Fiscal policy involves public spending and taxation. Expansionary policies increase spending and decrease tax revenue, while contractionary policies do the opposite. The effects on the budget deficit depend on the original budget and the size and direction of the change in policy. Fiscal policy can affect aggregate demand and supply, and can be used to target specific companies or behaviors. The lag between policy changes and their effects is a key issue.
Fiscal policy is a key tool of macroeconomic policy and consists of public spending and fiscal policy. When government spending on goods and services increases or decreases tax revenue collection, we speak of an expansionary or deflationary stance. Higher taxes or lower government spending are called contractionary policies. The effects of fiscal policy can be revenue-neutral, meaning that any change in spending is balanced by an equal and opposite change in revenue collection. Even with a revenue-neutral tax policy stance, however, the government has a powerful tool to influence both people and businesses based on the type of spending or tax policy changes it makes.
Expansive policies can lead to a public budget deficit, although not always. If the economy is healthy enough when spending increases, any budget surpluses will be reduced, but not necessarily eliminated. A contractionary policy stance can result in budget surpluses, especially if the budget is already in balance. The effect on the budget deficit in both cases, however, depends on the original budget as well as the size and direction of the change in fiscal policy.
When the government increases spending without changing fiscal policy, aggregate demand moves up. This is an expansionary policy, leading to an increase in gross domestic product (GDP) and higher levels of employment and output in the sectors of the economy where the government is spending. In general, the key recipients are the defense industry and its suppliers. There are further dampening effects of fiscal policy as workers in these industries spend more, boosting sales and hiring in all areas of the economy.
If the government lowers taxes while holding spending constant, there will be a shift in aggregate supply or demand, depending on the type of taxes that were lowered. If payroll taxes and individual income tax rates are reduced, consumers will have more income to spend on all kinds of goods and services, increasing aggregate demand. If corporate tax rates are reduced, businesses are likely to expand and hire more workers, expanding aggregate supply as more goods are produced. As these workers increase their consumption of goods and services, aggregate demand also increases, resulting in both higher GDP and higher price levels.
If the economy is in a recession, the expansionary effects of fiscal policy can put the unemployed back into work, with little or no effect on interest rates or inflation. If the economy is strong or unemployment is low, however, increased government spending can cause the economy to overheat, strain production capacity, or raise wages to fill job vacancies, which can cause inflation and higher interest rates. This is called “crowding out,” where government spending forces private spending and investment due to higher prices and higher interest rates. In an inflationary economy, the government often attempts to use fiscal policy to lower prices, either by reducing its spending or by increasing tax rates.
Tax policy can be fine-tuned by targeting specific companies, individuals or behaviours. For example, to stimulate the housing market the government may choose to give large tax breaks to people who buy a house. To increase investment in agriculture, implementing low tax rates for farmers and farms will have a positive effect. Conversely, governments can tax unwanted behavior, such as higher tax rates on certain businesses or goods, such as cigarettes or alcohol.
Another effect of fiscal policy is on the composition of aggregate demand. GDP is made up of government spending, corporate spending, individual consumption and net exports. Spending-increasing fiscal policy may result in public spending accounting for a larger share of GDP. Targeted changes in fiscal policy will result in a change in the percentage of output attributed to corporate or individual spending.
A key issue with fiscal policy effects is the lag from the time policy changes are implemented until individuals or firms change their behavior and the secondary lag until behavioral changes affect the economy. If policy changes are thought to be short-lived, neither companies nor individuals can change. In the case of special tax breaks, both individuals and businesses tend to act immediately to take advantage of what may be a temporary change.
Protect your devices with Threat Protection by NordVPN
