Government spending and taxation
Fiscal policy is the use of government spending and taxation to influence the economy. It is decided by legislatures and governments, not central banks.
What fiscal policy is
Fiscal policy covers decisions about government purchases (roads, schools, defence), transfer payments (pensions, unemployment benefits), and taxes. Beyond providing public services, it can be used to stabilise the economy: boosting demand in recessions and restraining it in booms.
Expansionary and contractionary policy
Expansionary fiscal policy (higher spending or lower taxes) increases aggregate demand, aiming to raise output and employment in a slump. Contractionary fiscal policy (lower spending or higher taxes) reduces aggregate demand, aiming to cool an overheating economy and reduce inflation.
Where governments spend
In most rich countries, the largest areas of government spending are social protection (pensions and benefits), health, education, interest on debt, and defence. Government spending ranges from around a third to over half of GDP across advanced economies.
Types of taxes
Governments raise revenue from income taxes, payroll (social security) taxes, corporate taxes, consumption taxes such as VAT or sales taxes, and property taxes. A progressive tax takes a larger share from higher incomes; a regressive tax takes a larger share from lower incomes; a proportional tax takes the same share.
Automatic stabilisers
Some fiscal policy works automatically. In a recession, incomes fall, so income tax revenue drops, and more people claim unemployment benefits. Both cushion household spending without any new decision. In booms, the reverse happens. These automatic stabilisers reduce the size of economic swings.
Discretionary policy
Discretionary fiscal policy involves deliberate new decisions, such as stimulus packages. Examples include the 2009 American Recovery and Reinvestment Act (about 800 billion dollars) and the large pandemic relief packages of 2020-2021. Discretionary policy can be powerful but is slowed by political debate.
Policy lags
Fiscal policy faces lags: recognising that a problem exists (data arrive late), deciding what to do (legislation takes time), and implementing it (projects take time to start). By the time stimulus takes effect, the economy may already be recovering, which is one argument for relying on automatic stabilisers.
Worked example
In a recession, a government cuts income taxes by 100 billion dollars. If households spend 70% of the extra income, the first-round boost to spending is 70 billion, smaller than a 100-billion increase in government purchases, which counts fully in the first round. This is why tax cuts are often estimated to have smaller multipliers than direct spending.
Key takeaways
Fiscal policy uses spending, transfers, and taxes. Expansionary policy raises demand; contractionary policy reduces it. Taxes can be progressive, regressive, or proportional. Automatic stabilisers cushion the economy without new decisions; discretionary policy needs legislation. Recognition, decision, and implementation lags can reduce effectiveness. Tax cut multipliers are typically smaller than spending multipliers.
Flashcard
Government spending and taxes
Check your understanding
During a recession, unemployment benefit payments rise without any new law. This is an example of: