Tools of Fiscal Policy

Tools of Fiscal Policy

The government possesses two major fiscal tools for influencing the economy. These tools can be divided into spending tools and revenue tools. Spending tools refer to the overall government spending. On the other hand, revenue tools refer to taxes collected by the government.

Government Spending Tools

Capital Expenditure

Capital expenditure refers to what a government spends on amenities such as schools, roads, and hospitals. This spending adds to a country’s capital stock. Besides, it affects the productivity of a country. Moreover, as the government increases its spending on such facilities, it increases the capital stock of the country. Since such facilities highly encourage investment, the total productivity of a country also increases due to an increase in investments.

Current Government Spending

Current government spending includes goods and services, which it regularly provides. Such services include defense, health, and education. This expenditure aims at at improving a country’s labor productivity.

Transfer Payments

Transfer payments are payments that the government makes through the social security systems. Transfer payments ensure a minimum level of income for low-income individuals. Also, they provide ways in which the government can change the distribution of income in society. Therefore, they comprise unemployment and child benefits. Such benefits also include state pensions, housing benefits, income support, and tax credits. It should be stated that such payments are not included in the calculation of the GDP because they are not attached to any factor of production.

Justifications for Government Spending

  • Providing services such as defense for the benefit of all citizens;
  • Enhancing infrastructure in the form of capital spending;
  • Assuring the less-wealthy individuals a certain minimum income level; and
  • Increasing the employment level.

Advantages of Spending Tools

  • Subsidies in development and research can aid a country’s economic growth;
  • An increase in government expenditure causes an increase in aggregate demand; and
  • It reduces the unemployment rate. In this sense, aincrease in government expenditure increases aggregate demand and the need for companies to employ more workers to meet the growing demand for goods and services.

Disadvantages of Using Spending Tools

  • Capital spending strategies tend to take time. Formulation and implementation of capital spending may take several years; and
  • Too much spending on recurrent projects might be unproductive and have negative effects on the economy.

Government Revenue Tools

Indirect Taxes

Indirect taxes refer to taxes imposed on specific goods such as cigarettes, alcohol, fuel and services. VAT is an example of an indirect tax. Health and education can be excluded from indirect taxes.

Direct Taxes

Levies on profit, income, and wealth are direct taxes. Taxes charged on deceased property can both raise revenue and distribute wealth. They include capital gains taxes, national insurance taxes, and other corporate taxes.

Advantages of Using Fiscal Tools

  • Raising taxes helps in discouraging alcoholism and drug abuse. This is made possible by increasing taxes on tobacco and alcoholic drinks;
  • The government can achieve its fiscal needs through taxes;
  • Spending tools such as defense are services that benefit everyone;
  • Through taxes, a country can build infrastructure, thus improving service delivery to citizens; and
  • Subsidies in development and research can aid a country’s economic growth.

Disadvantages of Using Fiscal Tools

  • Raising taxes is unpopular and can be politically challenging to impose and implement.


Which the following statements is the most accurate regarding fiscal tools?

A. Indirect taxes cannot be modified quickly; therefore, they are not relevant fiscal policy tools

B. Direct taxes are useful for discouraging alcoholism

C. Government capital spending decisions are slow to plan, implement, and  execute; thus, they are of little use for short-term stabilization of the economy


The correct answer is C.

The implementation of capital spending is slower compared to the implementation of changes in indirect taxes.

Option A is incorrect. Indirect taxes can be modified quickly. In fact, among all the tools, their implementation is the easiest and fastest.

Option B is incorrect. Indirect taxes have a greater effect on alcohol consumption as compared to direct taxes.

Reading 16 LOS 16p:

Describe tools of fiscal policy, including their advantages and disadvantages

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