[An updated version of this article can be found at Fiscal Policy in the 2nd edition.]
Fiscal policy is the use of the government budget to affect an economy. When the government decides on the taxes that it collects, the transfer payments it gives out, or the goods and services that it purchases, it is engaging in fiscal policy. The primary economic impact of any change in the government budget is felt by particular groups—a tax cut for families with children, for example, raises the disposable income of such families. Discussions of fiscal policy, however, usually focus on the effect of changes in the government budget on the overall economy—on such macroeconomic variables as GNP and unemployment and inflation.
The state of fiscal policy is usually summarized by looking at the difference between what the government pays out and what it takes in—that is, the government deficit. Fiscal policy is said to be tight or contractionary when revenue is higher than spending (the government budget is in surplus) and loose or expansionary when spending is higher than revenue (the budget is in deficit). Often the focus is not on the level of the deficit, but on the change in the deficit. Thus, a reduction of the deficit from $200 billion to $100 billion is said to be contractionary fiscal policy, even though the budget is still in deficit.
The most immediate impact of fiscal policy is to change the aggregate demand for goods and services. A fiscal expansion, for example, raises aggregate demand through one of two channels. First, if the government increases purchases but keeps taxes the same, it increases demand directly. Second, if the government cuts taxes or increases transfer payments, people's disposable income rises, and they will spend more on consumption. This rise in consumption will, in turn, raise aggregate demand.
Fiscal policy also changes the composition of aggregate demand. When the government runs a deficit, it meets some of its expenses by issuing bonds. In doing so, it competes with private borrowers for money lent by savers, raising interest rates and "crowding out" some private investment. Thus, expansionary fiscal policy reduces the fraction of output that is used for private investment.
In an open economy, fiscal policy also affects the exchange rate and the trade balance. In the case of a fiscal expansion, the rise in interest rates due to government borrowing attracts foreign capital. Foreigners bid up the price of the dollar in order to get more of them to invest, causing an exchange rate appreciation. This appreciation makes imported goods cheaper in the United States and exports more expensive abroad, leading to a decline of the trade balance. Foreigners sell more to the country than they buy from it, and in return acquire ownership of assets in the country. This effect of fiscal policy was central to discussions of the "twin deficits" (budget and trade) of the eighties.
Fiscal policy is an important tool for managing the economy because of its ability to affect the total amount of output produced—that is, gross domestic product. The first impact of a fiscal expansion is to raise the demand for goods and services. This greater demand leads to increases in both output and prices. The degree to which higher demand increases output and prices depends, in turn, on the state of the business cycle. If the economy is in recession, with unused productive capacity and unemployed workers, then increases in demand will lead mostly to more output without changing the price level. If the economy is at full employment, by contrast, a fiscal expansion will have more effect on prices and less impact on total output.
This ability of fiscal policy to affect output by affecting aggregate demand makes it a potential tool for economic stabilization. In a recession the government can run an expansionary fiscal policy, thus helping to restore output to its normal level and to put unemployed workers back to work. During a boom, when inflation is perceived to be a greater problem than unemployment, the government can run a budget surplus, helping to slow down the economy. Such a countercyclical policy would lead to a budget that was balanced on average.
One form of countercyclical fiscal policy is known as automatic stabilizers. These are programs that automatically expand fiscal policy during recessions and contract it during booms. Unemployment insurance, on which the government spends more during recessions (when the unemployment rate is high), is an example of an automatic stabilizer. Unemployment insurance serves this function even if the federal government does not extend the duration of benefits. Similarly, because taxes are roughly proportional to wages and profits, the amount of taxes collected is higher during a boom than during a recession. Thus, the tax code also acts as an automatic stabilizer.
But fiscal policy need not be automatic in order to play a stabilizing role in business cycles. Some economists recommend changes in fiscal policy in response to economic conditions—so-called discretionary fiscal policy—as a way to moderate business cycle swings. These suggestions are most frequently heard during recessions, when there are calls for tax cuts or new spending programs to "get the economy going again."
Unfortunately, discretionary fiscal policy is rarely able to deliver on its promise. Fiscal policy is especially difficult to use for stabilization because of the "inside lag"—the gap between the time when the need for fiscal policy arises and when it is implemented by the president and Congress. The tax cut proposed by President Kennedy to stimulate the economy in 1962, for example, was not enacted until 1964. If economists forecast well, then the lag would not matter. They could tell Congress in advance what the appropriate fiscal policy is. But economists do not forecast well. Most economists, for example, badly underpredicted both the rise in unemployment in 1981 and the strength of the recovery that began in late 1982. Absent accurate forecasts, attempts to use discretionary fiscal policy to counteract business cycle fluctuations are as likely to do harm as good.
