Fiscal Policy

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Fiscal Policy

I OVERVIEWHerbert Stein





Fiscal policy is an aspect of public finance, of making and financing government expenditures. It is distinguished from other aspects of public finance in being concerned with decisions about certain “over-all” variables—such as total expenditures, total revenues, and total surplus or deficit—in terms of their “over-all” effects—such as their effects on national income, total employment, and the general level of prices.

The management of their total revenues and expenditures and of the relation between them has become one of the principal instruments by which governments seek to achieve a high level of economic activity and general price stability. This effort encounters many problems—including the compatibility of these two objectives with each other and with other goals, the uncertainty of the size and timing of the necessary actions, and the difficulty of making and carrying out decisions in a large and political organization. Nevertheless, there is widespread confidence that the fiscal instrument is sufficiently powerful, and its use sufficiently understood, to make a substantial contribution to successful economic performance.

The distinction between fiscal policy and the other aspects of public finance that deal with particular expenditures and taxes and their particular consequences is an abstraction from the complexity of the real world. In fact, decisions about the “overall” variables are made up of decisions about particulars. Also, any decision that has “over-all” effects will also have particular effects on particular individuals, industries, or sectors of the economy.

While the boundary between fiscal policy and other aspects of public finance is necessarily arbitrary, the concept of fiscal policy is useful for analysis and for policy making. Every particular expenditure, tax, and debt issue may have a different over-all effect from every other. Yet for certain purposes it may be both convenient and safe to regard some large categories of expenditures, taxes, and debt issues, or even their totals, as single variables. In fact, it may be impossible to do otherwise, since existing knowledge is too crude to permit distinction among all possible variables.

It is necessary to distinguish fiscal policy not only from other aspects of public finance but also from monetary policy, which also consists of overall measures usually evaluated in terms of over-all effects—on national income, total employment, or the price level, for example. This distinction can be drawn in various ways, depending upon the definition given to monetary policy. The distinction and connection are clearest if monetary policy is defined as policy with respect to the quantity of money. Fiscal policy can then be defined as policy with respect to total government sources and uses of funds and their composition. Certain sets of actions are a mixture of both monetary and fiscal policy—such as an increase of government expenditures financed by an increase in government borrowing, which in turn causes or is permitted to cause an increase in the money supply. Even in the mixed cases it is possible to distinguish between the monetary and fiscal aspects and to consider what effects flow from each. Its relation to monetary policy is one of the central problems of fiscal policy; this will be discussed below.

Pre-Keynesian theory . Fiscal policy began to assume a leading role in economic thinking, economic controversy, and economic policy only in the 1930s. But as long as there have been governments there has been fiscal policy, and a substantial body of doctrine about it existed long before the 1930s. Although we shall be concerned here mainly with “modern,” i.e., post-1930, fiscal policy, a few words should be said about earlier ideas and practice. Modern thinking about fiscal policy, after first abandoning much of prior doctrine, has since rein-corporated a great deal of it.

Neither fiscal theory nor fiscal practice before the 1930s was primarily concerned with maintaining high employment and stabilizing the rate of growth of total national output. Economic thinking and policy in general were much less dominated by the high employment problem than they later came to be and were more focused on problems of long-run growth, efficiency in the use of employed resources, and equity in the distribution of income. It was believed that in the long run the economy would tend to produce at a rate determined by “real” factors—the supply of labor and capital and the state of technology. Prices and wage rates would tend to adjust to changes in total money expenditures for goods and services so as to leave real output unchanged.

This view still left the possibility that variations in the general level of prices would have unwanted distributional effects in the long run and would cause unemployment in the short run. This was commonly regarded as a monetary problem, which could be handled by appropriate management of the quantity of money. At the same time, certainly by the 1920s, the possible contribution of budget policy, particularly variation of public works expenditures, to short-run economic stabilization, was widely but not universally recognized. However, a well-developed theory of how budget policy worked was lacking. There was uncertainty and disagreement about whether budget policy was an independent instrument of economic stabilization or only a particular way of carrying out monetary policy which might nevertheless be helpful in special circumstances. Moreover, the small size of government budgets relative to national incomes severely limited the possibility of a major contribution of budget policy to economic stabilization.

Before the depression, attention in economic thinking about fiscal policy focused on its consequences for the distribution of the total output among uses, rather than on its consequences for the level of output in the short run. The main consequences of fiscal policy were considered to be its effects on (a) the division of output between consumption and investment and (b) the division of output between public and private use. Standards of good fiscal policy were largely derived from the desired objectives for these two divisions of the national output. (There was, of course, a vast literature on aspects of public finance other than “fiscal policy” which was concerned with other consequences.)

A major theme was the connection among budget balancing, saving, investment, and economic growth. If government expenditures were larger than tax receipts, the deficit would have to be financed by borrowing. The government’s borrowing would absorb part of the nation’s current private saving, which would therefore not be available to finance private investment. Investment would be lower than if the budget had been balanced, and consequently the rate of economic growth would also be lower.

This argument that total savings will be larger if there is a budget surplus than if there is a deficit is true only if the taxes used to achieve the surplus depress private savings by an amount less than the tax collections. Kinds of taxes are conceivable of which this would not be true. However, it is not necessary to adopt such taxes. Indeed, the same argument that calls for balancing the budget and running a surplus in order to promote economic growth also calls for avoiding kinds of taxation that depress private saving.

The conclusion that government budgets should be balanced was also reached by consideration of the proper division of the national product between private and public uses. The requirement that government expenditures should be financed by taxation was considered necessary to prevent a politically dangerous and economically wasteful excess of government spending. Ultimately the citizen might be thought of as buying services from the government and as obtaining the right amount when he acquires the amount whose cost he is willing to pay in taxes.

It is not demonstrable a priori that the total amount of government expenditures that would be made if they had to be paid for in taxes is the “best” amount, or even better than the amount that would be made if they could be financed by borrowing. Government expenditures have a real cost in private expenditures that must be forgone, however they are financed. The “discipline” argument for budget balancing is that citizens will not accurately appraise this real cost if they can borrow to pay it. Once this possibility of error is admitted, it becomes a question of fact in what direction the errors run. If the citizens may underestimate costs which are financed by borrowing, so may they overestimate costs financed by taxation and either overestimate or underestimate the benefits of expenditures.

As has been noted, consideration of the desirable division of the national product between consumption and investment and between public and private uses led economists before the 1930s to budget balancing as a basic principle of fiscal policy. But the common popular support for the budget-balancing idea was probably not chiefly based on the economists’ argument. The idea that government budgets should be balanced has a direct and intuitive appeal as a particular application of principles of conduct accepted as having moral and utilitarian validity in a much broader field. The “folk wisdom” basis of popular thinking about budgets probably explains the strong resistance of that thinking to the revolutionary change in economists’ views of the matter that began in the 1930s.

Post-Keynesian theory . Earlier thinking about fiscal policy was challenged in the 1930s at its root—namely, the proposition that fiscal policy does not affect total national output. Successful challenge to this proposition brought the level of total output and total employment to the forefront of the objectives of fiscal policy. It also radically altered thinking about policy to achieve the traditional objectives.

The revolution in thinking about fiscal policy can be dated from the publication of John Maynard Keynes’s General Theory of Employment, Interest and Money in 1936. This work had its precursors and was subsequently explained, extended, refined, and in part controverted by others. But the General Theory was the turning point. All serious argument about fiscal policy since it was published, even the argument that completely denied the Keynesian conclusions, has been influenced by it.

The first step in the new approach to fiscal policy was to loosen the link between the quantity of money and total money expenditures or total money income. If the ratio of total money income to the supply of money was fixed (or if not fixed, at least determined by factors that fiscal policy could not influence), fiscal policy that did not affect the supply of money would not affect total money income.

The new theory provided a way for fiscal policy to affect total money income, without a change in the supply of money. This, of course, implied a change in the ratio of money income to money supply. For example, suppose the government increases its expenditures without equally increasing taxes and without increasing the supply of money. The increase in government expenditures will initially increase the incomes of individuals and businesses. Since there has been no increase in the money supply, the ratio of their money holdings to their incomes has declined. Older theory would have emphasized reactions to a decline in this ratio which took the form of attempts of individuals and businesses to build up their money holdings by cutting their expenditures, which would in turn reduce total income. The newer theory emphasized two other possibilities. One was that money holdings were already “redundant,” so that there would be no felt need to increase money holdings as incomes increased. The other possibility was that individuals and businesses would try to build up their money holdings by selling interest-bearing securities (rather than by cutting their expenditures). This would reduce the prices of such securities, and raise the interest rates they yielded, until a point was reached at which people would no longer consider it worthwhile to sell securities at low prices, or give up interest, in order to get more money.

