What is Fiscal Policy?

Taxation and government spending are commonly used intervention tools during crises. What dangers and limitations do they present?

Keynes and the US government’s CARES

Nowadays, the government has the thankless job of problem-solving a troubled economy. But, until the 1930s, most economists agreed that markets were self-correcting and that government intervention actually caused more harm than good.

**John Maynard Keynes** 1936 book, _The General Theory of Employment, Interest and Money_, challenged the then conventional economic theory. Why wait for the economy to fix itself – an unnecessarily drawn-out process that prolongs people’s hardship – if the government can step in now? **The Keynesian perspective emphasizes the role of aggregate demand during recessions**. Because lack of spending is pushing the economy down, increased spending will solve the problem. But also, because many consumers are jobless due to the economic slowdown, the government has to make up for the shortfall in spending.

This is where fiscal policy comes in. During the COVID-19 pandemic, the US government provided small businesses with relief packages and loans through their Coronavirus Aid, Relief, and Economic Security (CARES) Act. This was done with the intent of propping up the US economy amidst a time of great uncertainty and economic slowdown.

Fiscal policy goes both ways

**Fiscal policy redirects an economy by adjusting how governments tax and spend**. When an economy is in a recession, the government decreases taxes or spends more – an expansionary fiscal policy – to stimulate the economy. Lower taxes allow workers to enjoy a larger disposable income, which boosts their spending. Increased government spending through infrastructure projects creates jobs. More jobs mean more income and increased spending, thus setting the economy on a course toward recovery.

Similarly, **the government uses fiscal policy to rein in aggregate demand and control inflation**. When the economy overheats from rapid growth, it is in danger of experiencing unprecedented levels of inflation. Thus, the government raises taxes or reduces spending to slow economic growth to a more manageable level to avoid losing control. We call this contractionary fiscal policy because it reduces aggregate demand.

The US government implements expansionary fiscal policies in times of crises. The American Recovery and Reinvestment Act of 2009 allocated $288 billion in tax relief and $111 billion on infrastructure and science, among others. Joblessness still grew as a result of the Global Financial Crisis, but economists agree that the Recovery Act saved the US from a deep depression.

Automatic mechanisms of government

There is no doubt that fiscal policy is a useful economic tool, but it has its share of doubters, especially within government. One of the problems with enacting fiscal policy as needed – **‘discretionary fiscal policy’** – is that bureaucracy works painstakingly slowly. When politicians argue over the finer details of relief programs, aid takes a while to reach recipients.

To put 2 cliches together, an ounce of prevention is worth a pound of cure, but it’s better late than never. Discretionary policies are useful for one-off events like terrorist attacks, global pandemics, and severe financial crises.

But with an economy’s cyclical nature, **downturns are a question of when, not if**. As such, governments have mechanisms built into their budget to provide immediate action whenever certain economic conditions are met. These automatic stabilizers take the form of welfare programs, unemployment benefits, and progressive income taxes. Unemployment benefits kick in when someone is laid off from work. Likewise, progressive income taxes impose lower rates when profits fall. **These mechanisms are effective because they activate automatically and provide relief** to those who need it most.

Sending aid to the right people

**Policymakers need to ensure that their programs reach the right people**. Take infrastructure programs, which usually create jobs in construction. If industry unemployment is low, the new jobs aren’t necessary. In fact, they just pull workers away from the private sector. Under these circumstances, the program fails to create any significant impact on unemployment or demand.

In 2020, the US government’s CARES Act provided assistance to families and businesses affected by the COVID-19 pandemic. At that time, many retail and hospitality workers lost their jobs. As such, stimulus payments would have benefited them the most instead of workers in other industries, whose jobs weren’t at risk.

Why does it matter where funds are funneled? Any extra money received by someone who doesn’t need it is just that – extra money. Instead of being spent, it’s put aside for another day. But a household that needs the money will spend it on groceries. The grocer might then spend part of that on employees’ wages, and the initial amount the government sent would have created a ripple effect across the economy. Flowing money is better than stagnant money.

Finding money in a pinch

If fiscal policy successfully keeps economies stable, why the ongoing debate? One crucial factor is that government spending requires money – oftentimes money that the government doesn’t have on hand.

