These fiscal actions reduce the flow of real spending in the economy.
They are considered to be appropriate when the economy is threatened by inflation of demand-pull variety.
So the basic equation, which expresses the equilibrium condition of national income becomes: E = C I G where G is government purchases of goods and services.
However, to cover its ever-growing expenditure, the government has to collect revenue from different sources. Thus a portion of national income is taxed away by the government.
Taxes reduce aggregate demand by reducing disposable income of the community. Government expenditure on goods and services produced in the private sector add to aggregate demand by channelling purchasing power back into the flow of spending.
Essays Government Intervention Economy
It logically follows from these two basic principles that economic activity can be slowed down by raising taxes and/or reducing government expenditures.
Of course, there is controversy among economists regarding the optimal level of government intervention in the economy.
However, the fact remains that government expenditure and taxation programmes exert considerable influence on national income, output and other key macro-economic variables.
On the other hand an exactly opposite type of fiscal action is called for when the economy is in deep depression.
So the government has to reduce taxes and/or increase its own spending.