Fiscal Policy

Key takeaways

• Fiscal policy uses government spending and tax decisions to influence aggregate demand, employment, inflation, and economic growth.
• Its modern practice is rooted in Keynesian ideas: governments can stabilize the business cycle by offsetting private-sector shortfalls or excesses.
• Expansionary fiscal policy (lower taxes or higher spending) aims to boost demand and growth but often increases deficits.
• Contractionary fiscal policy (higher taxes or lower spending) cools inflation but is politically unpopular.
• Fiscal policy is set by elected branches of government; monetary policy (the central bank) is a separate toolset for managing liquidity and interest rates.

What is fiscal policy?

Fiscal policy refers to actions by governments to influence the overall economy through changes in taxation and public spending. By adjusting these levers, policymakers try to smooth business cycles, reduce unemployment, and keep inflation under control.

Key economic logic

Keynesian economics—developed in response to the Great Depression—argues that aggregate demand (consumer spending, business investment, government spending, and net exports) drives economic performance. When private demand falls (for reasons including uncertainty or pessimism), governments can step in with tax cuts or increased spending to restore demand. Conversely, when demand is excessive, governments can raise taxes or cut spending to cool the economy.

Types and tools of fiscal policy

Expansionary fiscal policy
* Purpose: Stimulate demand during recessions.
* Tools: Tax cuts, direct rebates, increased public investment (e.g., infrastructure), higher transfer payments (unemployment benefits, social programs).
* Typical outcome: Higher output and employment; often results in budget deficits and increased public debt.

Contractionary fiscal policy
* Purpose: Slow demand when inflation is rising or the economy overheats.
* Tools: Tax increases, reduced government spending, cuts to public wages or employment.
* Typical outcome: Lower inflation and demand; can slow growth and raise unemployment temporarily. Politically difficult to implement.

Common considerations
* Budget balance: Expansionary policies usually widen deficits; contractionary policies aim for surpluses.
* Crowding out: Some economists argue that heavy government borrowing can raise interest rates and displace private investment.
* Political bias: Elected officials face incentives to favor stimulus and avoid austerity, which can create persistent deficits.

Fiscal policy vs. monetary policy

• Fiscal policy: Controlled by the government (legislative and executive branches) using taxes and spending.
• Monetary policy: Managed by a central bank (e.g., the Federal Reserve) to influence liquidity, credit conditions, and interest rates.

Typical monetary tools
* Open market operations (buying/selling securities)
* Policy interest rates (federal funds rate, discount rate)
* Reserve requirements for banks
* Lending facilities and liquidity programs

Who sets fiscal policy?

In many systems, fiscal policy decisions require coordination between the executive branch (which proposes budgets and programs) and the legislature (which approves taxes and appropriations). In the U.S., the President, Treasury, and Congress share these roles.

Distributional effects

Fiscal measures do not affect all groups equally. Tax cuts, subsidies, and public projects can disproportionately benefit particular income groups, regions, or industries depending on policy design. Policymakers often face trade-offs between efficiency, distributional fairness, and political feasibility.

Example

The New Deal and subsequent wartime spending in the 1930s–1940s are illustrative: large-scale government spending and programs helped raise aggregate demand and employment after the Great Depression.

Risks and downsides

• Persistent deficits can increase debt burdens and eventually require spending cuts or tax increases.
• Policy mistakes—excessive stimulus or delayed tightening—can contribute to inflation or asset bubbles.
• Political pressures can make it hard to reverse stimulus once implemented.

Bottom line

Fiscal policy is a fundamental tool for managing macroeconomic activity. By adjusting taxes and government spending, elected governments can influence demand, employment, and inflation. Because of political constraints and economic trade-offs, fiscal policy is most effective when used thoughtfully and in coordination with monetary policy.

Sources

International Monetary Fund; Encyclopedia Britannica; Board of Governors of the Federal Reserve System.