The U.S. government attempts to manage the overall economic activity, seeking to maintain high levels of employment and stable prices (little or no inflation). It does this through its Fiscal Policy and Monetary Policy.
Fiscal Policy is the manipulation of the government budget to affect the economy. It refers to the policy by which the government purchases and provides goods and services and the way in which the government finances these expenditures – through taxation or borrowing. The state of fiscal policy is usually summarized by looking at the difference between what the government pays out and what it takes in; that is, the surplus or deficit. Fiscal policy is said to be tight, or contracting, when revenues are higher than the spending. It is said to be loose, or expanding, when spending is higher than revenues. Often, however, the focus is not on the size of the surplus or the deficit but in the change in its size. Thus, a decrease in the deficit in one fiscal year from the prior fiscal year is interpreted as contracting fiscal policy, even though the budget is still in deficit.
The most immediate impact of fiscal policy is to change the demand for goods and services. If the government increases its spending, or if it lowers taxes, it increases the demand for goods and services. But there are other effects. When the government runs a deficit, it borrows some of that money by issuing bonds and, thus, competes with private borrowers, raising interest rates and crowding out some private investment. (See Monetary Policy.)
Fiscal policy is an important tool because it has the ability to affect the amount of output produced; that is, the gross domestic product (GDP). As stated above, the first impact of a fiscal expansion is to raise the demand for goods and services. This greater demand leads to increases in both output and, usually, prices. The degree to which higher demand increases output and prices depends on the state of the business cycle. If the economy is in recession, with unused productive capacity and unemployed workers, increases in demand will lead to more employment and production of goods and services without changing the price level. If the economy is at full employment, fiscal expansion will have more effect on prices. Therefore, in a recession the government can have an expansionary policy (by spending more and/or cutting taxes) and, in doing so, encourages an increase in output, putting unemployed workers back to work. During a boom economy, the government can have a contractionary policy (by spending less and/or raising taxes) to slow down the economy and, hopefully, hold off inflation.
There are two (2) forms of fiscal policy. One form of fiscal policy is known as “automatic stabilizers.” These are programs that automatically expand fiscal policy during recessions and contract it during booms. For example, unemployment insurance increases during recessions and, thus, serves the function of stabilizing the economy. Taxes, too, are proportional to wages and profits. So, during a boom the amount of taxes collected is higher and also stabilizes the economy.
The other form of fiscal policy is discretionary. Discretionary policy refers to the changes (as discussed above) done solely in an effort to change the economy. Unfortunately, it is very difficult for discretionary policy to actually influence the economy, primarily because of lag time. For instance, a tax cut proposed by a president will take two (2) years before it is passed by Congress and put into effect. The factors that called for the tax decrease two (2) years prior may no longer be in place and, at that time, a tax cut may be ineffective or even detrimental. Therefore, most economists agree that, in order to affect the economy, the application of monetary policy is more effective than the application of discretionary fiscal policy.
In addition, the ability of fiscal policy to affect the level of output of goods and services through demand wears off over time. For example, higher demand eventually will result in higher prices because output, over the long term, is ultimately determined by the supply of factors of production (capital, labor, and technology). Thus, discretionary fiscal policy can only cause a temporary effect and, ironically, can cause the opposite effect over the long term. Expansionary policy may lead to higher output in the short run but may lower output in the future. Contractionary policy may lower output in the short run but could lead to higher output in the future. This is because the level of output in the long run affects the saving rate.
The country’s saving rate is composed of two (2) parts – private saving by individuals and corporations and government saving (a budget surplus). Fiscal expansion entails a decrease in government saving since, in order to get an expansion, the government either cuts taxes or increases spending. A lower saving rate means less investment or increased deficit. Lower investment leads to lower capital stock and to a reduction in a country’s ability to produce output in the future. Increased indebtedness means more of the government’s budget is spent on interest, rather than on stimulating the production of goods and services.
Fiscal policy also changes the burden of future taxes. Expansionary fiscal policy adds to debt and increased debt leads to an additional burden on future generations, one that will have to be reduced by additional taxes.
© The Issue Wonk, 2006