Fiscal Policy

What It Means

Two of the main ways that a government influences its nation’s economy are fiscal policy and monetary policy. Fiscal policy consists of a country’s taxation and spending programs. In the United States these are developed and implemented by the legislative and executive branches of government (Congress and the president). Monetary policy, meanwhile, is a government’s effort to affect the country’s money supply (the quantity of money circulating in the economy), and it is crafted and carried out by a nation’s central bank (in the United States the central bank is called the Federal Reserve System).

The two tools used in fiscal policy, taxing and spending, represent opposite directions of money movement. When the government collects taxes from citizens, money is transferred from the public to the central government. This can help combat inflation (the general rising of prices), which weakens an economy. When the government spends money (for example, on Social Security payments, highway construction, or weapons for national defense), money moves from the government back into the public sphere. This can stimulate a sluggish economy by encouraging people to spend money.

Fiscal policy can therefore be either expansionary or contractionary. Expansionary fiscal policy increases the amount of economic activity and is accomplished by increasing government spending, lowering taxes, or by a combination of both. Contractionary fiscal policy decreases the amount of money held by private citizens, and it is accomplished by cutting government spending or raising taxes or by a combination of both.

When Did It Begin

National governments have always engaged in taxing and spending, but it was not until the rise of Keynesian economics during the Great Depression (the worldwide economic decline that occurred in the 1930s) that governments began using fiscal policy to spur changes in their economies. Keynesian economics is a theory named after the British economist John Maynard Keynes (1883–1946). In his 1936 book The General Theory of Employment, Interest, and Money, Keynes said that a government could use expansionary or contractionary fiscal policy to alter the level of aggregate demand (the total demand for all goods and services in an economy). Adjusting demand, Keynes believed, was the best way to solve problems in an economy. During the Depression, for example, one-third of the labor force was out of work. Because American consumers had little money to spend, there was little demand for the goods that U.S. factories could produce. Keynes argued that governments could alleviate an economic crisis of this kind by creating consumer demand through government spending. Once the government transferred money to the citizens, people would demand more goods and services, businesses would raise output, and the economy could get back on its feet.

The United States’ recovery from the Depression seemed to validate the Keynesian approach to fiscal policy. The increased spending that was part of President Franklin D. Roosevelt’s New Deal programs in the 1930s produced marked improvements in the U.S. economy. Full recovery from the Depression came with World War II (1939–45), when dramatically increased government spending on defense led to an economic boom. In the 1950s and 1960s the United States had a long period of postwar prosperity, and at the same time Keynesian demand-side ideology (so called because it focuses on raising demand) was the dominant economic theory.

More Detailed Information

Fiscal policy, whether it is expansionary or contractionary, can be divided into discretionary and nondiscretionary forms.

Discretionary fiscal policy involves purposefully altering taxation and spending programs in order to change aggregate demand and regulate the economy. The spending increases undertaken by the Roosevelt administration to combat the effects of the Depression were examples of discretionary fiscal policy; they were put in place to achieve a specific economic result. Likewise, when a president or Congressional representative argues that taxes should be cut in order to stimulate the economy, he or she is attempting to use discretionary fiscal policy.

Both of these examples, moreover, represent expansionary fiscal policy undertaken to combat a sluggish economy. But discretionary fiscal policy can also be contractionary, or employed to battle inflation (the general rising of prices that can be brought on by vigorous economic growth). If, for instance, a president’s economic advisers believed that inflation was getting out of hand, the president could either reduce government spending or raise taxes, either of which would decrease aggregate demand (by transferring wealth out of the public’s hands and into the government’s bank account) and rein in the economy.

Nondiscretionary forms of fiscal policy, commonly called automatic stabilizers, are tools of fiscal policy that work to stabilize the economy without any changes in taxation or spending levels. The established spending programs that provide citizens with unemployment and welfare benefits, for example, are automatic stabilizers. When the economy is struggling, more people file for these forms of government aid, and the payments these people receive help to diminish the effects of unemployment on the overall economy. When the economy picks back up again and people find jobs, government spending on these programs automatically falls. Taxes also work as automatic stabilizers. Under good economic conditions, jobs are created, people are more universally employed, and wages rise. As a result, the government collects more income tax from citizens, offsetting the economic growth and protecting against inflation. The reverse holds true for a stagnant economy.

Recent Trends

The Keynesian approach to fiscal policy has always been controversial, and although it dominated economic thought and government from the 1940s through the 1970s, it was partially blamed for the 1970s phenomenon known as stagflation, when both unemployment and inflation rose. Inflation usually occurs during times of economic expansion; the term stagflation was coined to describe the unusual situation of inflation occurring during a stagnant economic period. Ronald Reagan, elected president in 1980, ushered in an economic approach known as supply-side economics. Unlike the Keynesian idea of regulating aggregate demand and thereby controlling the economy, supply-side economics holds that the government should play no role in affecting demand. Instead, supply-siders contend, increasing aggregate supply (the total amount of goods and services produced by businesses in the economy) encourages simultaneous growth in an economy’s output, full employment, and low prices.

The most common tool of supply-siders, however, is tax cuts, which is also a Keynesian tool for managing aggregate demand. The two opposing economic viewpoints interpret tax cuts differently, however. In the supply-side view, tax cuts are noteworthy not for the effect they have on demand but rather because they motivate people to work and invest their money. An increase in income, according to the supply-side theory, encourages workers to put in more hours and take less time off. More work done by more people produces more goods and services (in other words, it causes an increase in aggregate supply). Workers will have more income to deposit in their bank accounts, which leads to increases in the number of loans banks can make to people who want to start or expand their businesses, which in turn leads to further increases in supply.

Supply-side tax cuts also often target businesses directly. For instance, the Reagan administration instituted tax credits (amounts of money that can be subtracted from one’s total tax payment) for businesses that invested in new equipment, new facilities, or increased research. The intended result was increased capacity to produce goods and services.