Fiscal Policy – A Comprehensive Guide

An infographic that explains what fiscal policy ism who implements it, the different types of fiscal policy, and its pros and cons.

Fiscal policy is one way the government influences economic performance and tries to fulfill its responsibility towards its people. It is often used in conjunction with monetary policy. Fiscal policy deals with government spending and taxation and aims to influence economic activity. 

Although many politicians argue about the purpose of U.S. fiscal policy, it is clear that during the Covid-19 crisis, fiscal policy has helped businesses and families survive. This guide explains what fiscal policy is, the different types, how it impacts consumers and businesses, and how it compares to monetary policy.

What Is Fiscal Policy?

Fiscal policy refers to the use of government spending and taxes (revenue collection) to influence the nation’s economy. Tax collection and spending are often used to influence macroeconomic aspects like employment, inflation, economic growth, and aggregate demand.

Fiscal policy aims to influence the economy in various ways, either through expansionary or contractionary approaches. For example, during times when inflation is getting too high, the federal government can employ contractionary fiscal policy to slow down economic growth and cut back on inflation. Conversely, when the economy experiences a recession, it can use expansionary fiscal policy to fuel economic growth by cutting taxes and increasing government spending.

The main goal of fiscal policy is to balance the economy. To grow the economy at a steady rate – not too fast and not too slow. Fiscal policy tries to stabilize the business cycle by maintaining a healthy economic growth rate, full employment, and stable wages and prices. It is also used to manage inflation, supply and demand, and other economic problems.

In the United States, a healthy economy is an economy with a Gross Domestic Product (GDP) growth rate between 2 and 3 % per year, an unemployment rate between 3.5 and 4.5 %, and a target inflation rate of about 2 %. In a healthy economy, the business cycle is in its expansion phase.

An infographic that shows that a healthy U.S. economy is based on the following values of 3 macroeconomic indicators: a GDP between 2 and 3 percent,a natural unemployment level between 3.5 and 4.5%, and a target inflation rate of about 2%.

Fiscal policy is implemented by the executive and legislative branches of the government. The President submits a federal budget proposal to Congress that contains estimates of government income and spending and also recommends funding levels for the federal government. Congress is responsible for passing appropriations bills that set the spending levels.

Politicians often disagree about the government’s level of involvement needed to steer the economy. They also often argue about which method of expansionary fiscal policy is best. Some advocate for “trickle-down” supply-side economics. They believe that lowering taxes will entice businesses to invest in the future, expand, and hire more employees. This will then result in more disposable income and eventually lead to increased demand and economic growth. 

Others advocate for demand-side economics. They believe that rising demand drives the economy and that increasing government spending will increase employment and consumer spending.

Expansionary Fiscal Policy

Many consider expansionary fiscal policy as a positive measure as it stimulates economic growth. The federal government employs expansionary fiscal stimulus when necessary during low economic growth or just after a recession or depression. The government uses 2 main tools to try to attempt to grow the economy. It can increase its spending and/or lower taxes (decrease revenue).

One way expansionary economic policy tries to reverse the decline in demand is by boosting the purchasing power of consumers. The government does this by implementing income tax cuts. Lower taxes increase disposable income. This, in turn, increases aggregate demand, leading companies to hire more employees which eventually will lead to higher wages. Then, this positive cycle starts again. Again, an increase in disposable income will lead to higher demand and so on.

Another way the government can stimulate the economy is by increasing government spending. Purchasing more goods and services from the private sector will definitely stimulate the economy. It will increase demand, which will lead to a decrease in unemployment. This will result in an increase in disposable income and eventually lead to an even higher demand for products.

In response to the financial crisis of 2008, U.S. Congress approved the Economic Stimulus Act to avert a depression. This fiscal stimulus package was worth $152 billion. It gave taxpayers between $300 and $1,200 in tax rebates in an attempt to increase consumer spending to jumpstart the economy again.

