Fiscal policy is the use of public spending – government spending – and taxation to impact the economy. National governments generally use fiscal policy to encourage strong and sustainable growth, achieve full employment, and reduce poverty.
The aims and role of fiscal policy gained prominence since the 2007/2008 global financial crisis and the Great Recession that followed it. Governments stepped in to support financial systems, stimulate growth, and minimize the impact of the crisis on vulnerable groups.
The prominence of fiscal policy as a policy tool historically has fluctuated. Up to 1929, an approach of laissez-faire – minimal government intervention – dominated the economic scene in North America and Western Europe.
When all is fine the government will likely adopt a neutral fiscal policy, during a recession it will probably prefer an expansionary fiscal policy, and a contractionary one when the economy is overheating.
The Wall Street Crash of 1929 – the most severe in America’s history – and the Great Depression that followed, dramatically changed how leaders and governments intervened in their nations’ economies, especially in the United States and the United Kingdom.
In the 1930s, policymakers pushed for governments to become much more proactively involved in kick-starting the economy. During the 1980s, governments across the world scaled back the size and function of governments, as markets started taking on an enhanced role in the allocation of goods and services.
Since the 2007-2008 global financial crisis, a more fiscal policy was back in fashion.
How does fiscal policy work?
When the leaders of a country seek to influence the economy, they have two main tools at their disposal:
– Monetary Policy: this is the main focus of a nation’s central bank – it involves regulating interest rates, effectively the cost of borrowing, and the money supply. The US Federal Reserve, the Bank of England and other central banks manage monetary policy to control inflation, stabilize their currency, and ensure that the economy is following the right path.
– Fiscal Policy: government spending policies that impact macroeconomic conditions. This is done through the collection of taxes, borrowing, and government spending. Through fiscal policy governments attempt to bring down unemployment, stabilize business cycles, influence interest rates, and in times of recession kick-start the economy.
By boosting public spending, especially on labor-intensive projects, and reducing taxes, aggregate demand will increase and the economy will grow, Keynesian economists believe.
Fiscal policy is largely based on the ideas put forward by John Maynard Keynes, 1st Baron Keynes, (1883-1946), an English economist who fundamentally changed the theory and practice of macroeconomics and the economic policies of governments.
Keynes believed that the government is able to change economic performance by adjusting taxation rates and government spending. His ideas are the basis for the school of thought we call Keynesian Economics and several of its offshoots.
According to Keynes, when the government alters the levels of taxation and government spending, it influences aggregate demand and the level of economic activity. He said fiscal policy can be used to stabilize the economy over the course of the business cycle – it can prevent the undesirable boom-and-bust economic cycle.
The two main instruments of fiscal policy are:
– Changes in the level and composition of taxation,
– Changes in government spending.
These two main fiscal policy instruments can affect the following variables in an economy:
– Aggregate demand and economic activity levels.
– The distribution of income.
– Savings and investment in the economy.
“Governments directly and indirectly influence the way resources are used in the economy. The basic equation of national income accounting helps show how this happens: GDP = C + I + G + NX.”
John Maynard Keynes was born in Cambridge, England, in 1883. He died in Firle, Sussex, England, in 1946. (Image: leftfootforward.org)
Fiscal policy stances
There are three main stances of fiscal policy – neutral, expansionary and contractionary.
– Neutral Fiscal Policy: undertaken by governments when the nation’s economy is in equilibrium. Government spending is completely funded by tax revenue, and the budget outcome has a neutral effect on economic activity levels.
– Expansionary Fiscal Policy: the government spends more than it collects from taxation. This approach is more commonly used when the economy is in recession. It is also called a reflationary fiscal policy.
– Contractionary Fiscal Policy: when public spending is less than tax revenue. This approach is commonly adopted when the aim is to pay off government debt.
Even if spending or tax laws remain unchanged, cyclic fluctuations in the economy may cause tax revenues to go up or down, which will affect some types of government spending, which in turn can alter the deficit situation – these are not considered to be policy changes.
Rather than using the terms ‘government spending’ and ‘tax revenue’, economists often use ‘cyclically adjusted government spending’ and ‘cyclically adjusted tax revenue’.
The terms ‘expansionary’ and ‘contractory’ are used in the similar way in relation to monetary policy as to fiscal policy.
How is fiscal policy funded?
Government expenditure can be funded in several different ways:
– The benefit from printing money (Seigniorage).
– Borrowing money by issuing securities, government bonds and bills. Less creditworthy nations might borrow directly from the World Bank or other international financial institutions.
– Consumption of fiscal reserves, i.e. dipping into its savings.
– Selling assets, such as land or floating government-owned companies – often referred to by left-wing parties as ‘selling the family silver’.
Keynesian economics suggests that greater government spending, accompanied by lower tax rates, are the best ways to boost aggregate demand – when the economic boom starts, spending must be brought down and taxes increased.
Keynesian economists argue that this approach should be used when there is low economic activity or in times of recession if the government is serious about aiming to eventually achieve full employment and building the framework for strong economic growth.
In theory, the resulting debt build-up would be paid for when the economy expands and government income (taxation revenue) increases.
Politicians of the Republican Party in the USA and Conservative Party in the UK worry that all that such a strategy might achieve is a high debt, with no economic growth. It goes against right-of-center parties’ policies of discouraging government interference in the economy.
According to lexicon.ft.com, fiscal policy is:
“A government’s policy regarding taxation and public spending. Like monetary policy, it can be loose (with the emphasis on increased spending and lower tax revenue to boost economic activity, with the acceptance of a wider fiscal deficit) or tight (with the emphasis on cutting spending and boosting tax revenue, resulting in a slower economy and a higher chance of a fiscal surplus).”
Video – Keynesian Economics
This video contrasts Keynesian and Classical Thinking.