Fiscal Policy

Fiscal policy plays an increasingly important role in many developing countries. Decisions on fiscal policy, especially if properly synchronized with monetary policy, can help smoothen business cycles, ensure adequate public investment and redistribute incomes. The four main components of fiscal policy are:

  1. expenditure, budget reform
  2. revenue (particularly tax revenue) mobilization,
  3. deficit containment/ financing and
  4. determining fiscal transfers from higher to lower levels of government.

Fiscal policy works through both aggregate demand and aggregate supply channels. Changes in total taxes and public expenditure affect the level of aggregate demand in the economy, whereas, the structure of taxation and public expenditure affect, among others, the incentives to save and invest (at home and abroad), take risks, and export and import goods and services.

Government’s revenue (taxation) and spending policy designed to

  1. counter economic cycles in order to achieve lower unemployment,
  2. achieve low or no inflation, and
  3. achieve sustained but controllable economic growth.

In a recession, governments stimulate the economy with deficit spending (expenditure exceeds revenue). During the period of expansion, they restrain a fast-growing economy with higher taxes and aim for a surplus (revenue exceeds expenditure). Fiscal policies are based on the concepts of the UK economist John Maynard Keynes (1883-1946) and work independently of monetary policy which tries to achieve the same objectives by controlling the money supply.

Objectives of fiscal policy

  • Full employment
  • Price stability
  • Accelerating the rate of economic development
  • Optimum allocation of resources
  • Equitable distribution of income and wealth
  • Economic stability
  • Capital formation and growth
  • Encouraging Investment

Contractionary fiscal policy is when the government either cuts spending or increases revenue through higher taxes. The purpose is to slow growth to a healthy economic level. Although you may think that there’s no such thing as an economy that’s growing too fast, an overheated economy has a lot of negative repercussions. First, it usually creates an asset bubble, similar to what happened to housing industry in 2006. Second, it lowers unemployment to below the natural rate of unemployment. This makes it difficult for employers to find enough workers to meet market demand.
Third, it can create inflation. That’s when prices, and often wages, rise higher and higher. This can destroy savings and your standard of living. Fourth, an economy that’s growing too fast will inevitably burn out, leading to a recession. For more, see Business Cycle.

Contractionary fiscal policy is so named because it actually contracts the economy by reducing the amount of money available for businesses and consumers to spend.

The purpose of contractionary fiscal policy is to cool off growth and prevent inflation. That’s only needed during the peak phase of the business cycle. That’s the only time the government should increase spending beyond the level of revenue it receives. It’s also the only time it should cut taxes below the level needed to support spending.

Expansionary fiscal policy is when the government uses its budgeting tools to provided consumers and businesses with more money. These tools include increased spending, including transfer payments, or tax cuts. It usually uses a combination of all three. In the United States, Congress must generally approve these measures.

Expansionary fiscal policy is so named because it expands the amount of money available for consumers and businesses to spend.

It puts more money into consumers’ hands to give them more purchasing power. It uses subsidies, transfers payments including welfare programs, and income tax cuts. It reduces unemployment by contracting public works or hiring new government workers. All these measures increase demand. That boosts business profit. They use it for new investment and hiring to meet the increased demand.

Fiscal policy is used by elected officials to change the business cycle. Although it can be more powerful than monetary policy, it is rarely used as effectively. That’s because elected officials have different opinions on the best ways to use fiscal policy.

Expansion: When the economy is in the expansion phase, politicians are happy because their constituents are happy. They will pursue other goals, such as foreign policy, defense, or immigration.

Peak: During the irrational exuberance phase, politicians will also ignore fiscal policy. However, this is they should pursue a contractionary fiscal policy to avoid the peak. That means raising taxes and cutting spending. However, since the budget cycle is usually 18 months in the making, by the time the economy reaches the peak, it’s probably too late. In addition, politicians don’t get re-elected by doing either of those things.

Contraction: This is when expansionary fiscal policy is desperately needed. That means cutting taxes and increasing spending to create jobs, demand, and confidence. Find out what are the best unemployment solutions.

Compiled and collected by
Basudev Sharma Poudel(PHD)

Have a question? Ask us in our discussion forum.