The second stimulus package Congress employed in 2009 during this economic turmoil was worth about $830 billion. This package increased government spending. The American Recovery and Reinvestment Act spread the money across several objectives. It included corporate tax benefits to businesses, an increase in infrastructure projects, and a boost to the education and healthcare sectors to improve employment and stimulate the economy.

Expansionary fiscal policy is expensive, and often, the government doesn’t have enough money to fund its own spending plans. So, when there is not enough money in the budget (a budget deficit), it will borrow money by issuing government bonds. These treasury bonds will increase government debt resulting in “deficit” spending. 

Another disadvantage of expansionary fiscal policy is that it often increases inflation. When the increase in spending and the lowering of taxes are not done carefully, inflation can rise and cause an economic slowdown instead of economic growth.

Infographic that shows the differences between expansionary fiscal policy and contractionary fiscal policy.

Contractionary Fiscal Policy

The second type of fiscal policy is contractionary fiscal policy. Contractionary policy is rare and unpopular among voters because its goal is to slow economic growth. The government uses 2 main tools to curb economic growth. It can limit its spending and/or increase tax rates. The reason it is so unpopular is that contractionary policy often results in higher taxes, reduced subsidies, and job cuts.

The federal government employs contractionary policy to slow down unsustainable economic growth. Curbing economic booms is necessary when inflation is rapidly rising (above 3%), the cost of living is skyrocketing, and unemployment is above healthy levels. At the same time, investor confidence and greed are high, and asset bubbles are forming. Thus, the goal of contractionary fiscal policy is to slow down economic growth and bring inflation back to a manageable level. 

The most recent contractionary policy was when President Clinton decided to reduce public debt and cut the deficit. He did this by decreasing government spending on welfare and defense and implementing a tax policy that increased taxes for high-earning taxpayers. This resulted in federal budget surpluses for 1998-2002. These were the only years with budget surpluses since 1970.

History of Fiscal Policy

Before the Great Depression that started in 1929, the U.S. economic system was largely laissez-faire. Laissez-faire is French for “allow to do” or “leave us alone.” It refers to a theory that restricts government intervention in the economy. It believes that free-market forces of supply and demand should be left alone, and the government’s only role should be to protect individuals’ rights. Unfortunately, this laissez-faire attitude made the Great Depression even worse.

The British economist John Maynard Keynes developed theories defying the classic assumptions about the self-correcting nature of economic swings. Instead, he argued that recessions were a result of reduced consumption and investment components of demand. Therefore, governments could influence the business cycle and regulate the economy by increasing and decreasing taxes and government spending.

Fiscal policy originated from the Keynesian economic theory that says spending or aggregate demand drives the growth and performance of an economy. Finally, the recession was brought to an end with an expansionary fiscal policy called “The New Deal.” It consisted of programs and projects focused on increased spending for public works by building bridges, dams, and roads. In addition, the government hired millions of people, which increased demand as the newly employed started spending their income. 

The economy expanded between 1933 and 1936. To slow economic growth, contractionary fiscal policy was implemented by reducing spending between 1936 and 1939. The depression ended, but unemployment was still high. In 1946, Congress passed the Employment Act enabling the government to use fiscal policy to keep inflation low and employment high.

Fiscal Policy versus Monetary Policy

An Infographic that explains the differences between fiscal policy and monetary policy.

While fiscal policy primarily deals with changes in spending and taxes, monetary policy aims to change the money supply within a nation. It is generally implemented to control economic growth by changing interest rates and the money supply. Just like fiscal policy, it focuses on either boosting or slowing down the economy.

While fiscal policy is the government’s responsibility, monetary policy is the responsibility of the U.S. Federal Reserve System, which is the Central Bank and its Reserve banks. The Fed implements different strategies to increase or limit the supply of money. It can use various tools but most often it depends on lowering or boosting the federal funds rate, which in turn influences other interest rates. 

When interest rates are lowered, the money supply expands, demand increases, and economic activity increases. This typically prevents a recession from occurring. In contrast, when interest rates are high, the money supply becomes tight, demand decreases, the economy contracts, and inflation doesn’t occur.

Just like fiscal policy, monetary policy can either be expansionary or contractionary. Monetary policy can be implemented faster than fiscal policy as the Federal Reserve can change interest rates 8 months per year. However, adjusting government spending will take much longer as it is set by the federal legislative and executive branches. In addition, it takes time to figure out how large the budget should be and what exactly to spend money on. 

Both monetary and fiscal policy have their benefits and limitations.

The Impact of Fiscal Policy on Consumers

Fiscal policy does not always affect everyone the same way. Often, fiscal policy only affects a specific group of people or businesses. Which group usually depends on the political affiliation of the policymakers and the main goal of the policy.

For example, an increase in the highest income tax bracket will only impact people with the highest incomes. This income tax increase will not affect low-income and middle-income earners. Another example is expansionary fiscal policy that increases spending on renewable energy. This will mostly benefit companies and employees in the green sector and possibly consumers who buy renewable energy products. It will not benefit the fossil fuel industry nor many other industries and sectors. But, of course, it will be beneficial to the environment.

Fiscal policy has an impact on aggregate demand through changes in taxation and federal spending. These changes will then increase or decrease employment and consumer income, which will impact consumer spending and investment. When consumers earn more, they spend more and private investment will increase as well. Conversely, when taxes increase, consumers cut down on their spending and investments. This means fiscal policy directly impacts consumer confidence.

The Impact of Fiscal Policy on Businesses

Fiscal policy does not only have a large impact on consumers, but it also has a huge impact on businesses, whether introduced in the form of taxation or government spending. Here are some of the primary effects of fiscal policy on businesses.

Creates Investment Opportunities – Expansionary fiscal policy will definitely open up investment opportunities for businesses as government spending increases and the private sector grows. While more money flows into the economy and taxation is low, businesses will have more money at their disposable to grow and make investments for the future.

Affects growth opportunities – Fiscal policy can have a large impact on a company’s growth prospects. For example, during contractionary fiscal policy, government spending decreases, taxes rise, and the economy slows down. Dependent on the industry a business is in, this can definitely stagnate a companies growth prospects.

For example, consumer cyclical companies, also known as consumer discretionary companies, are highly related to the state of the economy. These companies sell goods that are not necessities. For example, when the economy is contracting, consumers spend less on vacations, cars, and restaurants. In contrast, these companies will grow during economic expansion and expansionary fiscal policy, as consumers will spend more on discretionary products and services .

A change in corporate taxes will also impact the growth of companies. Higher taxes will stagnate growth, while a reduction in taxes will promote growth.

Impacts on wages and employment – One of the main goals of fiscal policy is to reduce unemployment. The government often lowers tax rates to get more money back into consumer pockets. As a result, people start spending more, and companies will see an increase in demand. As demand increases, businesses need to hire more employees. When this continues for a while, at some point, it will be harder to find qualified employees, and companies will have to increase wages. Hence, fiscal policy affects employment and wages to a great extent.

Global Fiscal Policy Response to Covid 19

The fiscal response to the coronavirus pandemic has been global, emergent, and of never-before-seen proportions. Fiscal policies have served as emergency lifelines to businesses and consumers during this crisis.

Fiscal policy has been necessary to increase a nation’s readiness to respond to such a crisis and help the economy recover. Unfortunately, some countries have better fiscal tools and policies than other countries. As expected, developing nations have fewer tools and are less capable of recovering from a recession than mature economies. The U.S. fiscal response to the pandemic has been quite effective and successful.

As the pandemic highlights vulnerability, countries have started focusing on social safety nets and extended unemployment benefits. The U.S. has implemented bigger lifelines in response to the pandemic than Europe, although traditionally, it has had a smaller social safety net. 

