Fiscal policy refers to the use of the government budget to affect the economy. This includes government spending and levied taxes. The policy is said to be expansionary when the government spends more on budget items such as infrastructure or when taxes are lowered. Such policies are typically used to boost productivity and the economy. Conversely, the policy is contractionary when government spending decreases or taxes rise. Contractionary policies might be used to combat rising inflation. Generally, expansionary policy leads to higher budget deficits, and contractionary policy reduces deficits.
Key Takeaways
- Governments use fiscal policy such as government spending and levied taxes to stimulate economic change.
- Expansionary policy is characterized by increased government spending or lower taxes to boost productivity.
- Contractionary policy is characterized by decreased government spending or increased taxes to combat rising inflation.
- Expansionary policy leads to higher budget deficits, and contractionary policy reduces deficits.
Understanding Keynesian Macroeconomics
The accounting for government budgets is similar to a personal or household budget. A government runs a surplus when it spends less money than it earns through taxes, and it runs a deficit when it spends more than it receives in taxes.
Until the early 20th century, most economists and government advisers favored balanced budgets or budget surpluses. The Keynesian revolution and the rise of demand-driven macroeconomics made it politically feasible for governments to spend more than they brought in. Governments could borrow money and increase spending as part of a targeted fiscal policy.
Keynesian macroeconomics emphasizes the role of government intervention in stabilizing economies. It suggests that during periods of economic downturn, governments should increase public spending and run budget deficits to stimulate demand, boost employment, and counteract recessions. This approach argues that increased government spending will lead to increased consumer and business spending, creating a cycle of economic activity.
By using deficit spending, governments can bridge the gap between reduced private sector spending and the overall level of demand needed to maintain economic stability. The focus is on managing aggregate demand to achieve full employment and stabilize the economy, even if it requires temporary budget deficits.
An expansionary fiscal policy leads to higher budget deficits while a contractionary policy reduces deficits.
Expansionary Policy
Governments can spend beyond their tax-based budgetary constraints by borrowing money from the private sector. The U.S. government issues Treasury Bonds to raise funds, for example. To meet its future obligations as a debtor, the government must eventually increase tax receipts, cut spending, borrow additional funds or print more dollars. Not all economists agree on the net effect of expansionary fiscal policy on the budget in the long run. In the short run, either surpluses will shrink, or deficits will grow.
During an economic downturn, when businesses are cutting back on investments and consumers are spending less, the government can step in and increase its own spending. This can involve funding public infrastructure projects, increasing social welfare programs, or investing in education and healthcare. By doing so, the government creates demand for goods and services, stimulating economic activity and prompting businesses to produce more.
Another way to implement expansionary fiscal policy is by reducing taxes. When individuals and businesses have more disposable income due to lower tax obligations, they are more likely to spend and invest. This increased spending and investment contribute to higher economic activity and job creation.
Contractionary Policy
Contractionary policy is the opposite of expansionary policy. In times of economic expansion when businesses and consumers are spending at high levels, the government can choose to decrease its own spending. This could involve cutting back on public infrastructure projects, scaling down certain social programs, or trimming government contracts. By reducing government expenditures, the overall demand for goods and services in the economy decreases. This, in theory, can help to moderate inflationary pressures.
Another approach to implementing contractionary fiscal policy is raising taxes. When individuals and businesses face higher tax obligations, they generally have less disposable income available for spending and investment. This decrease in spending and investment dampens aggregate demand, contributing to a reduction in inflationary pressures.
The Multiplier Effect
A crucial concept in economics, especially in the context of fiscal policy, is the multiplier effect. It refers to the magnified impact that a change in government spending, taxation, or investment has on overall economic activity. The effect operates through a series of interconnected spending and income flows such as initial spending, increased business revenue, increased income to workers, increased consumer spending, and business revenues and employment.
The multiplier effect quantifies the overall impact of this cycle. It shows that the total increase in economic output can be larger than the initial injection of spending. The magnitude of the multiplier effect depends on factors such as the marginal propensity to consume and the marginal tax rate.
For example, if the multiplier is 2, the overall economic output will increase by $2 for every dollar increase in government spending or consumer income. Therefore, a government can strive to make subtle fiscal policy changes with minimal implications to national deficits that may have a larger, scaled impact to the economy.
Note that the multiplier effect can amplify both positive and negative economic shocks. Increasing government spending can stimulate the economy, and reductions in spending leading to contraction. Therefore, there may be unintended magnified consequences based on fiscal policy changes.
A government may deploy expansionary and contractionary policies at the same time, especially if it strives to maintain a country’s current position. For example, it may unveil new taxes while also increasing government spending.
U.S. Fiscal Policy and Budget Deficit
The U.S. federal budget deficit for the fiscal year 2022, which ended on September 30, was $1.38 trillion. According t the U.S. Treasury, total government spending for the fiscal year was $6.27 trillion, while total revenue was $4.9 trillion. Note that this deficit is substantially less than the budget deficit from the fiscal year prior of $2.78 trillion ($1.4 trillion higher).
Biden’s 2022 fiscal year budget centered around the American Jobs Plan. The American Jobs Plan is a comprehensive investment strategy aimed at creating millions of jobs and rebuilding infrastructure. It includes modernizing 20,000 miles of highways, repairing bridges, upgrading ports, and delivering better utilities across America.
The American Families Plan also includes a historic investment to help families cover basic expenses, lower health insurance premiums, and continue the reductions in child poverty. In addition, it includes $10.7 billion in discretionary funding for the Department of Health and Human Services to support research, prevention, treatment, and recovery support services. Last, it also includes funding to prevent gun violence public health epidemic and the homelessness crisis.
The fiscal policy plan under this budget also called for some reductions in revenue. The plan extends key tax cuts in the American Rescue Plan including the expansions of the Child Tax Credit, Earned Income Tax Credit, and Child and Dependent Care Tax Credit. Therefore, these fiscal policy measures were set to net increase the federal deficit.
How Does Fiscal Policy Affect Unemployment and Inflation?
Fiscal policy can impact unemployment and inflation by influencing aggregate demand. Expansionary fiscal policies often lower unemployment by boosting demand for goods and services, while contractionary fiscal policy can help control inflation by reducing demand. Balancing these factors is crucial to maintaining economic stability.
What Are Automatic Stabilizers, and How Do They Interact With Fiscal Policy?
Automatic stabilizers are mechanisms built into the economy that automatically stabilize economic fluctuations. Examples include unemployment benefits and progressive income taxes. During recessions, these stabilizers kick in. For example, unemployment benefits increase and taxes decrease, helping to boost demand without requiring explicit policy changes.
Can Fiscal Policy Be Used to Address Long-Term Structural Issues in an Economy?
While fiscal policy is often used to address short-term economic challenges, it can also be used to tackle long-term structural issues. For example, targeted government spending on education, infrastructure, and research can contribute to long-term economic growth and competitiveness.
What Are the Potential Risks of Running Persistent Budget Deficits?
Running persistent budget deficits can lead to an accumulation of government debt over time. This can strain government finances, increase interest payments on the debt, and potentially crowd out private investment. Careful management is required to ensure the sustainability of deficits in the long run.
The Bottom Line
Fiscal policy refers to government’s use of spending and taxation to influence a nation’s economy. It aims to stabilize economic growth, employment, and inflation. Expansionary fiscal policy involves increased spending or tax cuts to stimulate demand and counter recessions, potentially leading to budget deficits. Contractionary fiscal policy involves reduced spending or increased taxes to control inflation, possibly leading to budget surpluses.