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Fiscal Policy

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Fiscal Policy

We often associate fiscal policy with Keynesian economics, a concept developed by John Maynard Keynes to understand the Great Depression. Keynes argued for increased government spending and lower taxation in an attempt to recover the economy as soon as possible in the short run. Keynesian economics believes that an increase in aggregate demand can boost economic output and take the country out of a recession.

In the long run we are all dead. - John Maynard Keynes

Fiscal policy is a type of macroeconomic policy that aims to achieve economic objectives through fiscal instruments. Fiscal policy uses government spending, taxation, and the government’s budgetary position to influence aggregate demand (AD) and aggregate supply (AS).

As a reminder of the basics of macroeconomics, check out our explanations on Aggregate Demand and Aggregate Supply.

What are the features of fiscal policy?

Fiscal policy has two important features: automatic stabilisers and discretionary policy.

Automatic stabilisers

Automatic stabilisers are fiscal instruments that respond to the upturns and downturns of the economic cycle. These processes are automatic: they do not require any further policy implementation.

Recessions tend to lead to higher unemployment rates and lower income. During these times, people pay fewer taxes (due to their lower income) and rely more on social protection services like unemployment benefits and welfare. As a result, government tax revenues decrease, while public expenditure increases. This automatic increase in government spending, accompanied by lower taxation, helps curb the drastic decrease in aggregate demand. During a recession, automatic stabilisers help reduce the effects of a fall in economic growth.

On the contrary, during an economic boom, automatic stabilisers help reduce the economy’s growth rate. When the economy is growing, income and employment levels rise as people work more and paying more in taxes. Therefore, the government receives higher tax revenues. This, in turn, leads to a drop in expenditure on unemployment and welfare benefits. As a result, tax revenues increase faster than income, restraining the increase in aggregate demand.

Discretionary policy

Discretionary policy uses fiscal policy to manage the levels of aggregate demand. To increase aggregate demand, the government would purposefully run a budget deficit. However, aggregate demand levels become too high at one point, increasing the price level through demand-pull inflation. This would also increase imports into the country, leading to a balance of payments problem. As a result, the government is forced to use deflationary fiscal policy to reduce aggregate demand.

Keynesian economists, therefore, used a discrete form of fiscal policy to optimise the level of aggregate demand. They regularly changed taxation and government spending to stabilise the economic cycle, achieve economic growth and full employment, and avoid high inflation.

What are the objectives of fiscal policy?

Fiscal policy can take one of two forms:

  • Reflationary fiscal policy.

  • Deflationary fiscal policy.

Reflationary or expansionary fiscal policy

Demand-side fiscal policy can be expansionary or reflationary, which aims to increase aggregate demand (AD) by increasing government spending and/or decreasing taxes.

This policy aims to increase consumption by lowering tax rates, as consumers now have a higher disposable income. Expansionary fiscal policy is used to close recessionary gaps and tends to increase the budget deficit as the government borrows more to spend more.

Remember AD = C + I + G + (X - M).

The policy results in the AD curve shifting to the right and the economy moving to a new equilibrium (from point A to point B) as national output (Y1 to Y2) and price level (P1 to P2) increase. You can see this in Figure 1 below.

Expansionary Fiscal Policy StudySmarter OriginalsFigure 1. Expansionary Fiscal Policy, StudySmarter Originals

Deflationary or contractionary fiscal policy

Demand-side fiscal policy can also be contractionary or deflationary. This aims to decrease aggregate demand in the economy by decreasing government spending and/or increasing taxes.

This policy aims to decrease the budget deficit and discourage consumption, as consumers now have lower disposable income. Governments use contractionary policy to decrease AD and close inflationary gaps.

The policy results in the AD curve shifting to the left and the economy moving to a new equilibrium (from point A to point B) as national output (Y1 to Y2) and price level (P1 to P2) decrease. You can see this in Figure 2 below.

Contractionary Fiscal Policy StudySmarter OriginalsFigure 2. Contractionary Fiscal Policy, StudySmarter Originals

Government budget and fiscal policy

To further understand fiscal policy, we first need to take a look at the budgetary positions a government can take (where G stands for government spending and T for taxation):

  1. G = T The budget is balanced, so government expenditure is equal to revenues from taxation.
  2. G> T The government is running a budget deficit, as government expenditure is higher than tax revenues.
  3. G <T The government is running a budget surplus, as government expenditure is lower than tax revenues.

