Fiscal Policy

What Is Fiscal Policy?

Fiscal policy is the management of government’s budget (which consists of inflows of tax revenues and outflows of expenditure) in order to affect the level and composition aggregate demand in the economy.

By definition, the word fisc means state treasury and fiscal policy refers to policy concerning the use of state treasury or the government finances to achieve certain macroeconomic goals.

Scholarly Definitions

Fiscal policy has however been variously defined by the economists. Arthur Smithies defined fiscal policy as

“a policy under which government uses its expenditure and revenue programs to produce desirable effects and avoid undesirable effects on the national income, production, and employment.”

G. K. Shaw, a well-known expert on the subject, defines fiscal policy as

“any decision to change the level, composition or timing of government expenditure or to vary the burden, structure or frequency of the tax payment.”

Shaw’s definition presumes that national economic goals are given. However, Samuelson and Nordhaus offer a more complete definition of fiscal policy.

By fiscal policy they “mean the process of shaping taxation and public expenditure to help dampen the swings of the business cycle Opens in new window and contribute to the maintenance of a growing, high-employment economy, free from high or volatile inflation.”

In their opinion, the role of fiscal policy is confined largely to stabilization of employment and the price level. It seems, they have defined fiscal policy keeping in view the problems of the developed countries.

Fiscal policy can be defined in more general terms as follows:

Fiscal policy is the government program of making discretionary changes in the pattern and level of its expenditure, taxation and borrowings in order to achieve certain economic goals such as economic growth, employment, income equality, and stabilization of the economy on a growth path.

Fiscal policy typically consists in all decisions concerning government spending and taxation that are taken in order to influence aggregate demand Opens in new window and to steer the economy Opens in new window toward equilibrium Opens in new window.

The decision may be to adjust spending or taxes (in which case we refer to discretionary fiscal policy) or to let them evolve automatically depending on growth and inflation (in which case we refer to automatic stabilizers).

A narrow concept of fiscal policy is budgetary policy. While budgetary policy refers to current revenue and expenditure of the financial year, fiscal policy refers to budgetary operations including both current and capital receipts and expenditure.

The essence of fiscal policy lies, in fact, in the budgetary operations of the government. The two sides of the government budget are receipts and expenditure.

  • The total receipts of the government are constituted of tax and non-tax revenue and borrowings (including deficit financing). These items in the budget represent the budgetary resources of the government.
  • The government expenditure refers to the total expenditure made by the government in the fiscal year. The total government expenditure consists of payments for goods and services, wages and salaries, interest and loan repayments, subsidies, pensions and grants-in-aid, and so on.

From economic analysis point of view, receipt items give the measure of the flow of money from the private sector to the government sector.

The government expenditure, on the other hand, represents the flow of money from the government to the economy as a whole. The government receipts are inflows and expenditures are outflows.

The government can, by using its statutory powers, change magnitude and composition of inflows and outflows and thereby the magnitudes of macroeconomic variables—aggregate consumption expenditure and private savings and investment.

The magnitude and composition of inflows and outflows can be altered by making changes in taxation Opens in new window and government spending Opens in new window. The policy under which these changes are made is what we (economists) call fiscal policy.

The Scope of Fiscal Policy

The scope of fiscal policy comprise the fiscal instruments and the target variable.

Fiscal instruments are the variables that government can use and maneuver at its own discretion to achieve stabilized economic goals.

Fiscal instruments include taxation (direct and indirect), government expenditure, transfer payments (grants and subsidies) and public investment.

The target variables are the macro variables including disposable income, aggregate consumption expenditure, savings and investment, imports and exports, and the level and structure of prices.

In view of fiscal policy, government budget simultaneously fulfils three functions: allocation, redistribution, and stabilization.

Governments build infrastructure, invest in research, and provide public services such as education; they levy progressive taxes and provide means-related transfers; and they let the budget oscillate with the cycle in order to smooth out economic fluctuations Opens in new window. Even though these functions are intricately intertwined, fiscal policy nowadays mainly refers to stabilization.

