What is Fiscal Policy?

Fiscal policy refers to the use of government spending and tax policies to influence economic conditions, especially macroeconomic conditions, including aggregate demand for goods and services, employment, inflation, and economic growth.

Key Takeaways

  • Fiscal policy refers to the use of government spending and tax policies to influence聽economic conditions.
  • Fiscal policy is largely based on ideas from John Maynard Keynes, who argued governments could stabilize the聽business cycle聽and regulate economic output.
  • During a recession, the government may employ expansionary fiscal policy by lowering tax rates to increase聽aggregate demand聽and fuel economic growth.
  • In the face of mounting inflation and other expansionary symptoms, a government may pursue聽contractionary聽fiscal policy.

Understanding Fiscal Policy

Fiscal policy is largely based on the ideas of British economist John Maynard Keynes (1883-1946), who argued that economic recessions are due to a deficiency in the consumption spending and business investment components of aggregate demand. Keynes believed that governments could stabilize the business cycle and regulate economic output by adjusting spending and tax policies to make up for the shortfalls of the private sector. His theories were developed in response to the Great Depression, which defied classical economics' assumptions that economic swings were self-correcting. Keynes' ideas were highly influential and led to the New Deal in the U.S., which involved massive spending on public works projects and social welfare programs.

In Keynesian economics, aggregate demand or spending is what drives the performance and growth of the economy. Aggregate demand is made up of consumer spending, business investment spending, net government spending, and net exports. According to Keynesian economists, the private sector components of aggregate demand are too variable and too dependent on psychological and emotional factors to maintain sustained growth in the economy.

Pessimism, fear, and uncertainty among consumers and businesses can lead to economic recessions and depressions, and excessive exuberance during good times can lead to an overheated economy and inflation. However, according to Keynesians, government taxation and spending can be managed rationally and used to counteract the excesses and deficiencies of private sector consumption and investment spending in order to stabilize the economy.聽

When private sector spending turns down, the government can spend more and/or tax less in order to directly increase aggregate demand. When the private sector is over optimistic and spends too much, too fast on consumption and new investment projects, the government can spend less and/or tax more in order to decrease aggregate demand.聽

This means that to help stabilize the economy, the government should run large budget deficits during economic downturns and run budget surpluses when the economy is growing. These are known as expansionary or contractionary fiscal policies, respectively.聽聽

Expansionary Policies

To illustrate how the government can use fiscal policy to affect the economy, consider an economy that's experiencing a recession. The government might issue tax stimulus rebates to increase aggregate demand and fuel economic growth.聽

The logic behind this approach is that when people pay lower taxes, they have more money to spend or invest, which fuels higher demand. That demand leads firms to hire more, decreasing unemployment, and to compete more fiercely for labor. In turn, this serves to raise wages and provide consumers with more income to spend and invest. It's a virtuous cycle, or positive feedback loop.聽

Rather than lowering taxes, the government may seek economic expansion through increases in spending (without corresponding tax increases). By building more highways, for example, it could increase employment, pushing up demand and growth.

Expansionary fiscal policy is usually characterized by deficit spending, when government expenditures exceed receipts from taxes and other sources. In practice, deficit spending tends to result from a combination of tax cuts and higher spending.

Fast Fact

Fiscal policy founder John Maynard Keynes argued nations could use spending/tax policies to stabilize the business cycle and regulate economic output.

The Downsides to Expansion

Mounting deficits are among the complaints lodged about expansionary fiscal policy, with critics complaining that a flood of government red ink can weigh on growth and eventually create the need for damaging austerity. Many economists simply dispute the effectiveness of expansionary fiscal policies, arguing that government spending too easily crowds out investment by the private sector.

Expansionary policy is also popular鈥攖o a dangerous degree, say some economists. Fiscal stimulus is politically difficult to reverse. Whether it has the desired macroeconomic effects or not, voters like low taxes and public spending. Due to the political incentives faced by policy makers, there tends to be a consistent bias toward engaging in more-or-less constant deficit spending that can be in part rationalized as 鈥済ood for the economy鈥.聽

Eventually, economic expansion can get out of hand鈥攔ising wages lead to inflation and asset bubbles begin to form. High inflation and the risk of wide-spread defaults when debt bubbles burst can badly damage the economy and this risk in turn leads governments (or their central banks) to reverse course and attempt to "contract" the economy.

Contractionary Policies

In the face of mounting inflation and other expansionary symptoms, a government can pursue contractionary fiscal policy, perhaps even to the extent of inducing a brief recession in order to restore balance to the economic cycle. The government does this by increasing taxes, reducing public spending, and cutting public-sector pay or jobs.

Where expansionary fiscal policy involves deficits, contractionary fiscal policy is characterized by budget surpluses. This policy is rarely used, however, as it is hugely unpopular politically. Public policy makers thus face a major asymmetry in their incentives to engage in expansionary or contractionary fiscal policy. Instead, the preferred tool for reining in unsustainable growth is usually contractionary monetary policy, or raising interest rates and restraining the supply of money and credit in order to rein in inflation.