Structural and cyclical budget position

The structural budget position is the economy’s long-term fiscal position. It includes the budgetary position throughout the entirety of the economic cycle.

The cyclical budget position is the economy’s short-term fiscal position. The economy’s current position in the economic cycle, like a boom or a recession, defines it.

Structural budget deficit and surplus

As the structural deficit is not related to the current state of the economy, it doesn’t get resolved when the economy recovers. A structural deficit is not automatically followed by a surplus, as this type of deficit changes the structure of the entire economy.

A structural deficit suggests that even after considering cyclical fluctuations in the economy, government spending is still being financed by borrowing. Moreover, it indicates that government borrowing will soon become less sustainable and increasingly more expensive due to increased debt interest payments.

An increasing structural deficit implies the government will have to impose stricter policies to improve finances in the public sector and balance its budgetary position. These may include a significant increase in taxation and/or a decrease in public expenditure.

Cyclical budget deficit and surplus

Cyclical deficits occur during a recession in the economic cycle. This is often followed by a cyclical budget surplus when the economy recovers.

If the economy is experiencing a recession, tax revenues will decrease and public expenditure on unemployment benefits and other forms of social protection will increase. In this case, government borrowing will increase and the cyclical deficit will also increase.

When the economy is experiencing a boom, tax revenues are relatively high and expenditure on unemployment benefits is low. The cyclical deficit, therefore, decreases during a boom.

As a result, the cyclical budget deficit eventually gets balanced out by a budget surplus when the economy is recovering and experiencing a boom.

What are the consequences of a budget deficit or surplus in fiscal policy?

The consequences of a budget deficit include increased public sector debt, debt interest payments, and interest rates.

If the government is running a budget deficit, it implies an increase in public sector debt, meaning that the government will have to borrow more to finance its activities. As the government runs a deficit and borrows more money, the interest on borrowings rises.

A budget deficit can also lead to an increase in aggregate demand due to increased public expenditure and lower taxation, which results in higher price levels. This can signal inflation.

On the other hand, budget surplus can result from sustained economic growth. However, if a government is forced to increase taxation and decrease public expenditure, it might result in low economic growth, due to its effects on aggregate demand.

A budget surplus can also lead to higher household debt if consumers are forced to borrow (due to high taxation) and pay off their debt, resulting in low spending levels in the economy.

The multiplier effect occurs when an initial injection passes through the circular flow of income of the economy several times, creating a smaller and smaller additional effect with each pass, thereby ‘multiplying’ the initial input effect on the economic output. The multiplier effect can be positive (in the case of an injection) and negative (in the case of a withdrawal.)

How are monetary and fiscal policy related?

Let’s take a look at how fiscal and monetary policy are correlated.

Recently, the UK government has used monetary policy, rather than fiscal policy, to influence and manage the levels of aggregate demand to stabilise inflation, boost economic growth, and decrease unemployment.

On the other hand, it uses fiscal policy to gain macroeconomic stability by overseeing public finances (tax revenue and government spending,) and stabilising the government’s budgetary position. The government also uses it for achieving supply-side objectives by creating incentives for people to work more and for businesses and entrepreneurs to invest and take more risks.

Fiscal Policy - Key takeaways

  • Fiscal policy is a type of macroeconomic policy that aims to achieve economic objectives through fiscal instruments.
  • Fiscal policy uses government spending, taxation, and the government’s budgetary position to influence aggregate demand and aggregate supply.
  • Discretionary policy uses fiscal policy to manage the levels of aggregate demand.
  • Governments use discretionary policy to avoid demand-pull inflation and a balance of payments crisis.
  • Demand-side fiscal policy can be expansionary, or reflationary, which aims to increase aggregate demand by increasing government spending and/or decreasing taxes.
  • Demand-side fiscal policy can also be contractionary or deflationary. This aims to decrease aggregate demand in the economy by decreasing government spending and/or increasing taxes.
  • The government budget has three positions: balanced, deficit, surplus.
  • Cyclical deficits occur during a recession in the economic cycle. This is most often followed by a subsequent cyclical budget surplus when the economy recovers.
  • The structural deficit is not related to the current state of the economy, this part of the budget deficit does not get resolved when the economy recovers.
  • The consequences of a budget deficit include increased public sector debt, debt interest payments, and interest rates.
  • The consequences of a budget surplus include higher taxation and lower public expenditure.

