Fiscal policy is the means by which a government adjusts its spending levels and tax rates to monitor and influence a nation's economy. It is the sister strategy to monetary policy through which a central bank influences a nation's money supply. These two policies are used in various combinations to direct a country's economic goals.
In economics
and political science, fiscal policy is used by the government revenue collection (mainly taxes) and expenditure (spending) to influence the economy.[1]
According to Keynesian economics, when the government changes the levels of taxation and
government spending, it influences aggregate demand
and the level of economic activity. Fiscal policy can be used to stabilize the
economy over the course of the business cycle.[2]
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, amongst others, in an economy:
- Aggregate demand and the level of economic activity;
- Savings
and Investment in the economy
- The distribution
of income
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.
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. [3]
Some classical and neoclassical economists argue that crowding
out completely negates any fiscal stimulus; this is known as the Treasury
View[citation needed],
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.