Fiscal policy

For more information on fiscal policy, visit Britannica.com.

Government spending policies that influence macroeconomic conditions. These policies affect tax rates, interest rates and government spending, in an effort to control the economy.

Investopedia Says:
Since the 1980s, most western countries have held a "tight" policy, limiting public expenditure.

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Federal taxation and spending policies designed to level out the business cycle and achieve full employment, price stability, and sustained growth in the economy. Fiscal policy basically follows the economic theory of the 20th-century English economist John Maynard Keynes that insufficient demand causes unemployment and excessive demand leads to inflation. It aims to stimulate demand and output in periods of business decline by increasing government purchases and cutting taxes, thereby releasing more disposable income into the spending stream, and to correct overexpansion by reversing the process. Working to balance these deliberate fiscal measures are the so-called built-in stabilizers, such as the progressive income tax and unemployment benefits, which automatically respond countercyclically. Fiscal policy is administered independently of Monetary Policy by which the Federal Reserve Board attempts to regulate economic activity by controlling the money supply. The goals of fiscal and monetary policy are the same, but Keynesians and Monetarists disagree as to which of the two approaches works best. At the basis of their differences are questions dealing with the velocity (turnover) of money and the effect of changes in the money supply on the equilibrium rate of interest (the rate at which money demand equals money supply). See also Keynesian Economics.

Fiscal policy is manifested in a government's policies on taxation and expenditures. To obtain funds for their operation, government units generally collect some form of taxes. The expenditure of these funds not only provides goods and services for constituents, but has a direct impact on the economy. For example, if expenditures are larger than the funds received by the government, the resulting deficit tends to stimulate the economy, as goods and services are produced for government purchase. In contrast, if a government runs a surplus by not spending all the funds it collects, economic growth will generally be curtailed, as the surplus funds are removed from circulation in the economy.

The Federal Budget

In the United States, the fiscal process of the federal government begins each February with the president sending to Congress a proposed federal budget for the coming fiscal year, which begins in October. Congress then develops a budget resolution, which is to be completed by April. The budget resolution contains overall revenue and spending budgets as well as the budgeted amount of discretionary and mandatory spending for each functional area, such as national defense. Mandatory spending is required by prior legislation, while discretionary spending must be approved during the current year's legislative process. The majority of all federal government spending is mandatory spending for established programs.

Using the budget resolution as a guide, bills that provide budget authority for annual discretionary spending must be completed by June each year. Legislative changes can also be made to mandatory spending or tax provisions at this time. However, any legislation that would cut taxes or increase mandatory spending must be accompanied by legislation that would raise revenue or cut spending in other areas to pay for these changes. Consequently, any new legislation in this area must be "budget-neutral."

In fiscal 1998, the federal government had receipts of $1,721 billion and expenditures of $1,651 billion, leaving a surplus of $70 billion. This was the first surplus recorded by the federal government since 1969, ending almost thirty consecutive years of deficits. During this time, the nonstop annual deficits forced the U.S. government to borrow additional money each year to make up the difference between the federal government's receipts and outlays. As a result, the outstanding federal debt reached roughly $5.5 trillion in 1998, representing more than $20,000 per citizen of the country. Paying the annual interest charges on this debt consumes a significant portion of the federal budget.

Federal Government Revenue

Individual income taxes have been the federal government's largest source of funds for many years. In 1998, $829 billion in individual income taxes were collected, comprising 48 percent of the federal government's receipts. Robust economic growth in the 1990s steadily increased individual income tax payments and was a large factor in turning the mushrooming deficits of the prior thirty years into a surplus in 1998, as tax collections grew faster than government spending.

Social Security taxes, which are paid by most workers in the United States, are the other major source of funds for the federal government. In 1998, payments of $540 billion were made into the Social Security system. These taxes, which are a percentage of a worker's wages, have increased substantially as a result of a growing work force in the 1990s with many workers in their peak earning years.

Federal Government Expenditures

The enormous impact of the Social Security system on the federal government's budget is demonstrated by the fact it is the largest outlay of the federal government each year. In 1998, almost 23 percent of federal government expenditures were payments of monthly benefits to families of retired and disabled workers. In 1940, in the early years of the Social Security program, there were only 222,000 beneficiaries receiving a total of $35 million a year in benefits. By 1998, the federal government was sending $379 billion to almost 45 million Social Security beneficiaries. When these payments are coupled with the burgeoning cost of Medicare, which generally provides health insurance for the same individuals who receive Social Security benefits, it means that the United States spent over 35 percent of the federal budget on this group of retired and disabled individuals in 1998. With the increased life expectancy of senior citizens and the large number of baby-boomers nearing retirement age, Social Security and Medicare will continue to consume a large part of the federal budget dollar in the foreseeable future.

