Fiscal policy


In economics and political science, fiscal policy is the use of government revenue collection and expenditure to influence a country's economy. The use of government revenue expenditures to influence macroeconomic variables developed in reaction to the Great Depression of the 1930s, when the previous laissez-faire approach to economic management became unworkable. Fiscal policy is based on the theories of the British economist John Maynard Keynes, whose Keynesian economics theorised that government changes in the levels of taxation and government spending influence aggregate demand and the level of economic activity. Fiscal and monetary policy are the key strategies used by a country's government and central bank to advance its economic objectives. The combination of these policies enables these authorities to target inflation and to increase employment. In modern economies, inflation is conventionally considered "healthy" in the range of 2%–3%. Additionally, it is designed to try to keep GDP growth at 2%–3% and the unemployment rate near the natural unemployment rate of 4%–5%. This implies that fiscal policy is used to stabilise the economy over the course of the business cycle.
Changes in the level and composition of taxation and government spending can affect macroeconomic variables, including:
Fiscal policy can be distinguished from monetary policy, in that fiscal policy deals with taxation and government spending and is often administered by a government department; while monetary policy deals with the money supply, interest rates and is often administered by a country's central bank. Both fiscal and monetary policies influence a country's economic performance.

Monetary/fiscal debate

Since the 1970s, it became clear that monetary policy performance has some benefits over fiscal policy due to the fact that it reduces political influence, as it is set by the central bank. Additionally, fiscal policy can potentially have more supply-side effects on the economy: to reduce inflation, the measures of increasing taxes and lowering spending would not be preferred, so the government might be reluctant to use these. Monetary policy is generally quicker to implement as interest rates can be set every month, while the decision to increase government spending might take time to figure out which area the money should be spent on.
The recession of the 2000s decade shows that monetary policy also has certain limitations. A liquidity trap occurs when interest rate cuts are insufficient as a demand booster as banks do not want to lend and the consumers are reluctant to increase spending due to negative expectations for the economy. Government spending is responsible for creating the demand in the economy and can provide a kick-start to get the economy out of the recession. When a deep recession takes place, it is not sufficient to rely just on monetary policy to restore the economic equilibrium.
Each side of these two policies has its differences, therefore, combining aspects of both policies to deal with economic problems has become a solution that is now used by the US. These policies have limited effects; however, fiscal policy seems to have a greater effect over the long-run period, while monetary policy tends to have a short-run success.
In 2000, a survey of 298 members of the American Economic Association found that while 84 percent generally agreed with the statement "Fiscal policy has a significant stimulative impact on a less than fully employed economy", 71 percent also generally agreed with the statement "Management of the business cycle should be left to the Federal Reserve; activist fiscal policy should be avoided." In 2011, a follow-up survey of 568 AEA members found that the previous consensus about the latter proposition had dissolved and was by then roughly evenly disputed.

Stances

Depending on the state of the economy, fiscal policy may reach for different objectives: its focus can be to restrict economic growth by mediating inflation or, in turn, increase economic growth by decreasing taxes, encouraging spending on different projects that act as stimuli to economic growth and enabling borrowing and spending.
The three stances of fiscal policy are the following:
  • Neutral fiscal policy is usually undertaken when an economy is in neither a recession nor an expansion. The amount of government deficit spending is roughly the same as it has been on average over time, so no changes to it are occurring that would have an effect on the level of economic activity.
  • Expansionary fiscal policy is used by the government when trying to balance the contraction phase in the business cycle. It involves government spending exceeding tax revenue by more than it has tended to, and is usually undertaken during recessions. Examples of expansionary fiscal policy measures include increased government spending on public works and providing the residents of the economy with tax cuts to increase their purchasing power.
  • Contractionary fiscal policy, on the other hand, is a measure to increase tax rates and decrease government spending. It occurs when government deficit spending is lower than usual. This has the potential to slow economic growth if inflation, which was caused by a significant increase in aggregate demand and the supply of money, is excessive. By reducing the economy's amount of aggregate income, the available amount for consumers to spend is also reduced. So, contractionary fiscal policy measures are employed when unsustainable growth takes place, leading to inflation, high prices of investment, recession and unemployment above the "healthy" level of 3%–4%.
However, these definitions can be misleading because, even with no changes in spending or tax laws at all, cyclic fluctuations of the economy cause cyclic fluctuations of tax revenues and of some types of government spending, altering the deficit situation; these are not considered to be policy changes. Therefore, for purposes of the above definitions, "government spending" and "tax revenue" are normally replaced by "cyclically adjusted government spending" and "cyclically adjusted tax revenue". Thus, for example, a government budget that is balanced over the course of the business cycle is considered to represent a neutral and effective fiscal policy stance.

Methods of fiscal policy funding

Governments spend money on a wide variety of things, from the military and police to services such as education and health care, as well as transfer payments such as welfare benefits. This expenditure can be funded in a number of different ways:
  • Taxation
  • Seigniorage, the benefit from printing money
  • Borrowing money from the population or from abroad
  • Dipping into fiscal reserves
  • Sale of fixed assets
  • Selling equity to the population

    Borrowing

A fiscal deficit is often funded by issuing bonds such as Treasury bills or and gilt-edged securities but can also be funded by issuing equity. Bonds pay interest, either for a fixed period or indefinitely that is funded by taxpayers as a whole. Equity offers returns on investment that can only be realized in discharging a future tax liability by an individual taxpayer. If available government revenue is insufficient to support the interest payments on bonds, a nation may default on its debts, usually to foreign creditors. Public debt or borrowing refers to the government borrowing from the public. It is impossible for a government to "default" on its equity since the total returns available to all investors are limited at any point by the total current year tax liability of all investors.

Dipping into prior surpluses

A fiscal surplus is often saved for future use, and may be invested in either local currency or any financial instrument that may be traded later once resources are needed and the additional debt is not needed.

Balanced budget amendment

The concept of a balanced budget amendment or fiscal straitjacket is a general economic principle that suggests strict constraints on government spending and public sector borrowing, to limit or regulate the budget deficit over a time period. Most US states have balanced budget rules that prevent them from running a deficit. The United States federal government technically has a legal cap on the total amount of money it can borrow, but it is not a meaningful constraint because the cap can be raised as easily as spending can be authorized, and the cap is almost always raised before the debt gets that high. A balanced budget amendment can include an adjustment for business cycles.

Fiscal policy in developing economies

The impact of fiscal policy is primarily talked about in the context of developed economies. However, fiscal policy is utilized differently in developing countries. Instead of maintaining economic growth, it is used to generate additional economic growth through improving human capital. This can be done by investment in public expenditures such as infrastructure and education. When done successfully, it can result in long-term economic gains. Nevertheless, developing countries must still consider the impact fiscal policy will have on inflation and unemployment. For some developing countries, implementing fiscal policy that improves economic stability involves "re-orientation" towards fiscal discipline and reducing government influence and intervention to give the country's private sector the ability to grow and stabilize.
One of the key issues developing economies are more likely to face is an inability to fund fiscal policy. The tax revenue collected by developed countries is almost twice that of developing countries in terms of percentage of GDP. In addition, there is a growing debt crisis in developing countries that has reached $11.4 trillion, fueled partly by development projects. This has led to governments prioritizing repaying debt over funding public essential services. Many developing countries have been left unable to continue implementing appropriate fiscal policy due to a lack of resources.