ECO15Taxation, Government Spending and Fiscal Policy
3.2.1.2 UK government revenue
Where the government's money comes from
Government revenue (receipts) is the money the government takes in, mostly from taxes.
Income tax and National Insurance contributions (NICs): taken from pay and other income. Together they are the biggest source.
VAT (value added tax): added to the price of most goods and services. The standard rate is 20%; some items are 5% or zero-rated, such as most food and children's clothes.
Corporation tax: a tax on company profits. The main rate is 25% (profits over £250,000) and the small profits rate 19%.
Excise duties: taxes on fuel, alcohol and tobacco. Council tax and business rates are local taxes on property.
Budget 2026 forecasts for 2026–27 (OBR, October 2026): income tax and NICs about £520 billion, VAT about £186 billion, council tax about £54 billion. Total receipts were forecast at about 41.4% of GDP.
Last checked: November 2026. Rates and forecasts can change at any Budget.
The three biggest single sources are income tax with National Insurance, then VAT
Government revenue
The money the government receives, mostly from taxes.
National Insurance contributions
A tax on earnings paid by workers and employers.
Corporation tax
A tax on the profits of companies.
Excise duty
A tax on particular goods such as fuel, alcohol and tobacco.
3.2.1.2 UK government spending
Where the government's money goes
Welfare (social protection): benefits and the state pension. The largest single area: about £353 billion (11.1% of GDP) was forecast for 2026–27 at Budget 2026.
Health: the NHS is the largest single department's budget.
Education: schools, colleges and support for universities.
Debt interest: interest paid on government borrowing, £109 billion (3.5% of GDP) in 2025–26, up from £39 billion in 2019–20 (OBR).
Defence, transport, housing, public order and safety (police, courts, prisons).
Total government spending was forecast at about 45.6% of GDP for 2026–27.
Current v capital spending: current spending is day-to-day (salaries, benefits); capital spending (investment) builds things that last (roads, hospitals, schools).
Last checked: November 2026.
Exam tipSpending more than revenue? 45.6% of GDP spent and 41.4% received means the government must borrow the gap. That is the budget deficit.
Government spending
Money spent by the government on services, benefits, investment and debt interest.
Debt interest
The interest the government pays on the money it has borrowed.
Capital spending
Government spending on things that last, such as roads, hospitals and schools.
3.2.1.2 Indirect and direct taxation
Direct and indirect taxes
Quick test: is it a tax on what I earn or own (direct) or on what I buy (indirect)?
Indirect taxes raise prices, so they can add to inflation. They are also used to discourage harmful products such as tobacco (see Market Failure).
Direct taxes
Indirect taxes
Taxes on
Income, profits and wealth
Spending on goods and services
Examples
Income tax, National Insurance, corporation tax, capital gains tax, inheritance tax
VAT, excise duties (fuel, alcohol, tobacco), tariffs on imports, the soft drinks levy
Who pays?
Paid directly to the government (often taken from pay)
Collected by businesses and added to prices
Can you avoid it?
Hard to avoid if you earn
Partly, by choosing what (and how much) to buy
Exam tipExaminers report students giving direct taxes when asked for indirect ones. Also, two duties on the same kind of product (cigarettes and rolling tobacco) score only once.
Direct tax
A tax on income, profits or wealth, paid directly to the government, such as income tax.
Indirect tax
A tax on spending, added to the price of goods and services, such as VAT.
3.2.1.2 Progressive taxation
Progressive, regressive and proportional taxes
Progressive tax: the proportion (percentage) of income paid in tax rises as income rises. UK income tax is progressive because of its bands.
Regressive tax: people on lower incomes pay a higher proportion of their income in tax. VAT and excise duties are usually regressive, because poorer households spend a larger share of their income.
Proportional tax: everyone pays the same percentage of their income.
Income tax bands, 2026–27 (England, Wales and Northern Ireland): Personal Allowance up to £12,570 at 0%; basic rate 20% on £12,571 to £50,270; higher rate 40% on £50,271 to £125,140; additional rate 45% above that. Scotland's bands differ. Thresholds are frozen until April 2031 (Budget 2026).
Each rate applies only to the slice of income in its band, not to the whole income.