Defense spending is the largest item of discretionary spending in the federal budget. In 1998, $270 billion, 16 percent of the federal budget, was spent on the armed forces of the United States. With an ever-larger portion of the federal budget being consumed by mandatory spending programs, defense spending has been the target of budget cuts since the resumption of normalized relations with the countries that constituted the former Soviet Union.

Interest on the federal government's debt is the other major federal government outlay, in 1998 requiring $243 billion in net interest payments on the federal debt, which exceeded $5 trillion. Declining interest rates and reduced federal government borrowing, however, have slowed the growth of this budget item.

Impact on the Economy

As discussed previously, the federal government's policies on taxes and spending have a large impact on the economy. The economic theory of the famous English economist John Maynard Keynes advocates the use of the government's fiscal policy to offset imbalances in the economy. According to Keynes, a government should use fiscal policy to stimulate an economy slowed by a recession by running a deficit, that is, by spending more than it takes from the economy in taxes. On the other hand, to slow down an economy that is threatened by inflationary pressures, Keynes urged increasing taxes or cutting spending to create a budget surplus that would act as a drag on the economy.

Keynes thought fiscal policy could be an automatic stabilizer for the economy because it automatically responds to changes in economic activity. Government spending on items such as unemployment benefits generally increases during a recession, whereas government receipts such as income taxes will fall during a recession, moderating the extremes of the business cycle. Consequently, fiscal policy, along with monetary policy, which is dictated by the Federal Reserve, has an important influence on the health of the economy in the United States.

Impact on Foreign Countries

The impact of fiscal policy in the United States extends far beyond the country's borders. For ex ample, top marginal income tax rates in this country have declined substantially since the late 1970s, when they were as high as 70 percent. This reduction in top rates has made it difficult for Canadian companies to attract and retain key executives because Canadian income taxes on high-income individuals are now substantially greater than in the United States. Even Canadian hockey teams have found that higher income tax rates north of the border encourage many of their players to flee to teams based in the United States, where they can retain a larger portion of their earnings. Consequently, even the balance of power in the National Hockey League is influenced by the fiscal policy of the U.S. government.

Bibliography

A Citizen's Guide to the Federal Budget: Budget of the United States Government, Fiscal Year 1999. (1999). Washington, DC: Executive Office of the President.

Baker, Dean. (1995). Robbing the Cradle?: A Critical Assessment of Generational Accounting. Washington, DC: Economic Policy Institute.

Bruce, Neil. (1998). Public Finance and the American Economy. Reading, MA: Addison-Wesley.

[Article by: DAVID MCGRADY]

A government's taxation policy. Tax enables the government to raise revenue in order to provide public goods which would not otherwise be provided by the market, such as a police force, national defence, and so on. The tax system may also have an effect on the distribution of income, and the allocation of resources in the market. A government's fiscal policy will have a broader effect on economic activity, unemployment, and inflation. Under Keynesian policies fiscal measures should be used to smooth out the cyclical, stop-go, nature of economic development, by stimulating the economy during slumps, and deflating the economy during booms.

The use of public finance and financial transactions to achieve desired economic goals. Taxing and spending power are used along with monetary policy to arrest and reverse declines in business activity. By cutting taxes, more money is left in the hands of consumers and businessmen which increases their spendable income. The government can act more directly on the economy by increasing purchases from the private sector and by pursuing public works projects. Taken together, tax cuts, increased government spending and "easy money" provide powerful and effective stimulation to the economy.

The policy of a government in controlling its own expenditures and taxation, which together make up the budget.

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In economics, fiscal policy is the use of government spending and revenue collection to influence the economy.^[1]

Fiscal policy can be contrasted with the other main type of economic policy, monetary policy, which attempts to stabilize the economy by controlling interest rates and the supply of money. The two main instruments of fiscal policy are government spending and taxation. Changes in the level and composition of taxation and government spending can impact on the following variables in the economy:

• Aggregate demand and the level of economic activity;
• The pattern of resource allocation;
• The distribution of income.

Fiscal policy refers to the overall effect of the budget outcome on economic activity. The three possible stances of fiscal policy are neutral, expansionary, and contractionary:

• A neutral stance of fiscal policy implies a balanced budget where G = T (Government spending = Tax revenue). Government spending is fully funded by tax revenue and overall the budget outcome has a neutral effect on the level of economic activity.

• An expansionary stance of fiscal policy involves a net increase in government spending (G > T) through rises in government spending, a fall in taxation revenue, or a combination of the two. This will lead to a larger budget deficit or a smaller budget surplus than the government previously had, or a deficit if the government previously had a balanced budget. Expansionary fiscal policy is usually associated with a budget deficit.

