Fiscal Policy - Fiscal Policy as a Supply-side Tool

Supply-side policies are policies that aim to increase the capacity of the economy to produce. Fiscal policy usually acts on the level of demand in the economy and the deflationary and reflationary policies on pages 2 & 3 are often known as demand-side policies. However, it is also possible for fiscal policy to act on the level of supply as well.

Income tax will always have an effect on people's incentives to work. This will be true at most income levels. If income tax at low income levels is too high, people may choose not to work but to remain on benefits instead. If income tax on high levels of income is too high, people may choose not to work so hard and take risks. Ultimately they may even choose to leave the country if taxes elsewhere are much lower (a "brain drain").

Supply-side fiscal policies could therefore include:

• Cutting the lower and basic rates of tax to open up the gap between earnings in and out of work and ensure people have an incentive to work
• Increasing the level of personal allowances for the same reason
• Reducing the top rate of tax to encourage enterprise, risk-taking and the incentive to work hard

Why not try some of these policies on the Virtual Economy? Click on the 4th floor on the side bar or on the link at the top of the page to access the model and try these policies. Try any of them and see the effect they have on economic growth and unemployment. When you cut taxes ensure you cut government expenditure by an equivalent amount. This ensures that your policies have no overall impact on demand. In this way you isolate out the supply-side impact of your policies. You should see an overall increase in economic growth over time as your policies begin to take effect.