What is fiscal policy and how does it affect the economy?
Fiscal policy refers to the spending programs and tax policies that the government uses to guide the economy. Governments frequently use fiscal measures along with monetary policy to achieve economic policy goals, including:
- Full employment
- A high rate of economic growth
- Stable prices and wages
These three factors lay the general foundation for a government’s economic policy. The tools to achieve them were largely developed in the 20th century.
How fiscal policy works
Government taxation and spending are the primary tools used to conduct fiscal policy. If the government lowers taxes, for example, it can lead to an increase in consumer spending (consumption) and business investment. These factors can stimulate the economy. Government spending on public works can also help boost economic growth.
If the government increases taxation (to generate more revenue) or reduces its spending, both can slow economic growth, possibly leading to a contraction or recession.
Three types of fiscal spending
There are generally three types of fiscal spending:
- Mandatory spending refers to entitlement programs such as Social Security and Medicare.
- Discretionary spending refers to annual spending for various administrative functions. The largest item on this list is national defense.
- Supplemental spending is used for budget items that require even more money to be approved and spent.
Depending on the needs of the economy, Congress and the Treasury may tweak spending programs or raise or lower tax rates to direct funds to different areas in the budget.
Fiscal policy developments in the 20th century
Fiscal policy rests on a government’s decision to spend more or less than it receives in revenue.
Historically, many governments believed the best way to approach fiscal policy was to maintain a balanced budget. Two events in the early 20th century changed that view: Great Britain’s unemployment crisis of the 1920s, and the Great Depression of the 1930s.
The severity of these crises prompted economists to develop new ways to think about and implement economic policy.
Smoothing the economic cycle
Economist John Maynard Keynes suggested that fiscal policy should be used “countercyclically.” In his view, the government should use its influence to offset the economic extremes of expansion and contraction, inflation and recession, or booms and busts.
In a nutshell, Keynes believed that the government’s budget should be in deficit when the economy is slowing and in surplus when economic growth is booming (usually accompanied by inflation).
The problem with the balanced-budget concept
Keynes suggested that, to be most effective, fiscal stimulus should be financed by government borrowing rather than raising taxes or cutting government expenditures.
Arguably, the first application of this new stabilizing technique in the United States was somewhat disappointing. Implemented during President Franklin D. Roosevelt’s administration, the amount of deficit financing in this first round might not have been large enough to produce the desired effect. With expectations dulled by the Great Depression, businesses were too slow in seizing opportunities that fiscal stimulus measures presented.
That scenario changed with the advent of World War II. With government expenditures soaring, unemployment in the United States virtually disappeared. This marked another shift in fiscal policy, one that would occur during the post-war period.
Following the war, large-scale unemployment was no longer a problem. What was proving to be significantly troubling, however, was the surge in inflation. By March of 1947, consumer inflation reached upwards of 20%. Meanwhile, the broader U.S. stock market began a sharp descent. Economic growth, which advanced at a rapid rate, began experiencing short periods of shallow recession.
Economists have since refined Keynes’s theories to smooth out these cycles. Still, fiscal policy hasn’t been as effective in countering inflation as many economists hoped. The reasons for this vary, but often stem from political constraints (see next section).
The influence of politics and automatic stabilizers on fiscal policy
Many politicians have found it unfavorable to raise taxes and cut government spending during an economic boom, even when the economy shows signs of overheating. In addition, so-called “automatic stabilizers” in the economy have inhibited the government from taking a more discretionary approach to fiscal policy.
Automatic stabilizers are fiscal mechanisms built into government budgets, such as taxes, unemployment insurance, and welfare programs.
One example is the progressive tax system, which disproportionately raises the tax rate on those generating higher incomes. As personal wages shrink during a recession, taxes collected through this system help cushion losses in consumers’ purchasing power, keeping more spending money in the hands of consumers.
Tax revenues may decline during such periods. But as long as the government doesn’t reduce expenditures to compensate for its revenue loss, the economy’s automatic stabilizers can help temper declines in economic activity.
A progressive tax system can also help smooth the economic cycle in times of expansion. A disproportionate share of taxes can boost the nation’s treasury while tempering spending activity from higher levels that might have resulted in the absence of a progressive tax system.
Unemployment benefits are another automatic stabilizer. During a recession, out-of-work individuals can receive income assistance through unemployment insurance. On a larger economic scale, this program can help prevent disposable incomes from dropping to low levels that risk further slowing the economy.
The situation reverses when the demand for labor picks up. Unemployment pay drops, tax revenue increases, and expenditures decrease.
The bottom line
Fiscal policy, in general, is a government’s strategic plan for running the economy in the short, medium, and long term by prioritizing spending, borrowing, and taxation. Fiscal policy is in constant flux. As an economy moves through cycles of boom and recession, and as different leaders and political parties move in and out of power, fiscal priorities change and adapt.
The Keynesian (“countercyclical”) approach to fiscal policy can help smooth out the cycles, but only if policymakers remain committed to the strategy—something that is much harder to accomplish during boom times, when the strategy calls for extra fiscal restraint to slow down the economy.