Frequently Asked Questions about Fiscal Policy

Fiscal policy is a type of macroeconomic policy that aims to achieve economic objectives through fiscal instruments. Fiscal policy uses government spending, taxation policies, and the government’s budgetary position to influence aggregate demand (AD) and aggregate supply (AS).

Demand-side fiscal policy can be expansionary, or reflationary, which aims to increase aggregate demand (AD) by increasing government spending and/or decreasing taxes.

Demand-side fiscal policy can be contractionary or deflationary. This aims to decrease aggregate demand in the economy by decreasing government spending and/or increasing taxes.

During an expansionary or reflationary period, interest rates are likely to increase due to the additional government borrowing that is used to finance public expenditure. If the government borrows more money, interest rates are likely to increase as they have to attract new investors to lend money by offering higher interest payments.

During an expansionary period, unemployment is likely to decrease due to the increased levels of aggregate demand and economic growth experienced by the economy. 

Final Fiscal Policy Quiz

Question

What are the two main reasons for government spending and taxation?

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Answer

Allocation and distribution of wealth.

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What is the primary reason governments collect taxes?

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To finance government spending.

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What are the main sources of government revenue?

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Direct and indirect taxes.

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Who argued for the principles of taxation?

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Adam Smith.

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Taxation should be:

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All of the above answers are correct

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Which criteria should the 'ideal' tax meet?

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Equitable, efficient, economical, flexible, convenient and certain.

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How does taxation impact the distribution of income?

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Certain types of taxation (i.e. progressive taxes) can have a positive and more equitable impact on the distribution of income in society.

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How does taxation impact consumption?

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Taxes like excise duties can influence the consumption of certain goods that are deemed to be harmful to health and/or the environment. For example, demerit goods are taxed heavily in order to disincentivize their consumption.

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What is public expenditure?

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Public expenditure is an important tool that governments can use to achieve economic objectives.

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What are the three types of public expenditure?

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The three main types of government expenditure include spending on health, education, defense and social protection (public services); transfer payments; and debt interest.

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What is capital expenditure?

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Capital expenditure involves government spending on fixed, or existing, assets like schools, hospitals, roads, bridges, etc.

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What is current expenditure?

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Current expenditure includes spending on goods and services that are consumed over a shorter period of time. This could include salaries of public sector teachers, doctors or heating costs of hospitals.

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What are transfer payments?

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Transfer payments are payments for which no goods or services are traded in return. Instead, they are just a transfer of money like unemployment benefits, disability support, state pensions or social security payments.

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What is the national debt?

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Answer

The accumulation of yearly budget deficits.

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What is a budget deficit?

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A budget deficit comes from the difference between government revenue from taxes and government spending on public services. When public expenditure is higher than tax revenue, the government is running a budget deficit.

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What is demand-side fiscal policy?

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Demand-side fiscal policy aims to either increase or decrease the level of aggregate demand in the economy.

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How does expansionary policy impact the AD curve?


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It shifts the AD curve to the right.

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How does contractionary policy impact the AD curve?


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It shifts the AD curve to the left.

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What is fiscal policy?

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Answer

Fiscal policy is a type of macroeconomic policy that aims to achieve economic objectives through fiscal instruments.

Show question

Question

What are automatic stabilisers?

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Answer

Automatic stabilisers are a type of fiscal instrument that responds to the upturns and downturns of the economic cycle. These processes are automatic as they do not require any further policy implementation.

Show question

Question

What is the role of automatic stabilisers in a boom?

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Answer

During an economic boom, automatic stabilisers help reduce the growth rate. When the economy is growing, income and employment levels rise and therefore governments receive higher tax revenues, as people work more and pay more taxes. This also leads to a fall in expenditure on unemployment and welfare benefits. As a result, tax revenue increases faster than income, which curbs the increase in aggregate demand. 

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Question

What is the role of automatic stabilisers during a recession?

