Fiscal policy

Fiscal policy attempts to alter aggregate demand through taxation, government spending, and borrowing. Aggregate demand (AD) is composed on household spending (C), investment spending (I), government spending (G) and 'net exports' (exports, less imports, X - M).

Fiscal policies target particular components of aggregate demand in order to achieve specific policy objectives.

For example, if the policy objective is to stimulate economic growth, policy makers may reduce the basic rate of income tax to increase disposable income, which may then trigger an increase in household spending - the largest component of aggregate demand.

Expansion or contraction?

Fiscal policy can be used either to 'expand' an economy by increasing economic activity and stimulating economic growth, or it can be used to 'contract' economic activity to reduce inflationary pressure or to control imports.

Discretionary or automatic?

There two main types of fiscal policy - 'discretionary' and 'automatic'.

Discretionary policy

Discretionary fiscal policy relates to the deliberate intervention by policy-makers to engineer a positive change in an economy - the intervention is 'at the discretion' of the policy maker taking into account the specific circumstances the economy faces at a particular point in time. For example, a rise in unemployment may trigger an increase in public spending through a 'one-off' policy change - usually in an annual budget. Assuming a positive multiplier effect, an injection of new government spending - say on infrastructure - will exert extra demand in the labour market, which is likely to reduce unemployment - assuming workers are willing and able to supply their labour.

A discretionary fiscal 'stimulus' - or fiscal 'brake' - is not 'built in' to the macro-economy, but requires deliberate decision-making in the face of specific economic circumstances. A fiscal stimulus means that the annual budget is moving towards an increased 'deficit' (or reduced surplus), when revenues from taxation are less than government spending, whereas a fiscal brake means that public finances are moving towards a 'surplus' (or reduced deficit).

Fiscal policy and unemployment

While supply-side policy has been the favoured policy option to reduce unemployment since the 1980s, fiscal policy was the preferred option for the majority of the 20th Century. Indeed, since Keynes, interventionist economists have argued that a fiscal stimulus is an effective way to reduce unemployment - this could involve reduced taxation, although an increase in public sector spending may have a more direct effect on job creation.

fiscal options to deal with unemployment

The effects of a fiscal stimulus

A fiscal stimulus will shift AD to the right, leading to economic growth (Y to Y1), and a fall in unemployment (U to U1). However, depending on the elasticity of aggregate supply, a fiscal stimulus will also put upward pressure on prices (P to P1).

a fiscal stimulus might increae growth and reduce unemployment

Critics would argue that jobs created his way may only result in a short term reduction in unemployment (see Phillips curve). In addition, a central feature of supply-side economics is the permanent reduction of marginal tax rates to create incentives to work (see the Laffer curve). This means that governments have become increasingly reluctant use discretionary tax policy to regulate the regulate aggregate demand.

Fiscal policy and the price level

While monetary policy is generally preferred to fiscal policy in terms of stabilising prices, changing tax rates or levels, and changing government spending may be used to supplement monetary policy at certain times. The options available are shown below:

fiscal options to deal with unstable prices

Discretionary fiscal policy can be used to supplement automatic stabilisers when the trade (or business) cycle goes through more extreme periods than would normally be expected.

Automatic stabilisers

In contrast to discretionary policy, automatic stabilisers (often just called 'stabilisers') are 'built-in' to the tax-benefits system through the use of 'progressive' taxation and welfare benefits. Stabilisers are like a 'background app' running 'behind' the economy and automatically adjusting aggregate demand without any deliberate decision-making.

Stablisers work in two ways - either through ‘fiscal drag’ which slows down the economy, or through ‘fiscal boost’ which speeds it up - these two processes work to regulate the business cycle to avoid the extremes of activity which can lead to significant economic problems.

Fiscal drag

Fiscal drag means that progressive taxes and welfare benefits combine to slow an economy down if it is growing too quickly.

For example, if real incomes are increasing, all income earners will pay more given that income tax will be paid as a percentage of income. In addition, some income earners may move to a higher tax bracket (tax band) so that more of the extra 'original' income goes to the government in taxation. The combined effect of this is that the increase in income is dampened by the increased amount that is withdrawn from the economy in tax revenue.

At the same time, rising income means that some individuals now join the labour market, and receive an income. However, if they were already receiving income support in the form of welfare benefits, their income 'jumps up' by a smaller amount than if they received much lower welfare benefits.

This can be seen in the diagram below. The introduction of progressive income tax and welfare benefits moderates any increases in 'original income', and 'drags back' the growth in income in comparison with having no (or low) progression in the tax-benefits system.

fiscal drag image

Fiscal boost

Fiscal boost occurs when an economy slows down or goes into recession. Welfare benefits provide a 'safety net' and prevent the economy falling too far and hence avoid the worst effects of falling income.

Welfare benefits are an injection into the economy, and reduce the negative impact of lower economic activity. Also, as incomes fall, individuals pay less tax (and there is a smaller leakage from the circular flow) and this helps them retain more of their own income - boosting the economy at a time of lower growth, or recession.

Video on macro-economic policies
automatic stabilisers

In recent years more emphasis has been placed on the use of fiscal policy - mainly as a result of the weak effect of monetary policy when interest rates are at a virtual zero.

This is especially true in recent months following the Covid-19 pandemic when a fiscal stimulus is more appropriate than a monetary stimulus. In late March 2020 the US Senate approved a stimulus package of around $2 trillion, while in April Japan agreed an $1 trillion stimulus package and India agreed a $260 billion package. In the face of a crisis such as the Covid pandemic, monetary policy may have little effect, and supply-side policy will take too long to have an impact - hence a fiscal stimulus has clear advantages over possible alternatives.

Aggregate demand

More on aggregate demand and the AD curve.

Aggregate demand
Supply-side policy

How does supply-side policy affect the economy?

Supply side
Monetary policy

Is monetary policy effective at controlling inflation?

Monetary poicy
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