Broadly speaking, fiscal policy refers to the tax and spending decisions made by a government. (The word ‘fiscal’ means anything to do with government taxes, debt and spending.) Put another way, fiscal policy is all about how governments get and spend money.
For governments, the effectiveness of fiscal policy can be the difference between re-election and electoral defeat. That’s because government fiscal policy can have a big impact on the economy, and therefore people’s livelihoods.
How Fiscal Policy Works
There are two levers that governments can use to adjust fiscal policy: taxation and spending. (If it helps, think of a government as a regular business that has money coming in and going out. In the case of a government, the money coming in is in the form of tax. And—just as a business has expenses like rent, wages and utilities—the government has things that it has to pay for.)
The types of taxes that many of the world’s governments collect:
- Income tax
- Payroll tax
- Corporate tax
- Goods and services tax / value-added tax
- Customs duties
- Excise duties (e.g., alcohol, fuel, tobacco)
- Land tax
- Capital gains tax
- Road tolls
The types of things that a government will spend its money on:
- Public infrastructure (e.g., building roads, bridges, railways, hospitals, schools)
- Welfare (e.g., unemployment benefits, disability services, child care, pensions)
- Defence (e.g., navy, army, air force, cybersecurity)
Fiscal Policy & The Economy
By altering fiscal policy, a government can impact the state of the nation’s economy. Generally, a government will adjust its fiscal policy if the economy is growing too fast, not fast enough, or shrinking (i.e., economic recession).
When a government wants to help stimulate the economy, it will adopt an expansionary fiscal policy stance. Taking on an expansionary fiscal policy stance is done by cutting tax rates, increasing spending, or a blend of both.
When a government is wanting to prevent the economy from growing too strongly, it will adopt a contractionary fiscal policy stance. Implementing a contractionary fiscal policy stance is done by increasing tax rates, reducing spending, or a blend of both.
Drawbacks of Fiscal Policy
By no means is fiscal policy a panacea. In any given scenario, one economist’s recommended fiscal policy action will differ to another’s. Indeed, like most things to do with economics—which is ultimately a social science—every issue has two sides, and each side comes with their own unique trade-offs.
Below are some weaknesses of fiscal policy that often pointed out.
- Lag effect. There is often an extended period of time between when a fiscal policy change is announced and when the effects of the change filter through to the economy. This lag effect can be very problematic. That’s because the possibility exists that the health of the economy will have changed by the time the fiscal policy change has an effect.
- Political influence. The fact that fiscal policy is carried out by politically influenced institutions is widely seen as a weakness. This is in contrast to monetary policy, which is conducted by central banks, which are often independent of the government.
Is Fiscal Policy Necessary?
When a government uses effective and efficient fiscal policy, the stability of the economy generally improves. A stable economy benefits everyone. Compared with unpredictable and volatile economies, stable economies generate greater investment activity. This is good for unemployment and consumption levels.
Whether or not fiscal policy works remains up for debate. However, in times of economic crisis—such as the global financial crisis and coronavirus pandemic—it is widely held that fiscal policy measures help prevent the severity of an economic downturn.
If a government were to sit by passively during an economic crisis (i.e., not use fiscal policy to help stimulate the economy), then it is very likely the economy would remain very weak for an extended period of time. This would have severe social ramifications such as higher crime rates, increased mental health issues, and a greater level of unemployment.