Fiscal Policy

Fiscal policy is the deliberate use of government spending and taxation to affect the level of economic activity. When the government spends more or taxes less, it puts money into the economy and tends to boost demand; when it spends less or taxes more, it withdraws money and tends to restrain demand. In the United States these decisions are made through the federal budget by Congress and the President, which is what sets fiscal policy apart from monetary policy, the central bank's management of interest rates and credit. The specific tax mechanics belong to the individual tax pages; this page is about taxing and spending as tools for managing the economy as a whole.

Fiscal policy comes in two directions. Expansionary fiscal policy uses higher spending, lower taxes, or both to add demand, typically to fight a recession or high unemployment. Contractionary fiscal policy, sometimes called austerity, uses lower spending or higher taxes to cool an overheating economy or to bring down borrowing. The idea that government budgets could be used this way to smooth the business cycle is associated with the economist John Maynard Keynes and became central to policy after the Great Depression.

A useful distinction is between discretionary and automatic fiscal policy. Discretionary policy is a deliberate act, a new spending program or a tax cut passed for the purpose. Automatic stabilizers work without any new decision: in a downturn, tax revenue falls as incomes fall and spending on programs like unemployment benefits rises, which cushions the economy on its own; in a boom the same mechanisms run in reverse. Much of fiscal policy's steadying effect comes from these built-in stabilizers rather than from headline legislation.

Fiscal policy and the budget arithmetic are tightly linked. If the government spends more than it collects in a given year, it runs a budget deficit and borrows to cover the gap by issuing Treasury securities. The running total of past deficits, plus interest, is the national debt, which is a stock built up over many years rather than a single year's shortfall. Expansionary fiscal policy therefore usually widens deficits and adds to the debt, which is one of the main constraints on how freely it can be used.

Because fiscal policy and monetary policy both influence demand, they can reinforce or work against each other. A large fiscal stimulus adds demand that a central bank fighting inflation may have to offset with tighter monetary policy, and coordination between the two is a recurring theme in economic debate. The key structural difference is accountability: fiscal policy is set by elected officials and can be aimed at particular groups, regions or industries, while monetary policy is run by a central bank kept deliberately independent.

Fiscal policy operates through the annual federal budget: decisions about how much to spend, on what, and how much to raise in taxes. A change on either side of the ledger flows into the economy, spending directly as government purchases and transfers, taxes indirectly by changing how much households and businesses have left to spend and invest.

A hypothetical shows the mechanism. Suppose the economy is in a recession with weak demand. Congress enacts a $300 billion package of infrastructure spending and temporary tax rebates. The infrastructure money pays contractors and workers, who spend their income at other businesses, so the initial dollars circulate and support additional activity, an effect economists call the multiplier. The tax rebates leave households with more to spend. Because the government did not have the $300 billion on hand, it borrows it by issuing Treasury securities, widening that year's deficit and adding to the national debt. The policy supports demand now at the cost of higher borrowing, which is the trade-off at the heart of expansionary fiscal policy.

What fiscal policy can do

• Support demand directly and quickly in a downturn through spending and tax cuts, without relying only on interest rates.
• Be targeted at specific needs, regions, or groups in a way monetary policy cannot.
• Work partly on autopilot through automatic stabilizers that cushion the economy without new legislation.

Its drawbacks

• Expansionary policy usually widens deficits and adds to the national debt.
• It is slow to enact, because spending and tax changes must pass through the political and legislative process.
• It is prone to political pressure, making it easier to cut taxes or raise spending than to do the reverse when the economy runs hot.