Various governments have been introducing temporary tax deductions to encourage businesses to keep their employees during the pandemic and hire new workers after the pandemic. Some governments have also given temporary tax reductions to help people spend more money. While these steps will give people much-needed fiscal support, the scope ultimately depends on how capable a country is of financing the measures.

U.S. Fiscal Policy Response to Covid 19

The pandemic has caused a major public health crisis and economic disruption for the USA and the whole world. However, in May of 2021, high vaccination rates in some countries such as Israel and the USA have resulted in a significant decline in the number of new Covid cases and deaths, and it appears that the worst of the pandemic in those countries is over. The hope is now that the recovery of the U.S. economy will be swift.

So far, the federal government has implemented six major relief bills. Their goal is to help manage the pandemic and to reduce the economic burden on companies and families. Here is an overview of the six relief bills that were enacted between March 2020 and March 2021.

Early March 2020 – Coronavirus Preparedness and Response Supplemental Appropriations Act

March 18, 2020 – Families First Coronavirus Response Act

March 27, 2020 – CARES Act (The Coronavirus Aid, Relief, and Economic Security Act)

April 24, 2020 – Paycheck Protection Program and Health Care Enhancement Act

December 27, 2020 – Consolidated Appropriations Act, 2021

March 11, 2021 – The American Rescue Plan

The total cost of the six bills is about $5.3 Trillion. The biggest line items in these bills include support for small businesses ($968 Billion) and Economic Stimulus Payments ($867 Billion). Other big-ticket items are increased unemployment compensation ($764 Billion) and public health/healthcare spending ($657 Billion).

Conclusion

A healthy economy is one of the primary goals of U.S. fiscal policy, as the population’s well-being depends on it. Although there are different views among politicians on how much the government should interfere in the economy, it is clear that some degree of involvement through fiscal policy is necessary to keep economic growth healthy.

The government uses various tools to implement expansionary and contractionary fiscal policies to sustain healthy levels of growth, employment, and demand. Fiscal policy has been used in various ways by various administrations to stabilize the economy. Unfortunately, not every fiscal policy enacted in the past has been successful. 

The Coronavirus pandemic has made it clear that fiscal policy can be successful and help the economy recover from an unexpected crisis. When the COVID-19 crisis started to spread in early March 2020, and economies started shutting down worldwide, panic took hold, which led to a major stock market crash. The virus spread like wildfire, businesses shut down, and unemployment reached levels it had not seen since the Great Depression. A major recession had started.

Both the U.S. Federal Reserve and the Government sprang into action by implementing monetary and fiscal policies. The goal was to help manage the pandemic and offer help to reduce the economic burden on families and businesses. After 15 long months, over 600,000 Covid deaths, and multiple economic shutdowns, now, June 2021, things are looking up again. An effective vaccination strategy has reduced the number of infections to a manageable level, and the economy is slowly rebounding.

High-quality investment in health care is crucial to reduce future risks from epidemics and it is clear that we need to get ready and prepare for the next pandemic. Besides pandemic investments, some other sectors need serious investment considerations. They should include green technologies, infrastructure, and sectors like education and sanitation. As most of these projects take time, governments need to start reviewing the pipeline of investments now so that they are ready to take action once the economy recovers.

Additional Reading;

The Shifting Roles of Monetary and Fiscal Policy in Light of Covid-19 – February 23, 2021 – By CSIS (Center for Strategic and International Studies)

Vikram R
Vikram Raghavan is a value investor, technologist, and Finexy co-founder. In addition to stock market investing, Vik also invests and advises startups on growth marketing and product management. Vik's work is focused on themes of marketplaces, micro-entrepreneurship, marketing automation, and user growth. Previously, Vikram led product and growth teams at Overstock.com, focusing on efforts across acquisition, new user experience, churn, and notifications/email. He holds an MBA in Finance from Temple University and a B.S. in Computer Information Systems and Finance from Bemidji State University.