What fiscal policy involves

Fiscal policy is a demand-side policy through which a government changes its expenditure, taxation or other revenue to influence aggregate demand and achieve macroeconomic objectives. Changes in government spending affect aggregate demand directly, since government spending is one of its components. Tax changes have an indirect effect. They alter households’ disposable income and firms’ after-tax profits, with the final impact depending on how households and firms respond.

Sources of government revenue

Governments receive revenue from several sources:

• Direct taxation is taxation imposed directly on the income, profit or wealth of a person or organization. Examples include personal income tax and corporation tax.
• Indirect taxation is taxation imposed on expenditure on goods and services. Producers or retailers collect it, though they can pass it on to consumers through higher prices.
• State-owned enterprises can generate revenue by selling goods and services, then transferring profits to the government.
• Governments may also sell assets such as land, buildings or shares in enterprises. An asset sale normally produces a one-off receipt, unlike recurring tax revenue.

Types of government expenditure

• Current expenditure is government spending on goods and services used in the present period to operate public services. This includes public-sector wages, medicines and routine maintenance.
• Capital expenditure is government spending that creates or improves long-lasting productive assets. Typical examples are transport networks, energy systems and public buildings. This spending can raise aggregate demand now and may increase productive capacity later.
• Transfer payments are payments made by the government without receiving currently produced goods or services in return. Examples include pensions and income support. Transfer payments don’t enter aggregate demand directly as government purchases, although recipients may use them to finance consumption.

The budget position

A budget deficit is a fiscal position in which government expenditure exceeds government revenue during a given period. By contrast, a budget surplus is a fiscal position in which government revenue exceeds government expenditure during a given period. Deficits often accompany expansionary fiscal policy, while surpluses may accompany contractionary policy. These pairings aren’t definitions, however: the policy stance depends on the changes being made and how they affect aggregate demand.

Macroeconomic goals

Fiscal policy isn’t just a way to balance the government’s books. Governments can use the budget to work towards several objectives at the same time.

• Low and stable inflation: cutting government expenditure or raising taxation can limit excessive aggregate demand, reducing demand-pull inflationary pressure.
• Low unemployment: when cyclical unemployment exists, higher government expenditure or lower taxation can increase aggregate demand, real output and employment.
• A stable environment for long-term growth: less severe economic fluctuation makes future demand more certain, which may encourage private investment. Capital expenditure can also improve infrastructure and productive capacity.
• Smaller business-cycle fluctuations: expansionary measures can support demand during a downturn. By contrast, contractionary measures can restrain an overheating economy.
• A more equitable distribution of income: progressive taxation, transfer payments and targeted public services can increase the relative disposable income and living standards of lower-income households.
• External balance: contractionary fiscal policy can reduce domestic expenditure, including spending on imports, and may therefore reduce a current account deficit. However, domestic growth and employment may weaken as a result.

These goals may conflict. A strong fiscal expansion, for instance, may reduce unemployment while creating inflation or a larger current account deficit. Fiscal-policy decisions involve priorities and trade-offs; they don’t guarantee an improvement in every objective.

Expansionary fiscal policy

Expansionary fiscal policy is a fiscal-policy stance that increases aggregate demand through higher government expenditure, lower taxation, higher transfer payments or a combination of these measures. Government purchases increase aggregate demand directly. Tax cuts and higher transfers increase disposable income, though consumption rises only when recipients spend at least some of that extra income. Lower business taxes can encourage investment too, but firms may still be cautious if confidence is weak.

A deflationary or recessionary gap is the shortfall by which equilibrium real output lies below the economy’s full-employment or potential output. Expansion shifts the aggregate demand curve to the right. In the Keynesian model, the outcome depends on the economy’s starting point. When there is substantial spare capacity, real output can rise considerably with little pressure on the price level. Nearer to capacity, the price-level increase is larger. In the monetarist/new classical model, an increase in aggregate demand raises short-run real output and the price level. The recessionary gap closes as output moves towards full-employment output.

The diagrams should show this rightward shift and label the initial recessionary gap in each model.

