State Role & Tax Policy: Understanding Fiscal Impact

The Role of the State and Tax Policy

Fiscal Policy

Fiscal policy refers to decisions made by the government regarding public spending and taxation.

Public Sector Expenses

There are two main categories of public sector expenses: transfers and the purchase of goods or services. Transfers are payments for which the government does not receive any goods or services in exchange.

Taxes

Taxes are imposed by the public sector on individuals, businesses, and households. These entities are required to pay sums of money based on economic activities.

Fiscal Policy and Economic Activity

Because aggregate demand may not always match the desired potential output (due to independent spending decisions by consumers, investors, and foreigners), the government uses public spending and taxes to influence the aggregate demand curve.

Fiscal Policy and the Public Sector Budget

Before each financial period, public sector entities create budgets detailing planned expenditures and revenues. The basic equation is:

Public Revenues - Expenses = Public Sector Budget

When revenues exceed expenses, there is a budget surplus. Conversely, when expenses exceed revenues, there is a budget deficit.

Public revenues are funds entering the public sector to meet objectives and expenditures. Public expenditure is the sum of payment obligations assumed by the public sector as a result of their actions as economic agents.

The Budget as an Instrument of Economic Policy

State budgets contain:

• General economic objectives to be achieved during the fiscal year.
• Detailed expenditure and income plans for each agency, institution, and company within the public sector.
• Microeconomic policy instruments used to meet budget goals, along with the technical means employed.

Financing the Deficit

A deficit can be financed in two primary ways:

1. Taxation: Increasing taxes such as income tax (individuals), consumption taxes, or taxes on company profits. This is often unpopular.
2. Public Debt: Issuing public debt.

Note: The deficit is the difference between revenue and earnings at a specific point in time, while debt is the accumulation of deficits over time.

Public Budgets and the Economic Cycle

Cyclical Fluctuations and the Deficit

During economic recessions, tax revenue decreases due to reduced economic activity. Unemployment increases, leading to higher public spending. This tends to create deficits.

During economic expansions, tax revenue increases due to increased economic activity. Unemployment decreases, leading to lower public spending. This tends to generate surpluses.