Fiscal policy is the use of government spending to influence the economy.
Government receives revenue from several sources including:
- taxes collected
- money borrowed by issuing debt (a.k.a bonds)
- printing additional money
- using up reserved funds
- the sale of fixed assets (for example selling government owned land to a corporation for development).
Fiscal policy differs greatly from monetary policy, which is concerned with controlling the money supply and interest rates.
Fiscal policy refers to the use of government funds to influence economic objectives such as maximizing employment, stabilizing prices and economic growth.
How is fiscal policy used?
There are three possible scenarios of fiscal policy:
- Neutral stance of fiscal policy. This occurs when there is a large tax revenue and a balanced economy. Government spending is not financed by issuance of debt, and the fiscal policy has a neutral effect on the level of economic activity. The government is essentially choosing not to use the income earned from taxation to directly influence the economy.
- Expansionary stance of fiscal policy. This is a situation where government spending is larger than tax revenue, thus the government needs to borrow money. This policy involves government attempts to increase aggregate demand (total demand for final goods and services in the economy.) The policy involves lowering taxes and/or higher government spending.
- Contractionary fiscal policy. This occurs when government is spending less than the total tax revenue it receives. The policy is a result of raising taxes and/or reducing spending.
Fiscal policy is connected to the government’s budget. The budget is simply the government’s financial “roadmap” for the upcoming year, and is similar to an individual or corporate budget in the sense that it determines projected income and spending.
The government prepares two sections of the budget:
- The revenue aspect, which is an estimate of the total amount of money it expects to collect.
- The expenditure aspect, outlining how much money the government expects to spend during the fiscal year.
These annual budgets also announce the government’s fiscal (and economic) targets.
Economic predictions for the upcoming year are introduced, and as such the appropriate fiscal strategies are presented for dealing with the conditions.
Fiscal policy in response to the 2008 economic crisis
The global economy entered a severe recession, caused by the financial crisis and a loss of consumer confidence.
The downtown was brought upon by the collapse of the housing bubble in the United States, affecting virtually all countries worldwide. The economic downtown affected financial markets, weaker commodity prices and a severe drop in international trade.
Many nations such as the United States, Germany, France and Australia have enacted a fiscal stimulus plan to deal with the financial crisis. These nations have used a distinct combination of government spending and tax cuts to boost the economy at least in the short term.
This follows the idea that deficit spending in the short term will lead to a higher tax revenue which will be sufficient to cover the debt incurred to finance the deficit spending.
As of 2011, many countries have exited the recession, unemployment levels have decreased, and corporate profits have increased.
Many credit the fiscal policies of the government for this turn around, which provided short-term relief and momentum, and allowed the economy to begin improving.
Disadvantages of Fiscal Policy
Fiscal policy has several drawbacks that are important to mention.
The most important being that conducting fiscal and economic studies are time consuming, thus the time delay between fiscal policy changes and its impact on the economy can take several years. Consider a government that deems a tax cut is necessary to its fiscal policy. Such a law must go through the proper channels of government and may take months or years to be implemented. It is possible that by this point the economy has worsened and requires a different course of action. As well, many economists argue that a change in fiscal policy can take at least two years before its effects are noticed.
Fiscal policy remains a closely watched data by investors because changes to the fiscal policy often involve a need to change or alter investment strategies.
Anyone who pays attention to politics will notice that the opposition parties often criticize the government’s fiscal policy, demonstrating how important a policy is in determining the short and long-term economic viability of the nation.