Fiscal policy is a macroeconomic policy to influence the economy by using budgetary instruments such as taxes and government expenditure. It complements monetary policy in affecting the economy.
Both are demand-side policies because they affect the economy through their effects on aggregate demand. Strengthening or weakening aggregate demand ultimately affects the level of economic activity.
Both also have limitations. Both require time lag to respond and affect the economy. And, often, economic agents’ responses do not match the policymaker’s expectation so that policies are ineffective.
Fiscal policy objectives
The government uses fiscal policy to influence economic activity. Fiscal policy involves the use of government expenditure and tax policy.
The government directs fiscal policy to stimulate a weak economy (known as expansionary fiscal policy) by increasing its spending or cutting taxes.
On another side, fiscal policy also aims to slow down an overheated economy by lowering its spending or increasing taxes, thereby weakening aggregate demand and avoiding hyperinflation.
Specifically, fiscal policy affects:
- Aggregate demand level, which its change affect overall economic activity
- Wealth distribution
- Resource allocation between various sub-sectors and economic agents
Types of fiscal policy
Fiscal policy is in two forms based on its purpose:
- Expansionary policy
- Contractionary policies
Both use tax and government expenditure instruments. Taxes (such as individual or company tax) have an indirect effect on aggregate demand. Whereas government spending directly affects aggregate demand and gross domestic product (GDP).
An expansion policy aims to stimulate a weak economy and avoid a recession. That can be done by:
- Cutting consumer or business taxes
- Increasing government spending
Lowering taxes makes households and businesses have more money to spend on goods and services. As the demand for goods and services increases, businesses are eager to raise their production. Strengthening demand encourages companies to recruit more workers and increase capital expenditure.
Increased public spending on goods and infrastructure, such as roads and bridges, directly increases aggregate demand. It can also have an indirect impact. Workers involved in the projects see their incomes rise. Likewise, companies hired for those projects also see an increase in earning. Higher earning then increases aggregate demand further.
The contractionary policy has the opposite effect of expansionary policy. The aim is to slow down overheated economic growth, hence avoiding hyperinflation. Hyperinflation is dangerous for the economy because it erodes the purchasing power of money. If not resolved, it could lead to a crisis on the domestic currency.
A contractionary policy can take one or more of the following steps:
- Increase personal income tax to reduce disposable income that households spend on goods and services.
- Increase indirect taxes to reduce real income.
- Raise corporate taxes, thereby reducing profits.
- Raise taxes on savings to lower disposable income.
- Reduce government spendings, such as goods and infrastructure spending.
Contrasting Keynesian and Monetarist Views
Keynesians and Monetarists differ in their views on the effectiveness of the fiscal policy. Keynesian believes that fiscal policy has a substantial impact on aggregate demand, output, and job creation.
Meanwhile, Monetarists believe that fiscal changes only have a temporary impact on the economy. They believe that monetary policy is more effective in controlling inflation and influencing the economy than fiscal policy. Furthermore, monetarists do not advocate the use of fiscal policy in managing the business cycle.
Pros and Cons
Fiscal policy’s effectiveness will vary over time and between countries depending on the underlying economic conditions. During a recession, unemployment increases because of the fall in aggregate output. Fiscal policy through income tax cuts will not necessarily increase consumer spending. The reason Consumers may prefer to save more to anticipate further economic downturn rather than spending on goods and services.
Indirect taxes are very effective in influencing spending behavior and in generating revenue with little cost to the government. The government can quickly raise indirect taxes for social purposes, such as reducing alcohol or cigarette consumption.
But, changes in the direct taxes and government spending often require time to be executed. The government needs to detect economic problems, formulate appropriate policies, change the structure of tax revenues and spending budget, and obtain parliamentary approval before implementing the plan. All of that takes time, and when applied, often, the economic conditions have changed from what has been formulated. The time lag of policy response on the economic problem is known as policy lag.