Fiscal policy

In economics, Fiscal policy refers to government attempts to influence the direction of the economy through changes in government taxes, or through some spending (fiscal allowances). It is the use of government spending and revenue collection to influence the economy.

Fiscal policy can be contrasted with the other main type of economic policy, monetary policy, which attempts to stabilize the economy by controlling interest rates and the supply of money. The two main instruments of fiscal policy are government spending and taxation. Changes in the level and composition of taxation and government spending can impact on the following variables in the economy:

• Aggregate demand and the level of economic activity;
• The pattern of resource allocation;
• The distribution of income.

Fiscal policy refers to the overall effect of the budget outcome on economic activity. The three possible stances of fiscal policy are neutral, expansionary and contractionary:

• A neutral stance of fiscal policy implies a balanced budget where G = T (Government spending = Tax revenue). Government spending is fully funded by tax revenue and overall the budget outcome has a neutral effect on the level of economic activity.
• An expansionary stance of fiscal policy involves a net increase in government spending (G > T) through rises in government spending or a fall in taxation revenue or a combination of the two. This will lead to a larger budget deficit or a smaller budget surplus than the government previously had, or a deficit if the government previously had a balanced budget. Expansionary fiscal policy is usually associated with a budget deficit.
• A contractionary fiscal policy (G < T) occurs when net government spending is reduced either through higher taxation revenue or reduced government spending or a combination of the two. This would lead to a lower budget deficit or a larger surplus than the government previously had, or a surplus if the government previously had a balanced budget. Contractionary fiscal policy is usually associated with a surplus.

Methods of funding

Governments spend money on a wide variety of things, from the military and police to services like education and healthcare, as well as transfer payments such as welfare benefits.

his expenditure can be funded in a number of different ways:

• Taxation
• Seignorage, the benefit from printing money
• Borrowing money from the population, resulting in a fiscal deficit.
• Consumption of fiscal reserves.
• Sale of assets (e.g., land).

Funding the deficit

A fiscal deficit is often funded by issuing bonds, like treasury bills or consols. These pay interest, either for a fixed period or indefinitely. If the interest and capital repayments are too large, a nation may default on its debts, usually to foreign creditors.

Some peculiarities exist: for example, the US owes most of its own debt to itself.

Consuming the surplus

A fiscal surplus is often saved for future use, and may be invested in local (same currency) financial instruments, until needed. When income from taxation or other sources falls, as during an economic slump, reserves allow spending to continue at the same rate, without incurring a deficit.

Economic effects of fiscal policy

Fiscal policy is used by governments to influence the level of aggregate demand in the economy, in an effort to achieve economic objectives of price stability, full employment and economic growth. Keynesian economics suggests that adjusting government spending and tax rates are the best ways to stimulate aggregate demand. This can be used in times of recession or low economic activity as an essential tool in providing the framework for strong economic growth and working toward full employment. The government can implement these deficit-spending policies due to its size and prestige and stimulate trade. In theory, these deficits would be paid for by an expanded economy during the boom that would follow; this was the reasoning behind the New Deal.

During periods of high economic growth, a budget surplus can be used to decrease activity in the economy. A budget surplus will be implemented in the economy if inflation is high, in order to achieve the objective of price stability. The removal of funds from the economy will, by Keynesian theory, reduce levels of aggregate demand in the economy and contract it, bringing about price stability.

Some classical and neoclassical economists argue that fiscal policy can have no stimulus effect; this is known as the Treasury View, and categorically rejected by Keynesian economics. The Treasury View refers to the theoretical positions of classical economists in the British Treasury who opposed Keynes call for fiscal stimulus in the 1930s. The same general argument has been repeated by neoclassical economists up to the present day. From their point of view, when government runs a budget deficit, funds will need to come from public borrowing (the issue of government bonds), overseas borrowing or the printing of new money. When governments fund a deficit with the release of government bonds, an increase in interest rates across the market can occur. This is because government borrowing creates higher demand for credit in the financial markets, causing a lower aggregate demand (AD), contrary to the objective of a budget deficit. This concept is called crowding out.

Other possible problems with fiscal stimulus include the time lag between the implementation of the policy and detectable effects in the economy and inflationary effects driven by increased demand. Fiscal stimulus does not cause inflation when it uses resources that would have otherwise been idle. For instance, if a fiscal stimulus employs a worker who otherwise would have been unemployed, there is no inflationary effect; however, if the stimulus employs a worker who otherwise would have had a job, the stimulus is increasing demand while labor supply remains fixed, leading to inflation.

References

• Sullivan, arthur; Steven M. Sheffrin (2003). Economics: Principles in action. Upper Saddle River, New Jersey 07458: Pearson Prentice Hall. pp. 387.