FISCAL POLICY

What Is Fiscal Policy? Types, Objectives and Tools

Definition: Fiscal policy is the government spending and taxation that influences the economy. Elected officials should coordinate with monetary policy to create healthy economic growth. They usually don't. Why? Fiscal policy reflects the priorities of individual lawmakers. They focus on the needs of their constituencies. These local needs overrule national economic priorities. As a result, fiscal policy is hotly debated, whether at the federal, state, county or municipal level.

Types of Fiscal Policy

There are two types of fiscal policy. The first, and most widely-used, is expansionary. It stimulates economic growth. It's most critical at the contraction phase of the business cycle. That's when voters are clamoring for relief from a recession.

How does it work? The government either spends more, cuts taxes, or does both if it can. The idea is to put more money into consumers' hands, so they spend more. That jump starts demand, which keeps businesses running and adds jobs. Politicians debate about which works better. Advocates of supply-side economics prefer tax cuts. They say it frees up businesses to hire more workers to pursue business ventures. For more, see Do Tax Cuts Create Jobs?

Advocates of demand-side economics say additional spending is more effective than tax cuts. Examples include public works projects, unemployment benefits and food stamps. The money goes into the pockets of consumers, who go right out and buy the things businesses produce.

For more, see Unemployment Solutions, How Extended Unemployment Benefits Boost the Economy and 14 Ways to Create Jobs.

Expansionary fiscal policy is usually impossible for state and local government. That's because they are mandated to keep a balanced budget. If they haven't created a surplus during the boom times, they must cut spending to match lower tax revenue during a recession.

That makes the contraction worse.

Fortunately, the federal government has no such constraints, so it can use expansionary policy when needed. Unfortunately, it also means Congress created budget deficits even during economic booms. That's despite a national debt ceiling. As a result, the critical debt-to-GDP ratio has exceeded 100 percent.

The second type, contractionary fiscal policy, is rarely used. That's because its goal is to slow economic growth. Why would you ever want to do that? One reason only, and that's to stamp out inflation. That's because the long-term impact of inflation can damage the standard of living as much as a recession.

The tools of contractionary fiscal policy are used in reverse. Taxes are increased, and spending is cut. You can imagine how wildly unpopular this is among voters. Thus, it's hardly ever used. Fortunately, contractionary monetary policy is effective in preventing inflation. 

Tools of Fiscal Policy

The first tool is taxation. That includes income, capital gains from investments, property, sales or just about anything else. Taxes provide the major revenue source that funds the government. The downside of taxes is that whatever or whoever is taxed has less income to spend on themselves.

That makes taxes unpopular. Find out how the U.S. federal budget is funded in Federal Income and Taxes.

The second tool is government spending. That includes subsidies, transfer payments including welfare programs, public works projects and government salaries. Whoever receives the funds has more money to spend. That increases demand and economic growth.

The federal government is losing its ability to use discretionary fiscal policy.  Each year, more of the budget must go to mandated programs. As the population ages, the costs of Medicare, Medicaid, and Social Security are rising. Changing the mandatory budgetrequires an Act of Congress and that takes a long time. One exception was the ARRA, or Economic Stimulus Act, which Congress passed quickly. That's because legislators knew they must stop the worst recession since the Great Depression.

Fiscal Policy vs. Monetary Policy

Monetary policy is when a nation's central bank changes the money supply. It increases it with expansionary monetary policy and decreases it with contractionary monetary policy. It has many tools it can use, but it primarily relies on raising or lowering the fed funds rate. This benchmark rates then guides all other interest rates. When interest rates are high, the money supply contracts, the economy cools down, and inflation is prevented. When interest rates are low, the money supply expands, the economy heats up, and a recession is usually avoided.

Monetary policy works faster than fiscal policy. The Fed can just vote to raise or lower rates at its regular Federal Open Market Committee meeting. It may take about six months for the impact of the rate cut to percolate throughout the economy.