Government spending and taxation policies to influence economic conditions.
Fiscal policy refers to the use of government spending and taxation policies to influence economic conditions, particularly macroeconomic conditions, including aggregate demand for goods and services, employment, inflation, and economic growth.
Fiscal policy is characterized by changes in government spending and taxation. These changes can affect aggregate demand, the pattern of resource allocation, and the distribution of income.
The two main instruments of fiscal policy are government expenditures and taxes. The government can use these instruments to achieve macroeconomic goals such as full employment, price stability, and economic growth.
Expansionary fiscal policy involves increasing government spending or reducing taxes to stimulate economic growth. This is typically used during recessions or periods of low economic activity. Conversely, contractionary fiscal policy involves reducing government spending or increasing taxes to slow down economic growth, often used to combat inflation.
The effectiveness of fiscal policy can be influenced by factors such as the size of the fiscal multiplier, the degree of crowding out in private investment, and the expectations of economic agents. Additionally, the political process and institutional constraints can affect the design and implementation of fiscal policy measures.
Based on Keynesian economics and modern macroeconomic theory, fiscal policy aims to stabilize economic cycles and promote long-term growth. It draws on principles of aggregate demand management and the concept of the fiscal multiplier.
If the government increases spending or reduces taxes during economic downturns and does the opposite during booms, then it can help stabilize economic fluctuations. For example, during the 2008 financial crisis, the U.S. implemented the American Recovery and Reinvestment Act, increasing spending by $831 billion, which helped create or save an estimated 2.1 million jobs by 2012, according to the Congressional Budget Office.
If fiscal stimulus is directed towards areas with high fiscal multipliers, such as infrastructure or education, then it can lead to stronger and more sustained economic growth. Research by Auerbach and Gorodnichenko (2012) found that the fiscal multiplier for government investment spending can be as high as 2.5 during recessions, meaning every dollar spent generates $2.50 in economic activity.
If the government keeps its debt-to-GDP ratio at a sustainable level (generally considered to be below 90% for advanced economies, according to Reinhart and Rogoff), then it preserves fiscal space for future economic shocks and maintains investor confidence. For instance, Canada's efforts to reduce its debt-to-GDP ratio from 66.8% in 1995 to 31.4% in 2007 allowed it to implement a substantial fiscal stimulus during the 2008 crisis without jeopardizing its fiscal sustainability.
If a country has strong automatic stabilizers, such as progressive tax systems and unemployment benefits, then the economy can respond more quickly to economic shocks without the need for discretionary action. For example, during the COVID-19 pandemic, Germany's existing short-time work scheme (Kurzarbeit) automatically kicked in, supporting about 6 million workers at its peak and helping to keep unemployment low.
If fiscal and monetary authorities coordinate their policies, particularly during crises, then their combined effect can be more powerful in achieving economic objectives. The coordinated response of fiscal and monetary policy in the U.S. during the 2008 financial crisis, with the Fed's quantitative easing complementing the government's fiscal stimulus, is credited with preventing a more severe recession.