In the early years of the “new fiscal theory” there was some disposition to carry the argument even further. That is, not only was the effectiveness of fiscal policy asserted, but the effectiveness of monetary policy was denied. If people were willing to absorb a change in their money holdings without any reaction, or if they reacted in a way that affected only interest rates, which did not in turn affect either private investment or saving, there would be no route by which a change in the money supply could affect total money income.

Controversy between the pre-Keynesian view and the extreme post-Keynesian view raged for some years in the late 1930s. But in time a consensus emerged on an intermediate position. The ratio of total money income to the money supply is not fixed, but can be affected by changes in interest rates, which can be changed by fiscal policy; but the ratio is not infinitely variable, and a change in the money supply will affect money income, either through an effect on interest rates and investment, or directly. Under this formulation the national money income may be affected by fiscal policy, or by monetary policy, or by various combinations of the two. Wide disagreement remains, however, about the probable magnitudes of the effects of each kind of action.

The foregoing discussion has run entirely in terms of the effect of fiscal action upon total money income and money expenditures. It will be recalled that earlier thinking held that variations in money income and expenditures would not in any case affect real output and employment, except temporarily, but would affect only prices and wage rates. The Keynesian analysis assumed that as long as employment was below some level, considered the full employment level, wage rates would be stable and variations in money income would be directly reflected in employment and real output. Some of Keynes’s early followers tended to argue as if this assumption, made for purposes of analysis, were also descriptive of the real world. However, there has since been a general recognition that the actual situation is more complicated. There is no single point of “full employment” below which variations in money income affect only employment and output without affecting prices and wage rates and above which only prices and wage rates, but not employment and output, would be affected. At least over a considerable range of employment levels, variations in money income will affect both prices and output, although the price effect will presumably be larger and the output effect smaller, the higher the initial level of employment. This makes the choice of the “desired” behavior of money income difficult, but it still leaves the behavior of money income an important objective of fiscal policy.

Sources and uses of funds . Discussion of the new fiscal policy initially concentrated on the effects of variations in government expenditures, taxes being given. Emphasis was placed on the stimulative effects of “deficit spending,” that is, of government spending not offset by tax revenues. It was shown that on certain assumptions the increase in the national income resulting from an increase in deficit spending would be a multiple of the increase in deficit spending. The increase in government spending initially causes private incomes to rise by an equal amount. Recipients of the additional private income will be induced to spend more, which will generate more income for others, who in turn will spend more, and so on in a “multiplier” process whose limit depends on the proportion of their additional income that people spend.

It soon became clear that similar effects could be expected from variations in taxes, expenditures being given. A reduction in taxes would increase, and an increase in taxes would reduce, private spending, which would affect private incomes, and thereby affect private spending, and so on in the multiplier process.

If an increase of government expenditure would increase the national income by some multiple of the increase, and an increase of taxes would reduce the national income by some multiple of the tax increase, an equal increase of expenditures and taxes would affect the national income in one direction or the other if the expenditure and tax multipliers were unequal. There is no a priori reason to think that the multipliers are equal. In the 1940s and 1950s there was a great deal of discussion of the implications of equal changes of expenditures and revenues. Most of it revolved about the “balanced-budget multiplier theorem,” which showed that on certain assumptions the multiplier of an equal increase in expenditures and revenues will be 1; that is, the total increase in spending from an equal increase in government spending and taxes will equal the increase in government spending.

The balanced-budget multiplier theorem demonstrated that the budget deficit or surplus could not logically be regarded as the sole source and measure of the effects of the budget on total spending, and opened the way to a more general view of the possibilities of fiscal policy.

The government may be conceived of as obtaining funds from a variety of sources and using funds in a variety of ways. The total sources and total uses are equal, if borrowing and the use of existing balances are considered sources of funds. Each of the sources and uses of funds has some effect on total national spending, but the effects of different sources and uses need not be equal per dollar. If every dollar used has an equal positive effect on total spending, and if every dollar obtained, including dollars borrowed, has an equal negative effect, then fiscal policy can have no net effect.

The new fiscal policy first said that the effect of borrowing funds to finance a deficit was less per dollar than the effect of obtaining funds from taxes and also less, and of opposite sign, than the effect of spending funds. Therefore, an equal increase of government spending and borrowing, or an equal decrease of taxes and increase of borrowing, would have an effect on total spending.

The balanced-budget multiplier discussion said that the effect of obtaining funds by taxing was different, per dollar, and of opposite sign from the effect of spending funds. Therefore an equal increase of taxes and government expenditures would have a net effect on total expenditures—an expansive effect if the expenditure multiplier was larger than the tax multiplier.

Once we have gone this far, it is a logical next step to say that different government expenditures and different taxes have different effects per dollar. In this case a shift from one kind of government expenditure to another, or from one kind of tax to another, would have a net effect on total expenditure. This net effect could be achieved without a change in the size of the deficit or surplus or in the total size of the budget.

Formally the possibility exists of obtaining any desired effect on total spending through any one of a large number of combinations of sources and uses of government funds. Any differences in the effect per dollar of any two sources or uses of funds would constitute a lever that could be used to affect total spending. Whether in fact the number of such levers is large depends on whether the differences in the effects of various sources and uses of funds are significant, whether the differences are known with some certainty, and whether the various sources and uses of funds can in practice be manipulated to serve some objective with respect to total spending.

Little is reliably known about the differences in the effects of various fiscal actions upon total spending. There is fairly general agreement that an increase in spending or a decrease in taxes has a larger expansive effect, per dollar, than the contractive effect of an increase in government borrowing, although even this would be disputed with respect to some kinds of government borrowing. If this is true, then any combination of fiscal actions that includes expenditure increases and tax decreases, but no expenditure decreases or tax increases, will have an expansive effect. But if the combination includes tax and expenditure actions that separately have effects of different directions, the direction of the net effect would be uncertain.

Modern theory opens up the possibility of a large number of combinations of fiscal actions that could affect total spending, some but not all of which would affect the surplus or deficit. We do not know even the direction of the effect of many of these combinations, including some that affect the surplus or deficit. Where there is considerable confidence about the direction of the effect, the magnitude of the effect is still uncertain, to a degree that varies with the particular action.

Theories concerning implementation . The new theory held out the possibility of achieving any desired level or rate of change of money national income. It said that given any objective for the behavior of money national income, and given all the factors other than fiscal policy that affect its behavior, there is some combination of government expenditure programs and tax rates that will achieve the objective. However, this proposition stops far short of specifying what the proper fiscal policy is at any time.

The implementation of fiscal policy must contend with several difficulties:

(1) It is not certain what behavior of money national income should be the objective of fiscal policy. The money national income is an intermediate objective, important because of its influence on employment, production, prices, economic growth, and the balance of payments. What the effect of a particular level and rate of change of money national income will be on these aspects of the economy is always impossible to tell precisely. Even if it were known what the effects would be, what would be the “best” effects would still have to be determined.

(2) The fiscal policy necessary to achieve any given course of money national income will depend upon the other autonomous factors that affect the national income in the future period in which the fiscal decisions will operate. If these other factors —which may be summed up as private tendencies to invest and consume—are strong, a less expan- sive fiscal policy will be required than if they are weak. These other factors are variable, and prediction of them is subject to a wide margin of error.

(3) The effects of various fiscal actions upon the money national income are known only very roughly. Presumably, for example, a one-point reduction in the basic rate of the individual income tax will make the money national income higher than it would otherwise have been. But informed estimates of the magnitude and timing of the effects will vary widely, and this will also be true of other fiscal actions.

(4) Even if the target for behavior of money national income, the autonomous factors affecting the national income, and the effects of all fiscal actions are precisely known, the proper fiscal policy is not uniquely determined. There will almost certainly be more than one combination of tax and expenditure actions that would yield the target national income. A choice will have to be made among these combinations, and it will have to be made on criteria other than the effect on national income, since the combinations are alike in that respect.

(5) Since the behavior of money national income is affected to some, much-disputed, degree by monetary policy, the policy packages among which a choice must be made consist not only of various combinations of fiscal actions but also of various combinations of fiscal and monetary policy.

(6) For all the foregoing reasons, the range and variety of fiscal policies that might reasonably be thought at any time to give a good combination of effects on employment, production, prices, etc., will be large, and it will not be possible objectively and certainly to select one policy as best. The selection of a policy to follow will be made in the political process, by people who are sensitive to the political consequences of the selection. This may introduce a bias into the selection, causing it to depart systematically from what is probably the best choice.

This list of difficulties does not constitute an argument against fiscal policy or even against using fiscal policy to achieve desired effects on employment, production, growth, prices, and the balance of payments. There will be a fiscal policy as long as there is government. This fiscal policy will have effects, and it is obviously desirable that it should have good rather than bad effects. But the difficulties listed here do suggest the problems that must be overcome to assure the choice of the fiscal policy that will have the best effects, or is most likely to have the best effects.

