely associated with the economists Bacon and Eltis, who looked at the apparent de-industrialisation of the UK economy during the 1960s and 1970s. Crowding out can be defined at the process of ‘squeezing’ out the privately owned manufacturing sector by the expansion of the public sector. It is argued that crowding out occurs because of the inherent scarcity of financial and real resources. The more the (inefficient) public sector uses scarce resources, the less resources are available for the more efficient and productive private sector.

Bacon and Eltis identified two types of crowding out.

  • Financial crowding out – if the public sector expands and needs to borrow from the financial sector interest rates may be driven up. This leads to a reduction in private sector investment.
  • Resource , or physical, crowding out – in a similar way, as the public sector expands there is an increase in the demand for other resources which drives up their price, including wages and rents – hence the private sector suffers.

Political constraints

A major constraint to government spending across the EU is membership of the Stability and Growth Pact which limits government borrowing to no more than 3% of  national income in any one year, and accumulated public debt should not exceed 60% of the value of national income. The purpose of the Stability Pact was to prevent euro area countries weakening the value of the Euro by printing money, which occurs when governments borrow from the money markets. In the late 1990s, the UK Chancellor imposed a different constraint – that borrowing is acceptable if it funds capital, rather than current public sector spending – the so-called golden rules. However, as early as 2006 a large number of EU countries had exceeded the debt limits laid down in the Stability Pact.

Greek debts

In 2011, Greece needed a massive bail-out from other members of the euro area to cope with debts which the IMF estimated represented some 165% of GDP. By 2014 this had risen to nearly 180%, as the table below indicates. Italy and Portugal were close behind, with debt ratios of 156.6% and 149.9% respectively.

See: Fiscal stabilisers and discretionary tax policy