• A contractionary fiscal policy (G < T) occurs when net government spending is reduced either through higher taxation revenue, reduced government spending, or a combination of the two. This would lead to a lower budget deficit or a larger surplus than the government previously had, or a surplus if the government previously had a balanced budget. Contractionary fiscal policy is usually associated with a surplus.

The idea of using fiscal policy to combat recessions was introduced by John Maynard Keynes in the 1930s, partly as a response to the Great Depression.

Contents 1 Methods of funding 1.1 Funding the deficit 1.2 Consuming the surplus 2 Economic effects of fiscal policy 3 See also 4 References 5 Bibliography 6 External links

Methods of funding

Governments spend money on a wide variety of things, from the military and police to services like education and healthcare, as well as transfer payments such as welfare benefits.

This expenditure can be funded in a number of different ways:

• Taxation
• Seignorage, the benefit from printing money
• Borrowing money from the population, resulting in a fiscal deficit
• Consumption of fiscal reserves.
• Sale of assets (e.g., land).

Funding the deficit

A fiscal deficit is often funded by issuing bonds, like treasury bills or consols. These pay interest, either for a fixed period or indefinitely. If the interest and capital repayments are too large, a nation may default on its debts, usually to foreign creditors.

Consuming the surplus

A fiscal surplus is often saved for future use, and may be invested in local (same currency) financial instruments, until needed. When income from taxation or other sources falls, as during an economic slump, reserves allow spending to continue at the same rate, without incurring additional debt.

Economic effects of fiscal policy

Governments use fiscal policy to influence the level of aggregate demand in the economy, in an effort to achieve economic objectives of price stability, full employment, and economic growth. Keynesian economics suggests that adjusting government spending and tax rates are the best ways to stimulate aggregate demand. This can be used in times of recession or low economic activity as an essential tool for building the framework for strong economic growth and working toward full employment. The government can implement these deficit-spending policies to stimulate trade due to its size and prestige. In theory, these deficits would be paid for by an expanded economy during the boom that would follow; this was the reasoning behind the New Deal.

Governments can use budget surplus to do two things: to slow the pace of strong economic growth, and to stabilize prices when inflation is too high. Keynesian theory posits that removing funds from the economy will reduce levels of aggregate demand and contract the economy, thus stabilizing prices.

Some classical and neoclassical economists argue that fiscal policy can have no stimulus effect; this is known as the Treasury View^{[citation needed]}, which Keynesian economics rejects. The Treasury View refers to the theoretical positions of classical economists in the British Treasury, who opposed Keynes' call in the 1930s for fiscal stimulus. The same general argument has been repeated by neoclassical economists up to the present. From their point of view, when government runs a budget deficit, funds will need to come from public borrowing (the issue of government bonds), overseas borrowing, or the printing of new money. When governments fund a deficit with the release of government bonds, interest rates can increase across the market. This is because government borrowing creates higher demand for credit in the financial markets, causing a lower aggregate demand (AD), contrary to the objective of a budget deficit. This concept is called crowding out; it is a "sister" of monetary policy.

Other possible problems with fiscal stimulus include the time lag between the implementation of the policy and detectable effects in the economy, and inflationary effects driven by increased demand. In theory, fiscal stimulus does not cause inflation when it uses resources that would have otherwise been idle. For instance, if a fiscal stimulus employs a worker who otherwise would have been unemployed, there is no inflationary effect; however, if the stimulus employs a worker who otherwise would have had a job, the stimulus is increasing demand while labor supply remains fixed, leading to inflation.

See also

• Functional finance
• National fiscal policy response to the late 2000s recession

References

1. ^ Sullivan, arthur; Steven M. Sheffrin (2003). Economics: Principles in action. Upper Saddle River, New Jersey 07458: Pearson Prentice Hall. pp. 387. ISBN 0-13-063085-3. http://www.pearsonschool.com/index.cfm?locator=PSZ3R9&PMDbSiteId=2781&PMDbSolutionId=6724&PMDbCategoryId=&PMDbProgramId=12881&level=4. 

Bibliography

• Heyne, P. T., Boettke, P. J., Prychitko, D. L. (2002): The Economic Way of Thinking (10th ed). Prentice Hall.

External links

• StimulusWatch
• Concise Encyclopedia of Economics
• Using Fiscal Policy
• Limitations of Fiscal Policy
• US - External Debt viz Savings rate Comparing External debt viz Savings rate - since 1995 (which are two of the components that finances the Fiscal Policy )
• What Is Fiscal Policy?

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