General strategies of implementation . Two main lines of thinking about the strategy of implementing fiscal policy have emerged in the postwar period, although each has variants and the two lines tend to meet when each is elaborated with regard to the conditions of the real world. One approach is direct and activist, the other indirect and passive.

The direct, activist approach might be called the “do your best” approach. It recognizes that the appropriate target for money national income, the future state of the economy upon which fiscal policy will operate, and the future effects of various fiscal actions cannot be known with certainty. Nevertheless, in this view, the responsible authorities in government must make, and act upon, their best estimates of these factors. While there will be departures from the ideal result, these departures, it is believed, will be smaller than would be yielded by any alternative system.

The indirect, passive approach would call for fiscal policy to adhere to some predetermined objective rule or standard which would not require forecasting short-run economic fluctuations. An effort was made to find such a rule which would, first, keep fiscal policy from being an independent destabilizing force and, second, insofar as consistent with the first objective, make fiscal policy a stabilizing force. This effort was more evident in the United States than elsewhere, perhaps because the American political process did not leave budget policy to “experts,” and this generated more public interest in specifying guides to budget policy.

The rule commonly suggested set as a standard a fixed relation between expenditure programs and tax rates such that revenues would exceed expenditures by some constant amount X (which might be positive, zero, or negative) when the national income was at some standard level Y. Examples of proposed budget rules may be found in the articles by the Committee for Economic Development and by Milton Friedman included in American Economic Association, Readings in Fiscal Policy (1955). Thus the actual surplus would be constant when the actual national income was at the standard. To this degree the budget would be neutral. If this rule were followed, the actual surplus would be below X when the actual national income was below the standard Y, and the surplus would be above X when the actual national income was above the standard Y. The farther the national income was below the standard, the less the government would subtract from the private income stream in taxes, and the more it would add in expenditures, so that the larger the government’s support for total spending and income would be. To this degree the budget would be stabilizing; it would resist variations in the actual national income relative to the standard. The standard level of national income would rise through time with the growth of potential national output. If actual national income did not rise as fast as potential, adherence to the rule would generate a rising deficit (or falling surplus), which would tend to accelerate the growth of actual national income.

The logic of the rule did not require that the standard national income should be equal to the potential or “full employment” national income, although it did require that the standard bear a certain constant relation to potential national income. However, in fact, the standard was usually prescribed as the full-employment national income, and the rule called for balancing the budget (or running some specified constant surplus or deficit) at full employment. Thus discussion of the rule focused attention on what the surplus or deficit would be at full employment, as distinguished from the actual surplus or deficit. The “full employment surplus” became a widely-used shorthand measure of the impact of fiscal policy. Whereas changes in the actual surplus or deficit result from changes in other economic conditions as well as from changes in budget policy, changes in the full employment surplus result almost entirely from changes in budget policy. Use of the full employment surplus for analysis or prescription did not necessarily imply that the full employment surplus should be constant, and the concept came to be used in the 1960s by many who did not accept the rule of constant full employment surplus.

Supporters of the indirect, passive approach recognized that in principle an active policy based on perfect foresight would yield superior stabilization results. However, perfect foresight was not possible, and actual decisions, if freed of all conventional rules, would not even be governed by the best possible economic forecasts. The political decisions might be random and destabilizing, or might be biased in an inflationary, expenditure-increasing direction. Therefore, a less ambitious and more restrained policy would lead to better results. In fact, a high degree of stability (meaning steadiness of growth) could be expected from a passive fiscal policy, especially if combined with a stabilizing monetary policy. In some variants this stabilizing monetary policy is also considered to be governed by a rule, such as a constant rate of growth of the money supply; in other variants the monetary policy is flexible and discretionary.

Probably the basic criticism of the indirect approach is that the establishment of a budget rule requires a forecast of what economic conditions will be on the average during the period when the rule is in force. A rule that might be highly inflationary in one set of conditions might be highly deflationary in another. Therefore the rule does not eliminate the need for forecasting but requires a more difficult, because longer-run, kind of forecast than a more active and flexible policy requires.

The choice between these two approaches reflects differences of opinion about the operation of the economic and political systems as well as some differences in evaluating the consequences of inflation and rising government expenditures. While these differences have not been resolved, experience and discussion have tended to narrow the difference between the two approaches. Advocates of what is called here the direct approach do not want or expect a continuous adjustment of fiscal policy to actual or forecast economic conditions, but only an adjustment at intervals. They would also recognize that it may not be desirable to change fiscal policy to deal with economic changes that are small or quite uncertainly forecast. And they have had, at least when in responsible positions, to accept as some restraint the popular sentiment favoring balanced budgets.

At the same time, at least many supporters of a “rule” of fiscal policy would recognize that it may be necessary or desirable to change the rule from time to time. They would also accept the possible necessity at some time to depart temporarily from the rule.

Once these points are reached, the differences between the two approaches come down to questions about the frequency of changes in fiscal policy and the strength of the evidence required to justify a change. These are matters of gradation, on which a continuous graduation of positions may be taken.

The fiscal-monetary “mix.” If fiscal policy is not the only instrument by which the government can influence the money national income, it is not a sufficient guide to fiscal policy to say that it must be so managed as to bring about the desired national income. It can only be said that the available instruments should be used in combination to effect the desired result, but this leaves open the question of the combination in which the various instruments should be used. The main question of combining instruments concerns the combination of fiscal and monetary policy.

Even though fiscal and monetary policy may both be capable, in general, of affecting the national income, there may be special circumstances in which they are not alternative instruments. For example, it has been thought that at the bottom of a deep depression, profit prospects may appear so bleak that no expansion of the money supply would stimulate an increase in investment or other private spending. In this case monetary policy would not be an alternative to fiscal policy for promoting recovery. However, whether this is a realistic possibility has been disputed, and there is no suggestion that such circumstances have emerged in the postwar world.

Fiscal actions and monetary actions may differ in the speed with which they can be taken, have effect, and be modified or reversed if necessary. This may provide the basis for a division of labor between fiscal and monetary policy, the more flexible instrument being used in those circumstances in which a quick and possibly reversible effect is needed. In much of the earlier postwar writing it was assumed that monetary policy was the more flexible instrument and therefore should be relied upon for short-run adjustments of the impact of the combined fiscal-monetary package. However, later study suggested that the lag between monetary action and its effects might be long and variable. This raised the question whether monetary policy was in fact the more flexible and manageable element in the monetary-fiscal combination. Thus, the principle remains that in the division of labor between fiscal and monetary policy, the more flexible instrument should be used for the more rapid and frequent adjustments, but which is the more flexible instrument is uncertain.

If the desired money national income for any period can be achieved by one of several combinations of fiscal and monetary policy, the choice among these combinations requires the invocation of some additional objective. Two such objectives have seemed particularly relevant: economic growth and balance-of-payments equilibrium.

On certain assumptions, the economy will grow more rapidly with a large budget surplus than with a small budget surplus or deficit, if in each case there is the appropriate monetary policy to attain the desired current rate of money national income. Unless there are fully offsetting effects, the larger surplus will mean larger total savings and larger total investment. Some offsets may be expected. Getting the larger surplus will require some combination of higher taxes, which may reduce private saving or have other growth-restraining effects, and lower public expenditures, some of which might have had growth-promoting effects. Also, the more expansive monetary policy required to accompany the larger surplus may depress private saving. Therefore, a larger-surplus policy cannot be said to be a faster-growth policy without further specification, but it is probably possible to design a larger-surplus policy that will be a faster-growth policy. Even this would not, of course, by itself make the larger surplus preferable. A larger surplus leads to faster growth only at some cost, in the form of reduced current consumption and possibly also in other forms; whether it is legitimate or wise for government to decide to pay that cost is a question that would still have to be answered.

In the late 1950s and early 1960s attention was focused on the balance-of-payments implications of the combination of fiscal and monetary policy. This new interest was largely derived from concern with the position of the United States, which was running a persistent balance-of-payments deficit along with more unemployment and less inflation than most of the rest of the world. A country in such circumstances seeks both domestic expansion and contraction of its external deficit. It was suggested that these two objectives might be simultaneously approached by a more expansive fiscal policy combined with a less expansive monetary policy. More generally, it could be shown that if domestic income and the balance of payments depend upon monetary and fiscal policy and on no other, and if these two policies affect no other objectives, the two objectives determine the best combination of the two policies. While these conditions may never be fully met, they may be approximated for short periods.