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Answer

Recessions tend to lead to higher unemployment rates and lower income. During this time, people pay fewer taxes (due to lower income) and rely more on social protection services like unemployment benefits and welfare. As a result, government tax revenues decrease while public expenditure increases. This automatic increase in government spending, accompanied by lower taxation, helps curb the drastic decrease in aggregate demand.

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What is discretionary policy?

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Discretionary policy is using fiscal policy to manage the levels of aggregate demand.

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What is reflationary fiscal policy?

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Demand-side fiscal policy can be expansionary, or reflationary, which aims to increase aggregate demand (AD) by increasing government spending and/or decreasing taxes.

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What are the implications of expansionary policy?

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Expansionary fiscal policy is used to close recessionary gaps and tends to increase the budget deficit as the government borrows more to spend more.

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What is contractionary fiscal policy used for?

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Contractionary policy is used to decrease AD and close inflationary gaps.

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What are the three positions of the government budget?

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Budget deficit, budget surplus, and a balanced budget.

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How would you define a balanced budget?

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When government revenue is equal to government expenditure.

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What is the cyclical budget position?

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The cyclical budget position is the economy’s short-term fiscal position. This is related to the short-term periods of the economic cycle. It is defined by the current position of the economy in the economic cycle, like a boom or a recession.


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What are the characteristics of a structural deficit?

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A structural deficit suggests that even after taking into account cyclical fluctuations in the economy, government spending is still being financed by borrowing. A structural deficit also implies that government borrowing can soon become less sustainable, and increasingly more expensive due to increased debt interest payments.

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What is government spending?

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A public sector spending on goods and services like education or healthcare.

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Name one factor that can influence the levels of government spending.

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The country's population.

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How can a country's population impact government spending?

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A country with a large population will have higher levels of government spending, compared with a smaller country.

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Outline how fiscal policy measures can impact government spending.

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During a recession, the government may pursue an expansionary fiscal policy. This would allow for an increase in the levels of government spending to boost aggregate demand and close a negative output gap. During these periods the level of government spending is higher than during periods of economic contraction.

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How can an increase in transfer payments impact poverty in a country?

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Answer

Spending on unemployment benefits, state pension, or disability support helps those that are unable to work or to find work. This is a form of redistribution of income, which can help reduce absolute poverty in the country.

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Describe how providing certain goods and services for free can impact the macroeconomy.

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Publicly funded services like education and healthcare are accessible for free in most countries. This allows for everyone to access these services, including those who would otherwise not be able to access them. This helps reduce the impacts of poverty. By providing these goods and services to everyone, the government is indirectly investing in the economy's human capital, which can increase productivity in the economy.

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How can progressive taxation influence poverty?

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It can reduce poverty levels by attempting to close the gap between low and high-income earners, as high-income earners pay progressively more taxes than low-income earners. 

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What is a budget deficit?

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A budget deficit occurs when current expenses are higher than current income received through standard operations.

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What is a budget surplus?

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A   budget surplus occurs when current expenses are lower than the current income received through standard operations.

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What happens when the government is running numerous budget deficits?

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If the government is running numerous budget deficits, it will have to increase borrowing even further to finance its activities. This further contributes to increasing the national debt.

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Define debt interest.

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The interest payments the government has to make on the money it previously borrowed.

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How can a budget surplus be achieved?

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By decreasing government spending and/or increasing taxation.

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How can higher taxation influence household debt?

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Higher taxation can lead to higher household debt if households are forced to borrow to finance their consumption. This leads to lower levels of spending and individual saving in the economy, as consumers are focused on paying off their debt.

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What are the two main rule-based fiscal policies in the UK?

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The deficit rule and the debt rule.

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Describe the UK government's implementation of the golden rule.

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The golden rule follows the idea that the public sector should only borrow to fund capital investments (like infrastructure) that encourage future growth. In the meantime, it cannot increase borrowing to fund current spending. As a result, the government has to maintain the current budget position in a surplus or a balance.

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Define taxation.

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Taxation is when a government imposes a compulsory levy on its residents and citizens to pay for its activities.

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What is taxation used for?

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Funding public expenditure and the redistribution of income in society.

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What is direct taxation?


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Answer

Direct taxes are taxes imposed on income and wealth.

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Name two types of direct taxes.


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Answer

Income tax and corporate tax.

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Question

Which of the following is not a direct tax?


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Value-added tax

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