When the government spends more than it collects from taxes, it can find money in 1 of 3 ways, 2 of which involve modifying economic levels. **The first way is by printing more money**. Unfortunately, that creates inflation by growing money supply at rates the economy cannot sustain. **The second option is raising taxes**, which ultimately hurts consumers. If you know that taxes will eat up even more of next month’s pay, won’t you cut spending in anticipation? Surely, that’s not what expansionary fiscal policy wants to achieve.

Since its first 2 options for funding fiscal policy create undesirable consequences, the government usually resorts to its **third option – borrowing money**. Although not as problematic, government borrowing raises an economy’s national debt. At some point, these debts – and their interest payments – must be paid. And how does the government pay for these debts? You guessed it. Printing more money, raising more tax dollars, or issuing even more debt.

The lender side of government debt

For most countries, national debt is not a grave concern. Lenders are confident that they will be repaid with future tax revenues. The government can also choose to roll over their debts – that is, taking on new debt to pay off old ones. **As long as lenders trust in the government’s ability to pay at some point, things are fine.**

However, once the seeds of doubt are sowed, lenders demand higher rates on government borrowing to compensate for increased risk. If the government has to print money for debt repayment, inflation is right around the corner. In fact, it doesn’t matter if the government actually does. As long as people believe it, they’ll demand higher interest rates in anticipation of inflation.

This behavior takes place across the board, not just with government borrowing. With higher interest rates, private investment and spending are put on hold. So, while government spending increases, it may be offset by less private spending.

Debating the pros and cons of national debt

Some people bristle at foreign debt, fearing it might leave a country vulnerable to pressures from other countries in what’s called ‘debt-trap diplomacy.’ Besides political pressure, reliance on foreign debt comes with a fair share of interest payments. Effectively, the borrowing country’s citizens pay interest to the lending country, diverting tax revenues overseas instead of using funds locally. This impedes savings and investment within the borrowing country, especially when much of the government’s tax revenues are allocated to interest payments alone.

Debt is blamed for creating a burden on future generations. Countries don’t worry about repaying long-term loans until they expire decades down the line. By then, the citizens paying off these loans are a different generation than the one that received immediate benefits from the debt.

When it comes to the tradeoff, others believe that the investment return will provide more long-term good. When debt is used for public investment, future generations will share in its fruit. Investing in long-term thinking through infrastructure, telecommunications, hospitals, and schools sets up future generations for economic growth.

Don’t panic, it's local

Even when governments issue debt locally, dissenters of deficit spending disapprove. Think about who can afford to lend the government large sums of money locally. It’s the affluent that have money to spare. So, taking off the nationalistic lens, inequality is still part of the picture. Taxes, in the form of interest payments, are benefiting the wealthy disproportionately due to internal debt.

Ultimately, **it’s a balancing act that the government needs to manage**. In times of crisis, politicians have no choice on the matter, especially when the nation needs the money now. And there’s no doubt that nudging the economy with stimulus programs does spark renewed confidence in the public to spend.

But, in times of surplus, the government should reduce debt to a healthy level. Unfortunately, prosperity drives us to spend more, not scrutinize our national budget like Scrooge. We don’t tend to worry about these things until they’re too big to ignore. Then come the higher taxes and the reduced government spending, but, by then, the unfortunate timing ends up hurting the economy.

Getting the timing right

**Fiscal policy – and racking up a national debt – has its time and place**. What’s crucial is recognizing when and how they can be most effective. When countries are operating at maximum, more government spending just ends up overheating the economy. This leads to a crowding out of the private sector because any gains made by the government take away resources from firms and households. Rather than fostering economic growth, it results in inflation. Once the government realizes what it has done, it may step on the brakes. Again, this sudden shift may backfire. As the market adjusts, it may enter a recession.

**‘Rational expectations’ are another limitation of fiscal policy**. When the public expects government spending to ramp up, they anticipate inflation. In doing so, workers demand higher wages, and businesses hike prices. Output stays the same, but prices have gone up. In the end, the extra government spending will have achieved nothing. These types of scenarios make a strong case for automatic stabilizers, as they are timely and targeted.

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