Definition of the budget . Any fiscal policy which uses the budget position—the size of the deficit or surplus—as a guide to action requires a decision on what is to be included in the budget—how it is to be defined. As was indicated earlier, government fiscal operations can be described by a statement of the sources and uses of government funds, the sources and uses being necessarily equal. The creation of a budget that can have a surplus or a deficit requires the selection of some but not all of these sources and uses of funds for inclusion in the budget. Which items should be included depends on the policy purpose to be served by the over-all budget figures. Aside from this purpose, there is no “true” budget.

The appropriate definition of the budget depends on whether the main purpose of budget policy is (a) to affect the money national income, (b) to exercise “discipline” over government spending, by requiring that expenditure be matched by taxation, or (c) to affect national saving by controlling the relation between government revenues and the government expenditures that are not for investment. Different emphases on these three objectives lead to different answers to the questions that arise about the definition of the budget. These questions relate chiefly to four kinds of transactions:

(1) Trust account transactions in which the government accumulates a fund from a particular class of individuals, out of which payments are made, simultaneously or subsequently, for specified purposes. Social insurance funds are a leading example.

(2) Loan transactions in which the government at some times lends money to private borrowers or to other governments or purchases their debt, and at other times receives repayment or sells the debt.

(3) Capital expenditures for the acquisition by government of assets (including loans) that yield a subsequent return, whether in money or in nonmonetary benefits.

(4) Transactions in which there is a considerable lapse of time between the accrual of a liability to or from the government and the corresponding cash payment.

Different treatments of these kinds of transactions are illustrated by the three “budgets,” or statements of government receipts and payments, commonly used in the United States:

The administrative budget, which excludes trust account transactions, is almost entirely on a cash basis, and makes no distinction between loan or capital transactions and current transactions;

The cash-consolidated budget, which includes trust account transactions and is entirely on a cash basis;

The government sector of the national income accounts, which also includes trust account transactions, but excludes loan transactions and reflects corporate-profits-tax liability accruals rather than cash payments.

None of these three financial accounts used in the United States distinguishes between capital and current transactions. However, many other governments use capital budgets which do make this distinction.

Since the main object sought in postwar thinking about fiscal policy has been a certain effect, presumably stabilizing, upon money national income, the search for definitions of the budget has focused on that which would be most revealing of the effects of fiscal policy on money national income. What is desired is the most comprehensive definition of the budget consistent with the requirement that all fiscal policies yielding an equal surplus in the budget so defined have, under similar general economic conditions, equal effects on money national income. This test can be literally met only if every expenditure has the same effect, per dollar, as every other expenditure and the same effect, with sign reversed, as every receipt. This is to say that the test cannot be literally met by any real budget. The test does suggest the desirability of excluding from the budget transactions that are markedly different in their effect per dollar from the transactions included and that vary substantially in magnitude relative to the transactions included. However, if important items are excluded in order to make the budget more homogeneous and thus to give the size of the surplus or deficit a more stable meaning, problems arise in establishing criteria and mechanisms for controlling the excluded items. In practice, some compromise beween homogeneity and comprehensiveness in defining the budget must be found.

It seems clear that if the budget is intended to reveal the effects of fiscal transactions on money national income, there is no good reason for excluding trust account transactions from the budget. Many, and probably most, of the receipts and expenditures made by trust accounts are quite similar in their aggregate economic effects to many of the receipts and expenditures included in the regular budget. A more difficult problem is the treatment of loan transactions. If the government makes a loan to a private business, a local government, or a foreign government, is this more like a government grant or purchase, in which case it should be treated as an expenditure, or more like government puichase (repayment) of its own securities, in which case it should not be treated as an expenditure? Probably the answer depends upon the terms and circumstances of particular kinds of loans.

If the main objective of budget policy is to stabilize, or otherwise influence, total money expenditures, there is no good reason to distinguish between the current and capital expenditures of government. Capital spending, at least when it is for purchase of real goods and services, is likely to have as great a direct and indirect effect on total spending in the economy as does current spending. The amount of taxation needed for economic stabilization does not depend on whether the government’s expenditures are for current or capital purposes.

Emphasis on the “disciplinary” function of a budget rule may provide a rationale for excluding the trust accounts from the budget. The purpose of requiring that the budget be balanced may be to assure that government expenditures are not made unless taxpayers have demonstrated their willingness to pay taxes for them. However, this purpose does not require the inclusion in the budget of transactions that have their own disciplinary safeguards. If the government undertakes a particular expenditure program to which specific revenues are assigned, with a definite plan and commitment over some period, the disciplinary function of budget balancing does not require inclusion of these transactions in the budget. The cogency of this argument for excluding a trust fund from the budget depends upon whether the trust fund actually conforms to this description, which is sometimes, but not always, the case.

A similar case on “disciplinary” grounds can be made for excluding from the budget capital transactions where the productivity of government capital investments can be objectively measured and compared with the cost of capital. This would provide a test of the desirability of public investments that would be superior to the test of the willingness of the community to pay taxes for them. Where the investment yields a product that is sold in the market—as is the case with a government-owned railroad—this objective test of productivity may be available. But there are many kinds of government investment—education being one example—where the product is difficult to measure or even to define. To remove the requirement that such expenditures be financed by taxation may leave no adequate limits to their expansion.

One case for use of a capital budget may be found in the desire to separate the government decision about the total amount of saving in the economy from the decision about the total amount of government investment. The total saving of the economy is equal to private saving plus the excess of taxes over current, noninvestment expenditure of government. The government, or the community through the government, may decide to make this total larger or smaller by deciding on a larger or smaller excess of taxes over current expenditures. (This assumes that private savings do not increase or decrease by an amount equal to the change in the excess of taxes over current expenditures.) The government may decide to run a large current surplus in order to generate large total savings and thus permit large total investment and a high rate of growth. This decision by itself logically implies nothing about the proportions in which the investments would be private and government. On the other hand, the government may decide on a larger or smaller amount of public investment. This by itself implies nothing about what total saving should be. The decision to have a large amount of public investment may reflect a judgment that many public investments are more productive (or otherwise desirable) than private investments and should be made instead of them—not in addition to them. The existence of large opportunities for productive investment may be a reason for wanting high savings and a large excess of taxes over current expenditure. But this would be equally true whether the opportunities were for public or private investment.

If a capital budget is used, the government would decide, by deciding on the size of its current surplus, how much it should contribute to total saving. It would decide this in terms of the value the community places on economic growth and the supply of productive investment opportunities, public and private. The government would also decide on the desirability of particular public investments in terms of their productivity, taking into account the cost of capital. Proponents of the capital budget maintain that this would result in better decisions about both the government’s contribution to saving and the government’s investment than does a budget which lumps together current and capital expenditure.

A different kind of concern with the effect of budget policy on total saving may justify the exclusion of trust accounts from the budget. It may be desired to balance the budget so that all private savings will be available to finance private investment, either on the grounds that growth will be promoted thereby or that “consumers’ sovereignty” requires that the amount of private investment should be determined by private saving. If individual citizens voluntarily make payments into a government-managed fund from which they will subsequently receive benefits, these savings should, on this principle, not be available to finance government expenditures, as would happen if they were lumped into the budget. The force of this argument depends upon the degree to which the trust account in fact has the character of a private voluntary savings institution.

The idea of the capital budget does not necessarily imply that the current budget should be balanced by taxation; the rule may be a surplus or deficit in the current budget. However, much discussion of the idea has assumed that the issue was between balancing the current budget and balancing the total budget. Since net government capital expenditures are likely to be positive, balancing the current budget will be more expansionary than balancing the total budget. This has won some support for the capital budget idea from those who believe there is need for an expansionary fiscal policy but who do not want to violate community sentiment in favor of balancing “some” budget.

Budget flexibility . Fiscal action taken at any time has its effects on some future time. The appropriateness of the action is its appropriateness to the future time at which its effects occur. Fiscal action therefore requires or implies a forecast. The reliability of the forecast will be greater the nearer the future period to which it relates. For this reason attention has been directed to increasing the flexibility of fiscal policy, so that it will have its effects more quickly and the time for which forecasts have to be made will be shortened. Increased flexibility has been sought along three main lines, sometimes called built-in flexibility, formula flexibility, -and discretionary flexibility.

Built-in flexibility. The stabilizing effect of the variation in government tax receipts or liabilities and unemployment compensation payments that automatically accompanies variation in the national income has already been noted. Recognition of the value of this automatic response of the budget has naturally led to the question whether this response could be strengthened. However, a basic difficulty arises in considering possible ways to strengthen the built-in stabilizing response. The extent to which tax receipts vary with a change in the national income depends upon the tax rates applied to individual and corporate incomes at the margin—the proportion of an increase in an individual’s or corporation’s income that is taken in taxes. If these marginal rates are high, the proportion of a change in national income that is absorbed in a change in tax receipts will be large, and this will have a stabilizing effect on the economy. However, if these rates are high, taxes will take a large proportion of the additional income that an individual or corporation may earn by productive activity. At least beyond some point this will weaken the incentive to productive activity and will adversely affect economic efficiency and growth. Thus the stabilizing value of high marginal tax rates can be obtained only at the cost of other important economic objectives.