Income tax bands for 2026–27 (England, Wales and Northern Ireland)
Worked exampleShow that income tax is progressive by comparing the share of income paid on £42,000 and on £70,000 in 2026–27 (England, Wales and NI).
£42,000: taxable income = £42,000 − £12,570 = £29,430, all at 20% = £5,886. Share = 5,886 ÷ 42,000 × 100 = 14.0%
The share rises from 14.0% to 22.0% as income rises, so the tax is progressive.
Worked exampleAli earns £16,000 and Beth earns £64,000. Each pays £800 a year in VAT. Show that VAT is regressive here.
Ali: 800 ÷ 16,000 × 100 = 5.0% of income
Beth: 800 ÷ 64,000 × 100 = 1.25% of income
The lower earner pays a larger share of their income, so VAT is regressive.
Exam tip‘Richer people pay more tax’ earns only 1 of 2 marks for a progressive tax. You must say a higher proportion or percentage of income. For regressive, examiners saw many answers describing progressive or proportional taxes instead.
Exam tipIn an income tax calculation, take off the Personal Allowance first. Most students in one recent exam taxed the whole income.
Progressive tax
A tax that takes a larger proportion of income as income rises.
Regressive tax
A tax that takes a larger proportion of income from people on lower incomes.
Proportional tax
A tax that takes the same proportion of income from everyone.
Personal Allowance
The income a person can earn before paying income tax: £12,570 in 2026–27.
3.2.3.1 Fiscal policy
Fiscal policy: what it is and how it works
Fiscal policy: the use of government spending and taxation to influence the level of demand (total spending) in the economy.
The Chancellor of the Exchequer sets out tax and spending plans in the Budget, usually once a year. The Office for Budget Responsibility (OBR) makes independent forecasts.
Expansionary fiscal policy: more government spending and/or lower taxes. Households and firms have more to spend, so demand rises.
Contractionary fiscal policy: less government spending and/or higher taxes. Disposable income falls, so demand falls.
How it changes income and spending: a tax cut raises disposable income, so consumers spend more; a cut in corporation tax leaves firms more profit to invest; government spending on, say, a new hospital creates jobs and incomes directly.
The knock-on effect: money spent becomes someone else's income, which they partly spend, so an initial injection can raise total income by more than the first amount. Some leaks out into savings, taxes and imports.
Expansionary and contractionary fiscal policy
Exam tipFiscal policy = spending and taxes. Interest rates are monetary policy. If a question asks only about government spending, don't drift into tax changes: examiners marked this down.
Fiscal policy
Using government spending and taxation to influence the level of demand in the economy.
Expansionary fiscal policy
Raising government spending or cutting taxes to increase demand.
Contractionary fiscal policy
Cutting government spending or raising taxes to reduce demand.
Disposable income
Income left after direct taxes, plus any benefits, available to spend or save.
3.2.3.1 How fiscal policy can be used to achieve government objectives
Using fiscal policy to meet the government's objectives
Targeted measures work on particular groups or regions: for example, tax breaks for investment or spending in areas with high unemployment.
Conflicts: expansionary policy can raise growth and jobs but risks inflation and more imports; contractionary policy can lower inflation but risks slower growth and job losses (see Government Objectives and Economic Growth).
Objective
Fiscal policy
How it works
Economic growth
Expansionary: spend more (especially on infrastructure) or cut taxes
More demand → firms produce more; investment in roads and skills also raises future capacity
Lower unemployment
Expansionary
More demand → firms need more workers (best for cyclical unemployment)
Lower inflation
Contractionary: cut spending or raise taxes
Less demand → less pressure on prices (best for demand-pull inflation)
Less inequality
Progressive taxes, benefits, free services
Redistributes income (see The Distribution of Income and Wealth)
Smaller current account deficit
Contractionary
Less spending on imports, but also slower growth
Exam tipBuild a chain from the policy to the objective: tax cut → more disposable income → more consumer spending → firms produce more → they hire more workers → unemployment falls.
Infrastructure
Basic structures an economy needs, such as roads, railways, broadband and energy networks.
3.2.3.1 The government budget
The government budget: balanced, deficit and surplus
Budget balance = government revenue − government spending, over one year.