The case for using discretionary fiscal policy to stabilize business cycles is further weakened by the fact that another tool, monetary policy, is far more agile than fiscal policy. Even here, though, many economists argue that monetary policy is too prone to lags to be effective, and that the best countercyclical policy is to leave well enough alone.
Whether for good or for ill, fiscal policy's ability to affect the level of output via aggregate demand wears off over time. Higher aggregate demand due to a fiscal stimulus, for example, eventually shows up only in higher prices and does not increase output at all. That is because over the long run the level of output is determined not by demand, but by the supply of factors of production (capital, labor, and technology). These factors of production determine a "natural rate" of output, around which business cycles and macroeconomic policies can cause only temporary fluctuations. An attempt to keep output above its natural rate by means of aggregate demand policies will lead only to ever-accelerating inflation.
The fact that output returns to its natural rate in the long run is not the end of the story, however. In addition to moving output in the short run, fiscal policy can change the natural rate, and ironically, the long-run effects of fiscal policy tend to be the opposite of the short-run effects. Expansionary fiscal policy will lead to higher output today but will lower the natural rate of output below what it would have been in the future. Similarly, contractionary fiscal policy, though dampening the level of output in the short run, will lead to higher output in the future.
Fiscal policy affects the level of output in the long run because it affects the country's saving rate. The country's total saving is composed of two parts—private saving (by individuals and corporations) and government saving (which is the same as the budget surplus). A fiscal expansion entails a decrease in government saving. Lower saving means, in turn, that the country will either invest less in new plant and equipment or increase the amount that it borrows from abroad, both of which lead to unpleasant consequences in the long term. Lower investment will lead to a lower capital stock and to a reduction in a country's ability to produce output in the future. Increased indebtedness to foreigners means that a higher fraction of a country's output will have to be sent abroad in the future rather than being consumed at home.
Fiscal policy also changes the burden of future taxes. When the government runs an expansionary fiscal policy, it adds to its stock of debt. Because the government will have to pay interest on this debt (or repay it) in future years, expansionary fiscal policy today imposes an additional burden on future taxpayers. Just as taxes can be used to redistribute income between different classes, the government can run surpluses or deficits in order to redistribute income between different generations.
Some economists have argued that this effect of fiscal policy on future taxes will lead consumers to change their saving. Recognizing that a tax cut today means higher taxes in the future, the argument goes, people will simply save the value of the tax cut they receive now in order to pay those future taxes. The extreme of this argument, known as Ricardian Equivalence, holds that tax cuts will have no effect on national saving, since changes in private saving will offset changes in government saving. But if consumers decide to spend some of the extra disposable income they receive from a tax cut (because they are myopic about future tax payments, for example), then Ricardian Equivalence will not hold; a tax cut will lower national saving and raise aggregate demand. The experience of the eighties, when private saving fell rather than rose in response to tax cuts, is evidence against Ricardian Equivalence.
In addition to its effect on aggregate demand and on saving, fiscal policy also affects the economy by changing incentives. Taxing an activity tends to discourage that activity. A high marginal tax rate on income reduces people's incentive to earn income. By reducing the level of taxation, or even by keeping the level the same but reducing marginal tax rates and reducing allowed deductions, the government can increase output. The "supply-side" economists who were prominent early in the Reagan administration argued that reductions in tax rates would have a large effect on the amount of labor supplied, and thus on output. Incentive effects of taxes also play a role on the demand side. Policies such as the investment tax credit, for example, can greatly influence the demand for capital goods.
The greatest obstacle to proper use of fiscal policy—both for its ability to stabilize fluctuations in the short run and for its long-run effect on the natural rate of output—is that changes in fiscal policy are necessarily bundled with other changes that please or displease various constituencies. A road in Congressman X's district is all the more likely to be built if it can be packaged as part of countercyclical fiscal policy. The same is true for a tax cut for some favored constituency. This naturally leads to an institutional enthusiasm for expansionary policies during recessions that is not matched by a taste for contractionary policies during booms. In addition, the benefits from such a policy are felt immediately, whereas its costs—higher future taxes and lower economic growth—are postponed until a later date. The problem of making good fiscal policy in the face of such obstacles is, in the final analysis, not economic, but political.
David N. Weil is a professor of economics at Brown University.
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