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In economics and political science, fiscal policy is the use of government revenue collection (taxation) and expenditure (spending) to influence the economy. The two main instruments of fiscal policy are changes in the level and composition of taxation and government spending in various sectors. These changes can affect the following macroeconomic variables in an economy:

• Aggregate demand and the level of economic activity;
• The distribution of income;
• The pattern of resource allocation within the government sector and relative to the private sector.

Fiscal policy refers to the use of the government budget to influence economic activity.

Stances of fiscal policy

The three main stances of fiscal policy are:

• Neutral fiscal policy is usually undertaken when an economy is in equilibrium. Government spending is fully funded by tax revenue and overall the budget outcome has a neutral effect on the level of economic activity.
• Expansionary fiscal policy involves government spending exceeding tax revenue, and is usually undertaken during recessions.
• Contractionary fiscal policy occurs when government spending is lower than tax revenue, and is usually undertaken to pay down government debt.

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 fiscal policy stance.

Methods of funding

Governments spend money on a wide variety of things, from the military and police to services like education and healthcare, 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
• Consumption of fiscal reserves
• Sale of fixed assets (e.g., land)

Borrowing

A fiscal deficit is often funded by issuing bonds, like treasury bills or consols and gilt-edged securities. These pay interest, either for a fixed period or indefinitely. If the interest and capital requirements are too large, a nation may default on its debts, usually to foreign creditors. Public debt or borrowing refers to the government borrowing from the public.

Consuming 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; notice, additional debt is not needed. For this to happen, the marginal propensity to save needs to be strictly positive.

Economic effects of fiscal policy

Fiscal policy is based on the theories of British economist John Maynard Keynes. Also known as Keynesian economics. Basic Keynesian theory suggests that government spending and tax revenue are represented as a percentage of GDP, because these two are components of the real GDP. Governments use fiscal policy to influence the level of aggregate demand in the economy, in an effort to achieve economic objectives of price stability, full employment, and economic growth. Keynesian economics suggests that increasing government spending and decreasing tax rates are the best ways to stimulate aggregate demand, and decreasing spending & increasing taxes after the economic boom begins. Keynesians argue this method be used in times of recession or low economic activity as an essential tool for building the framework for strong economic growth and working towards full employment. In theory, the resulting deficits would be paid for by an expanded economy during the boom that would follow; this was the reasoning behind the New Deal.

Governments can use a budget surplus to do two things: to slow the pace of strong economic growth, and to stabilize prices when inflation is too high. Keynesian theory posits that removing spending from the economy will reduce levels of aggregate demand and contract the economy, thus stabilizing prices.

But economists still debate the effectiveness of fiscal stimulus. The argument mostly centers on crowding out: whether government borrowing leads to higher interest rates that may offset the stimulative impact of spending. When the government runs a budget deficit, funds will need to come from public borrowing (the issue of government bonds), overseas borrowing, or monetizing the debt. When governments fund a deficit with the issuing of government bonds, interest rates can increase across the market, because government borrowing creates higher demand for credit in the financial markets. This causes a lower aggregate demand for goods and services, contrary to the objective of a fiscal stimulus. Neoclassical economists generally emphasize crowding out while Keynesians argue that fiscal policy can still be effective especially in a liquidity trap where, they argue, crowding out is minimal.

Some classical and neoclassical economists argue that crowding out completely negates any fiscal stimulus; this is known as the Treasury View , which Keynesian economics rejects. The Treasury View refers to the theoretical positions of classical economists in the British Treasury, who opposed Keynes' call in the 1930s for fiscal stimulus. The same general argument has been repeated by some neoclassical economists up to the present.

In the classical view, the expansionary fiscal policy also decreases net exports, which has a mitigating effect on national output and income. When government borrowing increases interest rates it attracts foreign capital from foreign investors. This is because, all other things being equal, the bonds issued from a country executing expansionary fiscal policy now offer a higher rate of return. In other words, companies wanting to finance projects must compete with their government for capital so they offer higher rates of return. To purchase bonds originating from a certain country, foreign investors must obtain that country's currency. Therefore, when foreign capital flows into the country undergoing fiscal expansion, demand for that country's currency increases. The increased demand causes that country's currency to appreciate. Once the currency appreciates, goods originating from that country now cost more to foreigners than they did before and foreign goods now cost less than they did before. Consequently, exports decrease and imports increase.

Other possible problems with fiscal stimulus include the time lag between the implementation of the policy and detectable effects in the economy, and inflationary effects driven by increased demand. In theory, fiscal stimulus does not cause inflation when it uses resources that would have otherwise been idle. For instance, if a fiscal stimulus employs a worker who otherwise would have been unemployed, there is no inflationary effect; however, if the stimulus employs a worker who otherwise would have had a job, the stimulus is increasing labor demand while labor supply remains fixed, leading to wage inflation and therefore price inflation.

