What Is Fiscal Policy?

July 27, 2023
Fiscal policy refers to how the government uses spending and taxation to influence the economy. During times of contraction or expansion, policymakers can use a combination of fiscal and monetary policy to accelerate and decelerate the economy towards the status quo. With fiscal policy in particular, this is believed to have a positive long-term effect on the redistribution of income and wealth.

How Does Fiscal Policy Work?

To keep the U.S. macroeconomy stabilized, the government will often intervene using the influence of monetary and fiscal policy. Monetary policy refers to activities that the central bank uses to raise and lower interest rates and adjust the money supply available in circulation. Fiscal policy refers to more long-term measures that can be used to influence the economy - particularly through the use of government spending and taxation.

The government regularly spends money on basic public needs such as education, healthcare, infrastructure, etc. However, they may also decide to inject more money into the economy by taking on special projects or allocating money toward specific public needs. An example would be the 2021 and 2022 federal stimulus payments that were sent to every qualifying family to help provide financial relief during the COVID pandemic.

Simultaneously, the government may also achieve the same effect by voting for short-term changes to the tax code. An example would be the American Rescue Plan in 2021 which expanded the Child Tax Credit from $2,000 per child to $3,600.

Expansionary vs Contractionary Fiscal Policy

Depending on the latest GDP trend or unemployment figures, the federal government can use fiscal policy to nudge the overall economy in one of two ways:

Expansionary Fiscal Policy

When the economy is heading into a recession, the outlook is not good for consumers. Businesses may lay off workers and consumers will generally not spend as much as they normally would.

Under these conditions, the government will try to jumpstart the economy by raising spending and lowering taxes. Raising spending helps businesses to keep employees staffed or provides jobs for them directly. Lower taxes also means that consumers will have less to pay the IRS and more discretionary income.

Expansionary fiscal policy seeks to utilize the multiplier effect. For every dollar they save businesses and consumers, they know that they will in turn spend that money, and so on. Thus it can have a positive ripple effect throughout the economy that helps to accelerate its recovery.

Contractionary Fiscal Policy

When the economy is doing well, businesses and consumers are happy. However, the government has to ensure that things don't trend upward too quickly or it may create a bubble. History has demonstrated that bubbles can be devastating for economies because once prices have been driven to the point of unsustainability, they fall rapidly resulting in job loss and deflation.

Therefore, the government will pull back on the economy by not spending as much as it did before or by raising taxes. This means fewer government jobs and financial incentives for businesses. More taxes can also lead to less discretionary income for consumers.

Though contractionary fiscal policy is sometimes necessary, it's not something many policymakers like to do - mainly because it makes them unpopular with the public. An example of this is when President George H. W. Bush raised taxes in the early 1990s after he had promised not to during his presidential run. During his reelection campaign, his opponents reiterated this point repeatedly, and it ultimately contributed to his not getting reelected as president in 1992.

Fiscal Policy and Keynesian Economics

The concept of fiscal policy can best be attributed to British economist John Maynard Keynes. Keynes has published several notable books, and his teachings have become dubbed as “Keynesian economics”.

During the Great Depression of the 1930s, it was assumed by economists of the time that the free markets would automatically fix themselves if given enough time. This proved to be untrue since workers continued to stay unemployed and the businesses didn’t earn enough revenue to hire them.

Keynes proposed a radical new idea that aggregate demand was the guiding force of the economy. If businesses and households were not able to sustain this demand, then it was up to the government to do their part and subsidize spending. These theories were detailed in his major work, "The General Theory of Employment, Interest, and Money” which is still held in high regard today. Eventually, Keynes’ ideas helped inspire new government policies which ultimately helped bring the U.S. out of its depression.

Does Fiscal Policy Work?

Even though fiscal policy is widely accepted and well-integrated into the U.S. economy today, its merits are still questioned. Economists have debated its effectiveness for decades suggesting it does not necessarily produce the outcome it's supposed to.

One example is the American Recovery and Reinvestment Act of 2009. While this initiative was said to have pumped $800 billion into the economy, it didn’t motivate spending as quickly as policymakers had hoped. On the other hand, some people argued that the Great Recession would have been in worse shape without it.

Another criticism of fiscal policy is the origin of the money it uses. When the government decides to take on new projects or decrease taxes, it has to borrow the funds it needs. This leads to more national debt.

Supporters of fiscal policy unfortunately have to wait several months or even years before they’ll see evidence of its effectiveness. While monetary policy usually brings about reactions from the stock market quickly, the actions of fiscal policy have a lag effect. That makes it difficult to know if further changes are needed or if the new initiatives are working.

The Bottom Line

Fiscal policy is a set of actions that the federal government can use alongside monetary policy to set the pace of the macroeconomy. Through a combination of government spending and taxes, policymakers can expand or contract the pace of economic growth.

Even though fiscal policy has been practiced since the times of John Maynard Keynes to recover from the Great Depression, its effectiveness has been the topic of debate. While it can add to the national debt and doesn’t produce immediate results, supporters will argue that the economy would be worse without government intervention.