Balanced budget: revenue equals spending.
Budget deficit: spending is greater than revenue. The government borrows the gap, mainly by selling bonds (gilts).
Budget surplus: revenue is greater than spending. The government can repay debt.
As a % of GDP = budget balance ÷ GDP × 100. This makes years and countries easier to compare.
UK figures: public sector net borrowing (the deficit) was £134.2 billion in 2025–26, 4.4% of GDP. The OBR forecast about £133 billion (4.2% of GDP) for 2026–27 (ONS and OBR, October 2026). Last checked: November 2026.
Balanced budget, deficit and surplus
Worked exampleA government's revenue is £900 billion, its spending is £960 billion and GDP is £2,400 billion. Calculate the budget balance as a percentage of GDP and say whether it is a surplus or a deficit.
Budget balance = £900bn − £960bn = −£60bn
As % of GDP = 60 ÷ 2,400 × 100 = 2.5%
A budget deficit of 2.5% of GDP.
Don't confuse the three deficitsBudget deficit: government spending > government revenue in a year. Trade deficit: imports > exports. Current account deficit: the trade balance plus income flows is negative (see The Balance of Payments and Exchange Rates). Only one-third of students got full marks on a recent question that tested this.
Exam tipAlways say surplus or deficit (or use a minus sign). A correct number with no direction loses a mark.
Balanced budget
When government revenue equals government spending.
Budget deficit
When government spending is greater than revenue in a year.
Budget surplus
When government revenue is greater than spending in a year.
3.2.3.1 The consequences of operating a budget surplus and deficit
Consequences of deficits and surpluses; borrowing and debt
National debt: the total the government owes from past borrowing, a stock. Each year's deficit is a flow that adds to it.
UK debt: public sector net debt was £3,005.0 billion at the end of September 2026, 94.0% of GDP, the first time it passed £3 trillion (ONS). Last checked: November 2026.
Possible benefits of a deficit: funds public services and investment (roads, schools) without raising taxes; supports demand, growth and jobs in a downturn.
Possible costs of a deficit: debt grows, so debt interest rises, leaving less for services (debt interest was £109 billion in 2025–26); may need higher taxes or cuts later; if lenders lose confidence, the government may have to pay higher interest rates.
Possible benefits of a surplus: debt can be repaid, cutting future interest costs; room to borrow in a future crisis; may reduce inflationary pressure.
Possible costs of a surplus: needs higher taxes or lower spending, which can reduce demand, growth and jobs, and squeeze public services.
Automatic changes: in a downturn, tax receipts fall (less income and spending) and benefit spending rises (more unemployed), so the deficit grows even without a policy change. In a boom, the opposite happens.
Exam tipDebt and deficit are different. ‘The deficit is falling’ means the government is borrowing less each year, but the debt still rises while there is any deficit.
National debt
The total amount the government owes from past borrowing.
Government borrowing
The money the government borrows in a year to cover a deficit.
Gilts
Bonds sold by the UK government to borrow money.
3.2.3.1 Fiscal policy
The limits of fiscal policy
Time lags: it takes time to spot a problem, agree a Budget and start projects. A new railway can take years.
Borrowing and debt: with high debt and high debt interest, the government may have little room to spend more or cut taxes.
Leakages: some of a tax cut may be saved rather than spent, and some spending goes on imports, so less boosts UK output.
Incentives: critics of higher taxes argue they can reduce the reward for working and investing; critics of tax cuts argue they mainly help people who already earn more.
Uncertain forecasts: the OBR's forecasts can be wrong, and events (a war, a pandemic, an energy shock) can change everything.
Conflicts: boosting demand can raise inflation; cutting demand can raise unemployment.
Politics: tax rises and spending cuts are unpopular, so they may be delayed. People disagree about how big the state should be, which is a matter of values as well as economics.
Exam tipFor a 15-mark fiscal policy question, weigh the size of the effect, how quickly it works, who gains, and the cost in borrowing, then reach a judgement that says what it depends on.
Time lag
The delay between a policy decision and its full effect on the economy.
Leakage
Income that is saved, taxed or spent on imports rather than on UK output.
Genious