Contractionary fiscal policy

Contractionary fiscal policy is a fiscal-policy stance that decreases aggregate demand through lower government expenditure, higher taxation, lower transfer payments or a combination of these measures. A reduction in government purchases lowers aggregate demand directly. Higher personal or business taxes can indirectly reduce consumption and investment.

An inflationary gap is the amount by which equilibrium real output exceeds full-employment or potential output because aggregate demand is excessive. Contractionary policy shifts aggregate demand to the left. In both models, demand-pull inflationary pressure falls and real output moves back towards potential output. The Keynesian model again focuses on the economy’s starting position. On the steep section of aggregate supply, a fall in aggregate demand causes a relatively large reduction in the price level and a smaller reduction in output than the same shift would cause on a flatter section.

The diagrams should show the leftward shift in aggregate demand and the closing of the initial inflationary gap.

Comparison of contractionary fiscal policy in two AD–AS models.

Judging the two policies

Closing a gap exactly is difficult. The size of the gap is uncertain, as are the response of private spending and the eventual change in aggregate demand. Expansion can also increase inflation before unemployment has fully fallen. Contraction may reduce inflation, but at the cost of slower growth and higher cyclical unemployment. A diagram shows the intended mechanism; it doesn’t prove that the government can choose a perfectly sized shift.

Why an initial injection has a multiplied effect

An injection is an addition to the circular flow of income arising from investment, government spending or exports. When one person spends, someone else receives that spending as income. They then spend part of this additional income on domestically produced goods and services, starting another round of income and expenditure.

A leakage is income withdrawn from the domestic circular flow through saving, taxation or spending on imports. Successive rounds get smaller as some of the additional income leaks out instead of funding more domestic consumption.

The Keynesian multiplier is a ratio measuring the eventual change in national income resulting from an initial change in an injection. If a larger proportion is spent on domestic output, the multiplier is larger. More saving, taxation or spending on imports reduces it.

Marginal propensities

A marginal propensity shows the proportion of an additional unit of income put to a particular use:

• The marginal propensity to consume (MPC) is the proportion of additional income spent on domestically produced consumer goods and services.
• The marginal propensity to save (MPS) is the proportion of additional income saved.
• The marginal propensity to tax (MPT) is the proportion of additional income paid in taxation.
• The marginal propensity to import (MPM) is the proportion of additional income spent on imports.

There are two equivalent ways to calculate the multiplier:

Use the first version when MPC is given. The second version displays the leakages directly. Before substituting any marginal propensity into the formula, write it as a decimal.

Calculating the change in GDP

A change in investment, government spending or exports has the following effect:

Suppose, for example, that MPC is $0.75$. The multiplier is:

$$k = \frac{1}{1-0.75} = 4$$

An additional injection of 20 billion currency units gives a predicted GDP increase of:

$$\Delta Y = 4 \times 20 = 80\text{ billion currency units}$$

If the required change in GDP is known instead, rearrange the relationship:

$$\Delta J = \frac{\Delta Y}{k}$$

This calculation gives a model prediction, not a promise. It assumes firms can raise output and the marginal propensities remain stable. If small leakages produce a large multiplier while the economy is already near productive capacity, the calculation may overstate the increase in real GDP. More of the effect may appear as inflation.

Strengths

Fiscal policy can work especially well during a deep recession. Government purchases directly increase aggregate demand, even if pessimistic households save their tax cuts or firms hold back on investment. When labour and capital are underused, stronger demand can increase real output and reduce cyclical unemployment without creating much inflationary pressure.

Governments can also target fiscal policy. Spending may go to a sector experiencing acute weakness or a region where unemployment is unusually high. It can also fund infrastructure that supports wider economic activity. Tax reductions and transfers can be directed towards lower-income households, potentially supporting aggregate demand while making income distribution more equitable.

Capital expenditure can promote growth in two ways. In the short run, it raises aggregate demand. If it improves transport, communications or worker productivity, it may also expand productive capacity and support long-term growth. But project quality matters: expenditure isn’t automatically productive simply because it’s labelled investment.

