Fiscal policy

Fiscal policy refers to government attempts to influence the direction of the economy through changes in government taxes, or through some spending (fiscal allowances).

Fiscal policy can be contrasted with the other main type of economic policy, monetary policy, which attempts to stabilize the economy by controlling interest rates and the supply of money. The two main instruments of fiscal policy are government spending and taxation. Changes in the level and composition of taxation and government spending can impact on the following variables in the economy:

• Aggregate demand and the level of economic activity;
• The pattern of resource allocation;
• The distribution of income.

Fiscal policy

Fiscal policy refers to the overall effect of the budget outcome on economic activity. The three possible stances of fiscal policy are neutral, expansionary and contractionary:

• A neutral stance of fiscal policy implies a balanced budget where G = T (Government spending = Tax revenue). Government spending is fully funded by tax revenue and overall the budget outcome has a neutral effect on the level of economic activity.

• An expansionary stance of fiscal policy involves a net increase in government spending (G > T) through a rise in government spending or a fall in taxation revenue or a combination of the two. This will lead to a larger budget deficit or a smaller budget surplus than the government previously had, or a deficit if the government previously had a balanced budget. Expansionary fiscal policy is usually associated with a budget deficit.

• Contractionary fiscal policy (G < T) occurs when net government spending is reduced either through higher taxation revenue or reduced government spending or a combination of the two. This would lead to a lower budget deficit or a larger surplus than the government previously had, or a surplus if the government previously had a balanced budget. Contractionary fiscal policy is usually associated with a surplus.

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
• Seignorage, the benefit from printing money
• Borrowing money from the population, resulting in a fiscal deficit.
• Consumption of fiscal reserves.
• Sale of assets (e.g., land).

Funding the deficit

A fiscal deficit is often funded by issuing bonds, like treasury bills or consols. These pay interest, either for a fixed period or indefinitely. If the interest and capital repayments are too large, a nation may default on its debts, usually to foreign creditors.

Consuming the surplus

A fiscal surplus is often saved for future use, and may be invested in local (same currency) financial instruments, until needed. When income from taxation or other sources falls, as during an economic slump, reserves allow spending to continue at the same rate, without incurring a deficit. Hong Kong ran a fiscal surplus of HK$123.6 billion in fiscal year 2007/08 (ended March 31, 2008), equal to US$15.85 billion or 7.7% of 2007 GDP.

Economic effects of fiscal policy

Fiscal policy is used by governments 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 adjusting government spending and tax rates are the best ways to stimulate aggregate demand. This can be used in times of recession or low economic activity as an essential tool in providing the framework for strong economic growth and working toward full employment. The government can implement these deficit-spending policies due to its size and prestige and stimulate trade. In theory, these deficits would be paid for by an expanded economy during the boom that would follow; this was the reasoning behind the New Deal.

During periods of high economic growth, a budget surplus can be used to decrease activity in the economy. A budget surplus will be implemented in the economy if inflation is high, in order to achieve the objective of price stability. The removal of funds from the economy will, by Keynesian theory, reduce levels of aggregate demand in the economy and contract it, bringing about price stability.

Despite the importance of fiscal policy, a paradox exists. In the case of a government running a budget deficit, funds will need to come from public borrowing (the issue of government bonds), overseas borrowing or the printing of new money. When governments fund a deficit with the release of government bonds, an increase in interest rates across the market can occur. This is because government borrowing creates higher demand for credit in the financial markets, causing a lower aggregate demand (AD) due to the lack of disposable income, contrary to the objective of a budget deficit. This concept is called crowding out. Alternatively, governments may increase government spending by funding major construction projects. This can also cause crowding out because of the lost opportunity for a private investor to undertake the same project. Another problem is the time lag between the implementation of the policy and detectable effects in the economy. An expansionary fiscal policy (decreased taxes or increased government spending) is usually intended to produce an increase in aggregate demand; however, an unchecked spiral in aggregate demand will lead to inflation. Hence, checks need to be kept in place.

See also

• Public finance
• Government spending
• Tax
• Deficit
• Model (macroeconomics)
• Fiscal policy in the United States
• Monetary policy
• Budgetary policy

External links

• Concise Encyclopedia of Economics
• Using Fiscal Policy
• Limitations of Fiscal Policy
• US - External Debt viz Savings rate Comparing External debt viz Savings rate - since 1995 (which are two of the components that finances the Fiscal Policy )
• What Is Fiscal Policy?

Bibliography

• Heyne, P. T., Boettke, P. J., Prychitko, D. L. (2002): The Economic Way of Thinking (10th ed). Prentice Hall.