In general, the marginal rates of tax, and also the rates of unemployment compensation payments, have been so closely determined by a combination of other factors economically and politically more important as to leave no room for adjusting them to increase “built-in” stabilization.

To get around this difficulty there have been proposals intended to increase the automatic responsiveness of tax collections or unemployment compensation to changes in the over-all state of the economy without increasing their responsiveness to the condition or activity of any individual. The general principle may be illustrated by the following hypothetical scheme: Weekly withholding of income tax from each taxpayer will be reduced by $2.00 for every percentage point by which the latest published seasonally adjusted figure for the rate of unemployment exceeds 4 per cent (and annual liability will be correspondingly reduced). Such a scheme would greatly increase the variability of tax collections in response to variations in the rate of unemployment without increasing the amount of tax taken out of an additional dollar of income earned by any individual.

Formula flexibility. Consideration of proposals for formula flexibility has not proceeded beyond an elementary and formal stage. One difficulty is that while, once the formula is adopted, reliance on long-term forecasting is eliminated, the formula itself implies a long-run forecast of the way in which fiscal policy should respond to changes in the economy. Formula flexibility buys speed of response in exchange for discretion in deciding what the response should be. This may be a worthwhile exchange, but that has not been satisfactorily demonstrated. Possibly a more serious difficulty is political. Governments may be willing to take active fiscal measures when the need is clear and present but unwilling to commit themselves in advance to the automatic occurrence of such measures.

Discretionary flexibility. Efforts to increase the flexibility of the budget have been largely concentrated on discretionary measures. Preparations are sought which, while leaving the government in all cases free to act or not, will enable the government to decide more quickly and will speed up the effects of the decisions taken. The classic case of such preparations is the “shelf of public works.” Ideally this is a reserve of government construction projects for which legislative authorizations and appropriations have been made, plans drawn, and sites obtained, so that work can be started quickly when the Executive decides to do so. Interest in the shelf of public works has diminished, at least in the United States, since the end of World War II. Federal nonmilitary public works activities have not been large, and the volume of projects that seem desirable enough to authorize but not urgent enough to begin immediately has been small relative to the size of the economy and its potential fluctuations. The volume of these that could quickly reach a high rate of operation and, if necessary, be stopped without great loss is even smaller. Also, it has appeared that the need for expansive action might arise when construction is running at a high rate, so that increasing public works would not be appropriate.

The revenue side of the budget seems to hold out greater possibility for quick and powerful fiscal action. Federal revenues in the United States are about 20 per cent of the gross national product. Changes in tax rates that are administratively feasible could increase or decrease the available aftertax incomes of individuals or businesses by large amounts in a short time. The period required for legislative enactment of a tax change may be long, however, and there have been a number of proposals for shortening this period. These involve advance legislative authorization to the president to make a specified tax cut, possibly subject to Congressional veto within a limited period, or an agreement by Congress to act upon a presidential recommendation within a limited period. In fact, even without such arrangements the legislative process would allow quick Congressional action on a tax change if a strong majority of Congress were agreed on the need for it.

Deliberate and systematic effort to use fiscal policy to keep the economy operating close to its potential while avoiding inflation and serving other objectives became standard practice in most Western industrial countries after World War II. The results of that experience were varied and interpretation of the results even more varied. But the experience did not contradict the idea that fiscal policy, at least when accompanied by appropriate monetary policy, is a powerful instrument for affecting economic performance in basically free economies. This instrument by itself may be unable to reconcile inconsistencies where they arise between some objectives, such as full employment and price stability or domestic stabilization and international equilibrium. Even aside from this, knowledge and institutions are inadequate for management of the fiscal instrument to achieve its ideal effectiveness. Yet there is little doubt that the results of freeing fiscal policy from older inhibitions have on the whole been beneficial and that further opportunities for improved use of the fiscal instrument, based on experience and study, remain.




AMERICAN ECONOMIC ASSOCIATION 1955 Readings in Fiscal Policy. Homewood, I11.: Irwin. ⇒ Contains an extensive classified bibliography.

ANDO, ALBERT; and MODIGLIANI, FRANCO 1965 The Relative Stability of Monetary Velocity and the Investment Multiplier. American Economic Review 55:693-728.

COLM, GERHARD 1955 Essays in Public Finance and Fiscal Policy. Oxford Univ. Press.

DEPRANO, MICHAEL; and MAYER, THOMAS 1965 Tests of the Relative Importance of Autonomous Expenditures and Money. American Economic Review 55:729—752.

Dow, J. C. R. 1964 The Management of the British Economy: 1945-1960. Cambridge Univ. Press.

Economic Policy in Our Time, by Etienne S. Kirschen et al. 3 vols. 1964 Amsterdam: North-Holland Publishing. ⇒ Describes the experience of eight industrial countries.

FRIEDMAN, MILTON (1951) 1959 The Effects of a Full-employment Policy on Economic Stability: A Formal Analysis. Pages 117-132 in Milton Friedman, Essays in Positive Economics. Univ. of Chicago Press. ⇒ First published in French in Volume 4 of Économic appliquée.

FRIEDMAN, MILTON; and MEISELMAN, DAVID 1964 The Relative Stability of Monetary Velocity and the Investment Multiplier in the United States: 1897-1958. Pages 165-268 in Stabilization Policies: A Series of Research Studies Prepared for the Commission on Money and Credit. Englewood Cliffs, N.J.: Prentice-Hall.

FRIEDMAN, MILTON; and MEISELMAN, DAVID 1965 Reply to Ando and Modigliani and to DePrano and Mayer. American Economic Review 55:753-785. ⇒ Contains a rejoinder by Ando and Modigliani on pages 786-790 and by DePrano and Mayer on pages 791-792.

KEYNES, JOHN MAYNARD 1936 The General Theory of Employment, Interest and Money. London: Macmillan. ⇒ A paperback edition was published in 1965 by Harcourt.

KIMMEL, LEWIS H. 1959 Federal Budget and Fiscal Policy: 1789-1958. Washington: Brookings Institution. ⇒ Contains a description of and references to early writings of economists and others.

LEWIS, WILFRED 1962 Federal Fiscal Policy in the Postwar Recessions. National Committee on Government Finance, Studies in Government Finance. Washington: Brookings Institution.

MUNDELL, ROBERT A. 1962 The Appropriate Use of Monetary and Fiscal Policy for Internal and External Stability. International Monetary Fund, Staff Papers 9:70-77.

SAMUELSON, PAUL A. 1942 Fiscal Policy and Income Determination. Quarterly Journal of Economics 56: 575-605.

SIMONS, HENRY C. (1942) 1948 Hansen on Fiscal Policy. Pages 184-219 in Henry C. Simons, Economic Policy for a Free Society. Univ. of Chicago Press. ⇒ First published in the Journal of Political Economy.

U.S. CONGRESS, JOINT COMMITTEE ON THE ECONOMIC REPORT 1947 Economic Report of the President: Hearings Before the Joint Committee on the Economic Report. Washington: Government Printing Office.

U.S. COUNCIL OF ECONOMIC ADVISERS 1947 Annual Report to the President, Second. Washington: Government Printing Office.

U.S. PRESIDENT 1947 Economic Report of the President. Washington: Government Printing Office. ⇒ Published annually since 1947.


The objectives and methods of peacetime fiscal policy are not invalidated by the onset of a major war. However, the overriding goal of winning the war modifies both the relative emphasis placed on the various objectives and the mixture of procedures adopted to achieve them.

The experience of the United States in World War Ii will serve to illustrate the points involved. The magnitude of that war and its grave threat to the nation demanded the greatest feasible effort. The public, with minor exceptions, strongly supported the war. On balance there could be no recourse to the resources of other countries; instead, the United States supplied large amounts of materiel to its allies. However, the war was considered a temporary interlude in the national Life, as is evidenced by the speed and completeness of demobilization at its conclusion.

The magnitude of the war required policies designed to achieve maximum engagement and utilization of human and material resources: a substantial proportion of the resources previously employed in producing civilian goods had to be shifted quickly to the military effort. Patriotic fervor was such that people were willing to sustain exactions, toil, inconvenience, and hardship not acceptable at other times, but only if they believed these burdens were being fairly shared by everyone. In the absence of both the opportunity and the reason to borrow abroad, all borrowing had to come from the same public that paid the taxes and bore the other burdens of the war, although not necessarily in the same proportions. Because of the expectation that the war would be a temporary condition, people were willing to postpone the purchase of many durable and semidurable goods, thus freeing resources for the war effort. The same expectation also strengthened public resistance to efforts by particular groups to use the wartime emergency as an occasion for permanently altering the social and economic structure of the economy.

