Lesson 3 of 5 · 14 min
Fiscal policy tools and what makes a good tax
Governments spend through transfers, current spending and capital spending and raise money through direct and indirect taxes; each tool differs in speed, potency and side effects, and a good tax system balances simplicity, efficiency, fairness and revenue sufficiency.
In short
- Transfer payments (pensions, child and unemployment benefits) set an income floor and redistribute; they are not part of GDP or of government purchases.
- Current spending recurs (health, education, defence); capital spending builds infrastructure and adds to productive potential.
- Direct taxes fall on income, wealth and profits; indirect taxes fall on spending (VAT, excise duties) and can serve social or environmental aims.
- Good tax: simplicity, efficiency (minimal distortion), fairness (horizontal and vertical equity) and revenue sufficiency, which can conflict.
- Speed: indirect taxes change almost immediately; direct taxes and transfers need months; capital projects take years but raise productive capacity.
- Potency: direct government spending moves output more than tax cuts or transfers, unless those are aimed at people who spend all their income.
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