Fiscal policy is a relative novelty. In the nineteenth and the early twentieth centuries, the primary economic role of a government was to build and maintain roads and other infrastructure, as well as to provide education and postal services (law and order, or defense being arguably not primarily economic functions). Allocation therefore came first.

Redistribution has in a way always been a dimension of fiscal policy because disputes over the distribution of the burden started with the first levies; social policies also emerged early — in Rome, bread consumption started being subsidized in 140 BC.

But it is only in the late nineteenth century, with the introduction of the progressive income tax Opens in new window (in 1842 in the United Kingdom and 1862 in the United States) and with the creation of social insurance Opens in new window (in Germany in 1889) that the redistributive state started to take place.

The idea that management of the government budget can stabilize the economy—that is, that it can help to keep unemployment close to its equilibrium value and avoid the build-up of deflationary or inflationary pressures—was a twentieth-century invention. It owed considerably to John Maynard Keynes and disciples such as Paul Samuelson.

In the highly stylized world of macroeconomics, the fiscal decision-maker handles the budget in the same way that the monetary decision-maker handles the interest rate, and their parallel actions make it possible to achieve both low unemployment and price stability.

Stabilization, however, does not only result from decisions. The macroeconomic role of the state owes at least as much to the secular rise of the share of public expenditures in gross domestic product (GDP) that resulted from the generalization of old-age and health insurance, as well as from welfare and publicly funded education programs.

In the United States, for example, total government expenditure as a proportion of GDP rose from 2% before World War I to 10% on the eve of World War II, 20 % in the 1950s, and 30% in the 1970s. It fluctuated between 30% and 40% until the Great Depression Opens in new window, which made it pass the 40% mark.

In Europe, it started from a higher level (about 10% in France and the United Kingdom, and 20% in Germany before World War I) and has reached higher levels (roughly between 45% and 55% of GDP). Within the course of half a century, governments have thus been transformed from irrelevant macroeconomic players into major contributors to aggregate demand.

The consensus on stabilization policy has never been complete. In post-World War II Germany Opens in new window especially, it has almost always been regarded with suspicion. Even in countries where it was more widely accepted, such as the United States or the United Kingdom, empirical and theoretical doubts surfaced in the late twentieth century about the effectiveness of active fiscal policy.

The 1970s first witnessed its ineffectiveness in response to an oil shock. Then, the 1980s saw the emergence of theoretical challenges (or the reemergence of old ones). And in the 1990s, experiences with failed fiscal expansions and a few cases of painless consolidations prompted a reassessment of the growth effects of a fiscal stimulus.

By 2000, faith in fiscal activism had been shattered: the consensus among policymakers was that, beyond the automatic stabilization provided by the public budget (e.g., by keeping stable expenditures in a down-turn), there was not much room for active policies.

A few years later, the global financial crisis Opens in new window brought fiscal policy back to the forefront.

In 2009 – 2010, in response to the fall in GDP, virtually all the largest advanced and emerging countries undertook a major stimulus effort that helped contain the global recession. In the following years, the effectiveness of fiscal policy was positively reassessed in a context of depressed demand, deflationary pressures, and near-zero interest rates. Under such conditions it was found to be both more effective and more necessary.

Already in 2010, however, several sovereign debtors, starting with Ireland and Greece, began having difficulty borrowing on the debt market because of concerns over solvency — an old issue that had come to be regarded as a concern of the past in the advanced world (though not in the emerging and developing world).

This triggered renewed discussions on whether fiscal expansions are effective when public debt Opens in new window reaches a high level. Hence, consensus views about fiscal policy have changed over time and will continue to evolve.

It should be noted, however, that structural changes such as the opening up of most economies, the development of financial markets, or different monetary arrangements have also changed the channels and trade-offs of fiscal policy and justified observed evolutions in the making of fiscal policy.