These wartime conditions had several implications for fiscal policy. The use of a draft to select persons for military service was an obvious necessity, but its superior equity over “buying” recruits also gave it a superficial attractiveness as a method of recruiting industrial and other supporting efforts. It was not, however, a practical method for eliciting the intensive, tedious, continued efforts required in war production. Moreover, such use of the draft and concomitant military command system would have threatened the postwar economy with the perpetuation of a totalitarian economic system.

Accordingly, it was deemed imperative to rely as much as possible on governmental expenditures and fiscal incentives to stimulate maximum utilization of human and material resources, and on taxation and borrowing to support the resulting financial costs of the war. However, certain direct controls were required to reinforce and complement the fiscal measures. To have diverted resources from civilian to military use through fiscal measures alone would have been a slow, incomplete, and very costly process; priorities and direct allocations were an effective addition, which, although sometimes drastic, were justified in the public mind by the war emergency. Furthermore, it was clear that, despite heavy taxation, persons with large incomes and accumulated wealth could virtually monopolize the purchase of scarce, necessary consumer goods, while persons with small incomes suffered intense hardship. Rationing, although administratively difficult and sometimes arbitrary, could assure broad distribution of the supply. For reasons of economy and morale price and wage controls were needed to prevent spiraling inflation, gross inequities, and permanent shifts in the economic positions of different persons and groups.

While fiscal measures alone cannot be expected to achieve the objectives, or cope with the economic problems, of a major war, they should be made to do as much as possible, thereby reducing the need to employ measures disruptive of the market economy. The major objectives of an effective wartime fiscal program are fairness of burden distribution, stimulation of military and supporting production, avoidance of inflation, and salutary consequences for the postwar economy. In practice these goals must be pursued through political and administrative processes in which policy and action are determined by what people believe, whether or not it is in accord with reality.

Taxation versus borrowing . The major alternatives for financing governmental expenditures are taxation, borrowing of private savings, and expansion of the money supply. The last usually takes the form of loans from commercial and central banks rather than direct money issue. Because of its inflationary effects, it is the least desirable alternative. No case has yet been noted of a major war financed by taxation alone. During World War 11 the U.S. federal government collected in taxes 45 per cent of its expenditures, a somewhat higher percentage than during World War I or the Civil War and a somewhat lower percentage than was collected by Great Britain and Canada in World War II.

The relative shares of war costs to be paid from taxation and from borrowing have been determined by various factors. A traditional belief that still seems to be influential is that through borrowing, a country can shift much of the cost of the war to “future generations” in the postwar years. This belief has no validity for a country relying on internal resources. While a relatively small part of the real economic burden of the war can in some sense be shifted to postwar years, the amount thus postponable cannot be increased by financing the war through borrowing instead of taxing. What can be changed by this means is the distribution of the cost among persons. Wartime borrowing places financial burdens during the war on lenders, who after the end of the war are repaid out of taxes, which in turn are paid by the lenders and non-lenders alike. [See DEBT, PUBLIC.]

The desirability of the redistribution resulting from wartime borrowing can be measured by applying the criteria listed above. With respect to fairness of burden distribution, there are conflicting considerations. Financing through taxation avoids the injustice of levying a double burden on members of the armed forces; once on the battlefield and again through taxation to reimburse wartime lenders. However, to pay the total cost of a major war through currently collected taxes would require imposing a heavier burden on low-income groups than would be necessary if part of the cost were met by accumulating debts to be serviced after the war out of collections from progressive taxes.

With respect to production incentives, lending to the government has a less adverse effect than paying taxes does, since the patriotic efforts of workers, farmers, and businessmen are strengthened by the assurance of a tangible reward in the form of current assets and postwar spending power.

Taxation is distinctly superior to wartime borrowing as a means of minimizing inflation both during and after the war. To the citizen’s mind his tax payments are gone forever, while what he loans to the government creates for him an asset that psychologically encourages his continued expenditure. To minimize this effect, the government seeks through shortages, rationing, and patriotic appeals to maximize private savings and to tap them through the sale of war bonds and other securities. The inadequacy of voluntary savings commonly necessitates borrowing from banks as well, with consequent expansion of the money supply. If the economy moves into war from a low level of output, as was the case in the United States in 1940-1941, some growth in the money supply is needed to finance expanded production and any price increases that may be required to stimulate and transfer resource utilization. Also, the chances for a prosperous postwar economy are improved by sufficient wartime borrowing from the public and from banks to provide the reserves of liquid assets needed to support demand during the postwar transition period. However, such borrowing throughout the war greatly exceeded these needs and created an excessive volume of liquid assets. Although the resulting inflationary pressures were largely suppressed during the war, the liquid assets contributed importantly to the inflationary spending of the postwar period.

All these considerations may be variously evaluated and balanced in choosing between more taxes or more borrowing. The conclusion almost certainly will be that more should be paid through taxation than will be politically feasible, because the psychological limits to taxation are undoubtedly much below the economic limits set by adverse effects on production incentives. The psychological limits appear to be determined more by the rapidity and extent of rate increases than by the previous level of the rates. In the United States the political and psychological limits undoubtedly were closely approached by 1943, when Treasury Department efforts to secure substantial tax increases met with great political resistance and a minimum of public support.

Use of income taxes. The major sources of expanded revenue to finance World War II were taxes on net income, particularly the personal income tax but also the corporation income tax and excess profits tax. The characteristics of progressive income taxation are especially needed in time of war. The progressive income tax is highly flexible in that rates and exemptions can be readily changed, yields at given rates increase more than proportionately to the rise in national income, and with current collection, rate increases can be quickly reflected in government revenues. The income tax is the best adapted of all taxes for adjusting the tax load in accordance with the social consensus on what is equitable. Taxes on net income do not drive businesses into bankruptcy and are less likely than most other taxes to be shifted forward in higher prices with consequent wage and price escalation. However, despite its merits, the income tax can be overused; very high income tax rates may impair incentives to produce and unquestionably stimulate the search for ways to avoid or evade the tax. [See TAXATION.]

Use of sales taxes. An exception to the heavy use of the income tax by nations fighting World War Ii was in the Soviet Union, where sales taxation is part of the apparatus of socialist income distribution. In other countries the use made of sales taxes and other gross transactions taxes differed greatly, but the rates generally were not greatly increased during the war, perhaps because of the regressive incidence of the taxes and their tendency to upset wage stabilization programs. In the United States the pre-emption of the sales tax field by the states was a factor, as was a political reluctance to introduce a general sales tax that might well remain as a permanent element of the postwar system. In Great Britain a heavy “purchases tax” on sales at the wholesale level was imposed, at rates ranging up to 100 per cent. The objective was not only to raise revenue but also to discourage the purchase of scarce, less necessary goods. A very modest use of this principle was made in the United States in the form of moderate excise taxes on scarce durable goods, with the unintended sequel that they were treated as purely revenue taxes and their repeal was delayed long after the shortages had turned to surpluses.

Special taxation. A major question regarding the concept of fairness in war taxation is to what extent higher rates or special taxes should be imposed on increases of income realized because of the war. The corporate excess profits tax, which has become an expected element in wartime tax structures, is the principal illustration of taxation used for this purpose. It has the twofold objective of raising revenue where psychologically and economically it will presumably hurt the least and of preventing businesses from reaping unconscionable profits from the common emergency. In practice, the excess profits tax has proved to be extremely difficult to administer in harmony with its objectives; in a complex business society truly excessive profits are hard to define with precision and even harder to measure. Yet having in the tax system an “excess profits tax,” even a weak or arbitrary one, seems to be essential to promote morale and make more acceptable the wartime controls that limit the incomes of workers and farmers.

The principle of special taxation on increases of income was not extended to individuals, despite considerable support for such action, no doubt because both the formulation and administration would have been even more difficult than for corporate business. The tax would also have damaged the war effort by impairing the incentives of war workers, whose new-found prosperity was indeed the target of the proposals.

Substantial resistance appeared to any tax changes that would permanently modify the relative economic positions of taxpaying groups and might therefore be considered reforms. Perhaps the clearest illustration is the estate tax, which was increased only moderately. The reasoning of the Congress seemed to be that if higher wartime rates continued into the postwar years, the result would be a major shift in the distribution of wealth and income; while strictly as wartime levies the rate increases would arbitrarily fall only on the estates of persons who died during the war.

New methods of raising revenue did not prove popular with the wartime congresses. An effort by the Treasury Department late in the 1942 session to secure a progressive tax on personal expenditures was summarily rejected. The idea of distinguishing part of the income tax as a refundable, compulsory loan, proposed by J. M. Keynes in 1940, was strongly supported by some economists in the United States administration, and it was incorporated to a small degree in the “victory tax” on income—a tax designed to hit lower incomes, with war workers again the main target. The compulsory loan feature was in effect repealed before collection. The compulsory loan was, however, used in Great Britain and, for a short time, in Canada. The experience can scarcely be considered a success (Heller 1951). Keynes’s objective in proposing compulsory lending was to raise the psychological limits of wartime taxation, but apparently the taxpayers rarely distinguished between the loan part and the tax part of the payment.

External resources . Countries in a position to supplement their domestic resources with resources from other countries have used various methods to accomplish the transfer. For the most part, intergovernmental loans were used during World War I, but the repayment mechanism broke down after the war; the United States, which was the principal creditor, imposed such heavy protective tariffs as to make repayment in goods virtually impossible. In World War II the use of intergovernmental loans was minimized, and large use was made of the Lend-Lease program, which in effect was a method of common burden sharing with no postwar indebtedness liability. At the opening of World War II the British nationalized foreign securities held by citizens and, as the situation required, either sold them for foreign exchange or used them as collateral for loans. The British also incurred large foreign exchange debts in Commonwealth countries, some of which were not liquidated until long after the war. The Germans made substantial drafts on the resources of countries that they occupied during the war (Lindholm 1947).

“In-between” periods . Turning from major wars to periods marked by minor war or heavy cold war defense budgets, we find that some of the characteristics discussed above are absent. The economic and financial requirements during such periods impose burdens that large and growing economies may absorb with little difficulty—except for potentially greater inflationary pressures than would be present in time of real peace. There is little sense of national emergency or outpouring of patriotic fervor and willingness to sacrifice. There is gradual although reluctant recognition that the problem may continue indefinitely rather than be quickly ended. It may prove to be significant that thus far the experience of the United States with modern fiscal policy has not been during periods of substantially unimpaired peace but during periods of major war, reconversion from war, minor war, and the “gray area” between war and peace.

In a situation falling between peace and war the appropriate fiscal policies tend to be similar to those of a peacetime period, although of course much depends on the size and rate of growth of defense and military expenditures. At times, even the need for further fiscal stimulus may emerge. In an “in-between” period the use of control measures to supplement fiscal policy is usually resisted, and if they are imposed, their administration is less successful in achieving compliance than in a time of major war.

Fiscal measures must be carefully oriented. The policy toward borrowing should depend on current conditions, not on projections into a doubtful “postwar” period. The tax system should be developed for the long run, not for a short-run emergency. An excess profits tax, for example, would be less appropriate in an “in-between” period than in time of major war, as well as more difficult to design and administer, since there is no valid base period against which to measure the excessiveness of profits.

In short, a period between peace and major war is an unusually difficult one in which to operate fiscal policy. The economy may develop too much inflationary pressure for successful containment through fiscal and monetary policy alone, while the absence of patriotic fervor and sense of urgency prevents wartime controls from being either acceptable or readily administrable. It is a period in which quasi controls, “voluntary” restraints, and other halfway measures, unsatisfactory as they are for all concerned, may represent the only feasible supplement to fiscal and monetary policies.



British White Paper on War Finance. 1946 [U.S.] Board of Governors of the Federal Reserve System, Federal Reserve Bulletin 32:723-748. ⇒ First published as National Income and Expenditures in the United Kingdom: 1938-1945. Great Britain, Parliament, Papers by Command, Cmd. 6784.

CHICAGO, UNIVERSITY OF, LAW SCHOOL 1952 Defense, Controls, and Inflation: A Conference. Edited by Aaron Director. Univ. of Chicago Press.

COLM, GERHARD 1935 War Finance. Volume 15, pages 347-352 in Encyclopaedia of the Social Sciences. New York: Macmillan.

CRUM, WILLIAM L.; FENNELLY, JOHN F.; and SELTZER, LAWRENCE H. 1942 Fiscal Planning for Total War. New York: National Bureau of Economic Research.

HARRIS, SEYMOUR E. 1951 The Economics of Mobilization and Inflation. New York: Norton.

HELLER, WALTER W. 1951 Compulsory Lending: The World War II Experience. National Tax Journal 4: 116-128.

KEYNES, JOHN MAYNARD 1940 How to Pay for the War: A Radical Plan for the Chancellor of the Exchequer. New York: Harcourt; London: Macmillan.

LINDHOLM, RICHARD W. 1947 German Finance in World War II. American Economic Review 37:121-134.

MURPHY, HENRY C. 1950 The National Debt in War and Transition. New York: McGraw-Hill.

PAUL, RANDOLPH E. 1954 Taxation in the United States. Boston: Little.

STUDENSKI, PAUL; and KROOS, HERMAN E. (1952) 1963 Financial History of the United States: Fiscal, Monetary, Banking, and Tariff, Including Financial Administration and State and Local Finance. 2d ed. New York: McGraw-Hill.

SUMBERG, THEODORE A. 1946 The Soviet Union’s War Budgets. American Economic Review 36:113-126.

TAX INSTITUTE 1944 Curbing Inflation Through Taxation, by Marriner S. Eccles et al. New York: The Institute.

Policy, Fiscal

views updated May 17 2018

Policy, Fiscal






Fiscal policy is the use of a governments spending, taxing, and debt issuance authority for the purpose of influencing economic activity. The origins of fiscal policy are rooted in the worldwide economic depression of the early twentieth century (19291939). Prior to that time, there was little in economic theory or practice suggesting the deliberate use of the governments authority to achieve particular economic ends. Rather, emphasis was placed on the governments role in creating a favorable environment for private economic activity.


A tool for understanding fiscal policy is governments intertemporal budget constraint. This constraint relates the path of government spending to the path of government receipts. It highlights the fact that a governments budget need not be balanced each time period. However, the present value of current and future government spending must equal the present value of government revenue.

To fix the ideas, let G equal current government spending, Gf equal future government spending, T equal current taxes imposed on the private sector, Tf equal future taxes imposed on the private sector, and r equal the real rate of interest. Further, let D equal the governments current budget deficit. That is, D = G T. The government finances the deficit by selling an equal amount of government bonds.

In the future, the government must collect enough taxes to repay the debt (including interest) and to pay for future government purchases. That is, Tf = (1 + r ) D + Gf. Substituting into this latter equation the expression for D and rearranging yields a governments intertemporal budget constraint:

G + Gf / (1 + r ) = T + Tf / (1 + r )

The left-hand-side of this expression is the present value of government purchases. The right hand side is the present value of government taxes. A fundamental fiscal policy lesson learned from this analysis is that all government spending ultimately must be reconciled with current and/or future government taxes so that the governments intertemporal budget constraint is satisfied.

Recognition of the governments budget constraint is crucial for assessing the impact of fiscal policy on long run economic growth. Neoclassical growth theory suggests that fiscal policys only impact is on the level of output per capita and the transition dynamics from one per capita output level to another. On the other hand, endogenous growth models suggest that fiscal policy can affect the steady state rate of economic growth. Key to this prediction is the distinction between distortionary and non-distortionary taxation and productive and nonproductive expenditures. Using data from twenty-two Organisation for Economic Co-operation and Development (OECD) member countries, in 1999 Richard Kneller, Michael Bleaney, and Norman Gemmell demonstrated that if appropriate account is taken of the implicit financing of government spending, then the evidence suggests that distortionary taxation (income, profit, property, and payroll taxes) reduces growth and productive government expenditure (education, health, housing, and transportation spending) enhances growth.


Because the government is not constrained to balance its budget period-by-period, it may adopt other objectives for its spending and taxing authority in the short run. One short-run objective that has been adopted is stabilization of the macroeconomy. Discretionary fiscal policy seeks to moderate fluctuations in overall economic activity by adjusting government expenditure or taxes. (Whether there is much scope for effective discretionary fiscal policy is controversial.) Traditional macroeconomic theory suggests that for a closed economy performing below its potential, an increase in government expenditure will stimulate aggregate expenditure. Private business firms respond to the increase in expenditure by raising production and employment. The total rise in production exceeds the increase in government spending because of a chain reaction of private consumption spending induced by the initial government expenditure. This chain reaction of spending is called the multiplier. An alternative, though slightly less potent, way for the government to trigger a chain reaction of spending is to reduce the amount of taxes it collects from the private sector. These policies also work in reverse. Therefore, if the economy is performing above its potential, the government can reduce its expenditures or raise taxes to prevent the economy from overheating.