Effects on aggregate demand

Aggregate demand is entire demand for final goods and services in the economy at a given time and price level. Aggregate-demand curve in Fig.1 shows the quantity of goods and services that households, firms and the government wants to buy at each price level. Fiscal policy is a tool relevant to government’s choice of the economy, which is based on the overall level of government purchases and taxes. It plays an important role that government involves the economy overall the country. Based on Macroeconomics fact, in the short run, an increase in government purchases or a cut in taxes shifts the aggregate-demand curve to the right, and vice versa. However, in terms of the long-run effects of fiscal policy on interest rates, investment and economic growth are more significant. Most economists believe the aggregate-demand curve would remain at a constant shift in the long run. When the government alters spending or taxes, the resulting shift in aggregate demand can be larger or smaller than the fiscal change. For instance, if the U.S. Department of Health and Human Services placed a $20 billion order for their new medical equipment by GE Company, this order would increase the demand for the output produced by GE Company, which encourages the company to hire more workers and to increase their production. Because the GE Company is a part of the economic market, the increase in the demand for medical equipment means that the total quantity of goods and services demanded will increase at each price level. As a result, the aggregate-demand curve shifts to the right, with the extent of the shift that will be determined by the multiplier effect.

Effects on changing in taxes

Besides the level of government purchase, the other half part of fiscal policy is the level of taxations. When government cuts personal income taxes, households can have additional income and spend it on the goods and services. Therefore, the increase of consumers’ spending, the taxes cut will shift the aggregate-demand curve to the right. Similarly, a taxes increase depresses the consumers’ ability to pay and shift the aggregate-demand curve to left. The size of the shift is also affected by the multiplier and crowding out effects., An extreme example of a temporary tax cut was announced on 1992. President George H.W. Bush was confronted with a lingering recession and an upcoming reelection campaign. His response of this circumstance was reducing a big amount of income tax that the federal government was withholding from workers’ paycheckers. Every dollar for reduced withholding in 1992 means an extra dollar of taxes due on April 15,1993. Therefore, this “tax cut” only refers to a short- term loan from the government. Compared with long-term affect, the impact of the policy on consumer spending and aggregate demand was comparatively small.,

Effects on aggregate supply

Most economists believe the short-run effects of fiscal policy mainly work through aggregate demand, however, fiscal policy might also influence aggregate supply. Base on the Ten Principles of Economics, it demonstrates that people respond to incentives. When government policymakers cut tax rates, workers gains more dollar, which encourages them have a greater incentive to work, and more goods and services will be supplied at each price level. Therefore, the aggregate supply will increase. Some economists argued that the influence of tax on aggregate supply is large. This idea called supply-siders is not considered as a normal case.

Unpredictable effects

In the reality, the influence of fiscal policy does not always follow economic fact. It can be various and unpredictable, because the economic forecast is so imprecise. If forecasters could accurately predict the condition of economy in a year, monetary and fiscal policymakers can look ahead when they make decisions for the next year. In practice, according to history, for example, the 2010’s global economy recession and the Great Depression of the United States, major recessions and depressions come without any cautioning. The best way policymakers can do is to respond to economic changes as soon as they can. For the long-term budget outlook, projections rely on numerous assumptions about economic and fiscal factors. Although long run forecast is highly uncertain, policies of rising costs for health care and the aging of the country’s population will cause the federal government spending to increase rapidly. According to the data from the Congressional Budget Office (CBO), they have already prepared budgetary projections through 2080 under two assumptions about federal laws and policies. Those projections demonstrates that, the federal debt will continue to grow much faster than the economy over the long run under either set of assumptions.

Fiscal straitjacket

The concept of a 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. The term probably originated from the definition of straitjacket (anything that severely confines, constricts, or hinders). Various states in the United States have various forms of self-imposed fiscal straitjackets.

Using policy to stabilize the Economy

Federal government expenditures or receipts automatically increase or decrease without requiring action by Congress or the President. Examples are unemployment compensation and individual income tax. Economic stabilization has been an explicit goal of U.S. policy since the Employment Act of 1946. The Employment Act has two implications; first, government should avoid suffering economic fluctuations. Some economists disagree with having large and sudden change in monetary and fiscal policy, since this change is likely to cause fluctuation in aggregate demand; second, the government should have more sensitive responses to change in private economy to stabilize aggregate demand. Some economists argue that the government should avoid active use of monetary and fiscal policy to try to stabilize the economy. They emphasized the long-run goal and claim that these policy instrument should be set to achieve long-run goals, for example rapid economics growth and low inflation. Government should no longer focus on short-run fluctuation.,

How fiscal policy works

Fiscal policy is attributed into a lot of political process. For example, in the United States, most changes in government spending and taxes will go through congressional committees in both House and Senate, and then it must be passed by both legislation and signed by the president. To finish this process, it might take a couple months, mostly, years.

See also

• Fiscal policy of the United States
• Fiscal union
• Functional finance
• Interaction between monetary and fiscal policies
• National fiscal policy response to the late 2000s recession
• Macroeconomics

Bibliography

• Heyne, P. T., Boettke, P. J., Prychitko, D. L. (2002): The Economic Way of Thinking (10th ed). Prentice Hall.
• Larch, M. and J. Nogueira Martins (2009): Fiscal Policy Making in the European Union – An Assessment of Current Practice and Challenges. Routledge.
• Hansen, Bent (2003): The Economic Theory of Fiscal Policy, Volume 3. Routledge.

External links

• Using Fiscal Policy
• Limitations of Fiscal Policy
• What Is Fiscal Policy?

* Category:Public finance