🛍 VAT
Value added tax is a percentage added to the price of most goods and services. Many countries use a version of it, often called a sales tax or goods and services tax.
Government Policies » Fiscal Policy: Taxes and Spending
What you'll learn this session
Study time: 30 minutes
Edexcel spec: 2.1.2 (a)
- What fiscal policy is and the two tools it uses
- How governments raise revenue from direct and indirect taxes
- The main areas where governments spend money
- How to tell direct and indirect taxes apart in the exam
🔒 Unlock Full Course Content
Sign up to access the complete lesson and track your progress!
Unlock This CourseWhat is fiscal policy?
Fiscal policy is how the government uses taxes and its own spending to steer the economy
Every government needs money to run a country, and every government has to decide how to spend it. These choices have a big effect on jobs, prices and growth. This content is examined on Paper 2: Macroeconomics and the Global Economy.
Key terms:
- Fiscal policy: the use of government revenue (taxes) and government expenditure (spending) to influence the economy.
- Government revenue: the money the government collects, mainly from taxes.
- Government expenditure: the money the government spends on goods, services and payments to people.
So fiscal policy has two tools: taxes (money coming in) and spending (money going out). Changing either one changes how much money households and firms have, and how much is spent in the economy.
Government revenue: direct taxes
Most government revenue comes from taxes. Taxes are split into two groups, depending on what is taxed and who pays.
Key terms:
- Direct tax: a tax on income, profit or wealth, paid by the person or firm that earns or owns it.
- Indirect tax: a tax on spending, added to the price of goods and services. The seller collects it and passes it to the government, but the buyer pays it through the price.
Examples of direct taxes:
- Income tax: paid on the money people earn from work.
- Corporation tax: paid by companies on their profits.
- National Insurance: a UK tax taken from wages. It helps pay for things like the state pension.
- Wealth taxes such as inheritance tax, paid on money and property passed on after someone dies.
Government revenue: indirect taxes
Indirect taxes are paid when you spend. You usually do not see a separate payment. It is already inside the price on the shelf.
🍷 Excise duties
Taxes on particular goods, such as alcohol, tobacco and fuel. They are charged on top of VAT in the UK.
Another example is a customs duty (tariff) on imports, which you will meet later in the course.
Direct or indirect? A quick test
Ask: "Is it taken from what I earn, or added to what I buy?" Taken from earnings, profit or wealth means direct. Added to the price of something you buy means indirect.
Government expenditure: the main areas
Healthcare is one of the biggest areas of government spending
Governments spend revenue on goods and services for the whole country and on payments to people. The main areas are:
🏥 Health
Hospitals, doctors, nurses, medicines and public health programmes.
🏫 Education
State schools, teachers, colleges and universities.
💰 Welfare
Benefits for unemployed or low-income people, and state pensions.
🛢 Infrastructure
Roads, railways, bridges, ports and broadband networks that businesses and households use.
💪 Defence
The armed forces and equipment that protect the country.
Governments also pay for other services such as the police, courts and the fire service. Spending on infrastructure and education is sometimes called an investment in the future, because it can help the economy grow for many years.
Worked example: reading a revenue table
Worked example
Country Lantor collected the following revenue in one year.
| Source of revenue | Amount (billion lantors) |
|---|---|
| Income tax | 120 |
| Corporation tax | 40 |
| VAT | 90 |
| Fuel and tobacco duties | 50 |
Step 1: sort the taxes. Direct: income tax and corporation tax. Indirect: VAT and fuel and tobacco duties.
Step 2: add up each group. Direct = 120 + 40 = 160 billion. Indirect = 90 + 50 = 140 billion.
Step 3: total revenue = 160 + 140 = 300 billion. Share from direct taxes = 160 ÷ 300 × 100 = 53.3% (to 1 decimal place).
Common mistakes
- Thinking the difference is who hands the money over. Both types end up with the government. The difference is whether the tax falls on income, profit and wealth (direct) or on spending (indirect).
- Calling VAT a direct tax because "you pay it". You pay it through the price, so it is indirect.
- Writing "government spending" when the question asks for areas of expenditure. Name the area, such as health or defence.
- Mixing up revenue and expenditure. Revenue is money in. Expenditure is money out.
Exam-style question
Country Lantor's government is deciding its budget. Its main sources of revenue are income tax, corporation tax, VAT and tobacco duty. It spends most of its revenue on health, education and welfare, with the rest on defence and new railways.
(a) Define fiscal policy. [2 marks]
(b) Identify one direct tax and one indirect tax from the information. [2 marks]
(c) Explain one reason why a government spends money on infrastructure. [3 marks]
(d) Total revenue is 300 billion lantors. Health spending is 75 billion lantors. Calculate health spending as a percentage of total revenue. [2 marks]
Model answer
(a) Fiscal policy is the use of government revenue, such as taxes (1), and government spending (1) to influence the economy.
(b) Direct tax: income tax or corporation tax (1). Indirect tax: VAT or tobacco duty (1).
(c) New railways make it quicker and cheaper for firms to move goods and workers (1), which lowers their costs and helps them produce more (1), so the economy can grow (1).
(d) 75 ÷ 300 (1) × 100 = 25% (1).
Exam tip
For an "explain" question like part (c), write a chain: what the spending builds, what that does for firms or households, and why it helps the economy. One linked chain earns more than three separate facts.
Recap
- Fiscal policy is the use of government revenue and expenditure to influence the economy.
- Direct taxes are on income, profit and wealth (income tax, corporation tax, National Insurance). Indirect taxes are on spending (VAT, excise duties).
- Main areas of expenditure are health, education, welfare, defence and infrastructure.
- Deficits, surpluses and their effects come in the next lesson.