Empirical evidence from the United States in the postWorld War II period suggests that shocks to government spending and taxes effect real gross domestic product (GDP) in a manner that is broadly consistent with the aforementioned description. According to a 2002 study by Olivier Blanchard and Roberto Perotti, increases in government spending raise real GDP contemporaneously and over time. The peak dynamic effect of the increased spending on GDP occurs between one and fifteen quarters in the future. Tax increases, on the other hand, lower real GDP contemporaneously and over time. The peak dynamic effect of tax increases on GDP occurs between five and seven quarters in the future.

In order to detect the impact of discretionary fiscal policy, it is necessary to account for important yet passive changes in spending and taxation by a government. Automatic stabilizers are changes in spending and taxation that occur in response to changes in economic activity. They do not require initiative by a government. Transfer payments such as unemployment insurance and tax payments linked to income are examples of automatic stabilizers. Net tax payments (taxes minus transfers) tend to rise during economic expansions and fall in recessions.


The effectiveness of fiscal policy in economies open to international trade depends on several factors, including whether a country is large or small relative to the size of the world economy, whether capital can flow freely in and out of the country, and whether a countrys exchange rate is fixed or floating.

Consider, for example, the case of a small country with capital mobility and a flexible exchange rate. Such a country takes the world interest rate as given. Further, the domestic interest rate equals the world interest rate plus a risk premium. An increase in government expenditure increases aggregate spending. The rise in spending will cause an incipient rise in the domestic interest rate. Capital from abroad will be attracted to the domestic country causing the countrys exchange rate to appreciate. Net exports will fall in response to the appreciation, thereby choking off the expansion of domestic production. In the end, there will be no expansion of total output. Fiscal policys only impact will be to change the composition of the initial level of output. The government sector is larger. The export sector is smaller. The theoretical prediction that fiscal policy is totally ineffective in this case stands in stark contrast to the closed economy case previously discussed.

Canada is a relatively small country whose characteristics closely match those described. The evidence from Canada suggests that the impact of fiscal policy on economic activity at the business cycle frequency is small at best. In 2005 Perotti estimated that the cumulative response of real GDP to positive shocks to government spending is positive but less than one, suggesting that there is no multiplier effect. In fact, in the post-1980 period, the cumulative response of real GDP to positive shocks to government spending is actually estimated to be negative. Tax cuts are estimated to stimulate economic activity in Canada. This finding, however, appears to be particular to Canada as it was not the case in any of the other OECD countries studied by Perotti.


Several issues make the theory and practice of fiscal policy controversial and difficult. First, there is uncertainty as to how fiscal policy should be measured. A generational accounting approach, such as the one taken by Laurence Kotlikoff, would focus on the lifetime tax burden born by different age cohorts. Second, lags in the recognition of the need for a policy change, the design of a new policy, and the implementation of a new policy may render fiscal policy too ponderous to be timely. Third, private sector expectations may thwart fiscal policy. According to a 2003 article published by Alan Auerbach in Brooking Papers on Economic Activity, tax changes known to be temporary, for example, are likely to have different affects than those that are permanent. Finally, fiscal policy makers may not be able to resist the temptation to renege on tax and spending promises in order to realize short-term gains. According to Edward Prescotts 2004 work, this time inconsistency problem may cause more damage to the economy in the long run because the private sector may lose confidence in the government.

SEE ALSO Business Cycles, Real; Multiplier, The; Phillips Curve; Policy, Monetary; Shocks; Treasury View, The


Auerbach, Alan. 2003. Fiscal Policy, Past and Present. Brooking Papers on Economic Activity 34 (1): 75122.

Blanchard, Olivier and Roberto Perotti. 2002. An Empirical Characterization of the Dynamic Effects of Changes in Government Spending and Taxes on Output. The Quarterly Journal of Economics 117 (4): 13291368.

Kneller, Richard, Michael Bleaney, and Norman Gemmell. 1999. Fiscal Policy and Growth: Evidence from OECD Countries. Journal of Public Economics 74 (2): 17190.

Kotlikoff, Laurence. 1992. Generational Accounting. New York: Free Press.

Perotti, Roberto. 2005. Estimating the Effects of Fiscal Policy in OECD Countries. Center for Economic Policy Research (CEPR) Discussion Papers : 4842.

Prescott, Edward. 2004. The Transformation of Macroeconomic Policy and Research. The Region, 2004 Annual Report. Federal Reserve Bank of Minneapolis.

Philip N. Jefferson

Fiscal Policy

views updated May 23 2018

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.

Fiscal Policy

views updated May 29 2018


Fiscal policy is a term that denotes the approach that government takes to managing the income it collectsusually termed taxes and the expenditures of those taxes. It refers ordinarily to any level of government, including federal, state, municipality, and occasionally private organizations such as Girl Scouts and Boy Scouts, private and public organizations, and many other thousands of similar organizations.

The term fiscal refers to timing. It is an invention designed to maximize the convenience of establishing various beginning and ending times. An example would be a fiscal year that begins on October 1 and ends on September 30. Fiscal policy is manifested in a government's policies on taxation and expenditures. To obtain funds for their operation, government units generally collect some form of taxes.

Particularly in the case of the federal government, the expenditure of these funds not only provides goods and services for constituents, but, additionally, has a direct impact on the economy. For example, the expenditures of the tax dollars may exceed the amount of the funds received by the government. (The government spends more than it receives.) The resulting deficit tends to stimulate the economy. As goods and services are produced for government purchase, it puts extra money into the economy and into the hands of the producers of those goods and services.

But what if the expenditures of the government are fewer than the tax dollars received? (The government spends less than it receives.) The resulting governmental surplus curtails the economy because now the government does not buy as much, and fewer dollars get into the economy.


In the United States, the fiscal process of the federal government begins each February with the president sending to Congress a proposed federal budget for the coming fiscal year, which begins in October. Congress then develops a budget resolution, which is to be completed by April. The budget resolution contains overall revenue and spending budgets as well as the budget amount of discretionary and mandatory spending for each functional area, such as discretionary and mandatory spending.


Bills that provide budget authority for annual discretionary spending must be completed by June each year. Legislative changes can also be made for mandatory spending or tax provisions at this time. Any legislation that would cut taxes or increase mandatory spending, however, must be accompanied by legislation that would raise revenue or cut spending in other areas to pay for these changes. Consequently, any new legislation in this area must be "budget neutral" (income and spending must be equal).

According to the Financial Management Office, in fiscal year 2004, receipts for the U.S. budget totaled $1,879,799 billion. Outlays totaled $2,292,352 billion. The deficit was $412,553 billion. (Differences between any two figures may not be equal because of rounding differences. Sources of the above data are the Financial Management Service, U.S. Department of the Treasury; and the Congressional Budget Office.)


Individual income taxes have been the federal government's largest source of funds for many years. Individual income taxes for the years 19992004 are as follows:

1999 $879,480 billion
2000 $1,004,461 billion
2001 $994,339 billion
2002 $858,545 billion
2003 $793,699 billion
2004 $808,958 million

The enormous impact of the Social Security system on the federal government's budget is without question as it is the largest outlay of the federal government every year. In 2004 total Department of Health and Human Services outlay was $543,215 billion. In 1998 the same outlay was $359,700 billion.

Defense spending was the largest item of discretionary spending in the federal budget. In 2004 the amount was $437,111 billion.


In 2004 the public debt of the United States was $739.1 billion. This amounted to $25,182 per capita for the United States. In contrast, the debt per capita in 1990 was $13,000. The interest paid in 2004 was $321.6 billion.

Though fiscal policy could be an automatic stabilizer for the economy because it automatically responds to changes in economic activity, government spending on such items as unemployment benefits generally increases during a recession, moderating the extremes of the business cycle, whereas government receipts such as income taxes will fall during a recession, also moderating the extremes of the business cycle. Consequently, fiscal policy, along with monetary policywhich is dictated by the Federal Reservehas an important influence on the health of the economy in the United States.

see also Government Role in Business


Bruce, Neil (2001). Public finance and the American economy (2nd ed.). Reading, MA: Addison-Wesley.

Citizen's guide to the federal budget: Budget of the United States government (1996). Retrieved March 5, 2006, from

G. W. Maxwell

Fiscal Policy

views updated Jun 11 2018


Fiscal policy concerns the federal government's use of taxation and public spending to affect the general flow of the economy. If, for example, the government wanted to stimulate consumer spending it might cut taxes and spend more on government programs, which would have the effect of giving consumers more cash. If, however, the government wished to cool off an economy that was in danger of inflation, it might raise tax rates and cut government spending to dampen economic activity. During the 1950s and 1960s many economists, especially followers of the British economist John Maynard Keynes (18831946), believed that fiscal policy could be used to fine-tune the economy. Some believed, for example, than the government might achieve a certain level of unemployment or gross domestic output through fiscal policy. However, later economists came to discredit this notion. They believed that government attempts to fine-tune the economy through fiscal policy were more likely to create problems than solve them.

See also: Keynesian Economic Theory