Constraints

Political pressure is influence on fiscal decisions arising from electoral incentives, interest groups or competing political priorities rather than solely from macroeconomic conditions. Before an election, a government may avoid unpopular tax increases. It might also approve conspicuous projects that offer weak economic returns. As a result, fiscal policy may be poorly timed or misdirected.

A fiscal-policy time lag is a delay between recognizing an economic problem, deciding and approving a response, implementing it, and experiencing its effects. A downturn may have already begun before the data reveal it. Legislative approval can take months, while large projects need planning and procurement. Economic conditions may therefore have changed by the time the spending takes effect.

Sustainable government debt is public debt that a government can continue servicing without an unrealistic future rise in taxation, an abrupt fall in expenditure or default. Repeated deficits increase both debt and interest obligations. Borrowing may be more sustainable when interest costs are low or the funds pay for productive assets. It becomes less sustainable if debt is already high, revenue is unstable or borrowing simply finances persistent current expenditure.

Tax reductions bring uncertainty too. When confidence is poor, households may save the additional disposable income instead of spending it. Firms may likewise keep the higher profits rather than invest. Tax cuts can also widen inequality if higher-income groups receive most of the benefits.

Performance against the main objectives

• Growth: expansion can increase short-run real GDP. Well-chosen capital expenditure may also support long-run growth. However, inflation can emerge when spare capacity is limited, and there may be concerns about debt or implementation.
• Low unemployment: stronger aggregate demand can reduce cyclical unemployment. Fiscal policy is far less effective against unemployment caused by skills mismatches or geographical immobility.
• Low and stable inflation: contraction can reduce demand-pull inflation, though at the cost of weaker growth and employment. It is poorly suited to inflation driven mainly by rising production costs.

The judgement depends on the circumstances. Fiscal expansion tends to be more effective when a recession is deep and spare capacity is substantial. Public projects should be ready to implement, while debt needs to remain manageable. Contraction is more likely to reduce inflation if excess aggregate demand is the principal cause. The policy’s size and timing matter. So do its composition and the wider economic context.

The crowding-out mechanism

Crowding out is a reduction in private-sector consumption or investment caused by government deficit spending increasing borrowing costs or absorbing financial resources. To finance a budget deficit, the government borrows and increases demand for loanable funds. Other things equal, this pushes up the market interest rate. Firms may then be discouraged from financing investment, while households may cut back on interest-sensitive consumption.

In the loanable-funds diagram, increased government borrowing shifts demand to the right. The equilibrium real interest rate rises, linking government borrowing to lower private investment and consumption.

As a result, the expected increase in aggregate demand becomes weaker. Higher government expenditure may be partly offset by a fall in private spending. With complete crowding out, the reduction in private spending fully offsets the fiscal expansion. Partial crowding out is more plausible in most circumstances.

How important is it?

Crowding out is likely to be stronger when the economy is near full employment and private demand for credit is already high. The effect also increases when the supply of loanable funds responds weakly to interest rates.

During a deep recession, however, crowding out may be limited. Firms and households are reluctant to borrow, banks have unused lending capacity, and the government isn’t competing with vigorous private investment. Public investment that raises productivity may even encourage private investment later rather than displace it.

Crowding out is a possible constraint, not an automatic consequence of every budget deficit.

Built-in responses to the business cycle

Automatic stabilizers are features of the government budget that change taxation or transfer payments without a new discretionary policy decision, thereby moderating fluctuations in aggregate demand. They work automatically, so fresh legislation isn’t needed whenever national income changes.

In a downturn, household incomes and company profits fall. Revenue from progressive taxes drops as a result. Meanwhile, unemployment rises, leaving more people eligible for unemployment benefits. Disposable income and consumption fall by less than they otherwise would, which cushions the decline in aggregate demand.

As the economy expands, incomes and profits rise. A progressive tax is a direct tax for which the proportion of income paid in tax increases as income rises. The tax system therefore withdraws a growing share of additional income. Unemployment falls and benefit payments decline, limiting the increase in disposable income and aggregate demand. This lowers the risk of an inflationary boom.

Strength and limitation

Automatic stabilizers respond faster than discretionary fiscal measures because they avoid the decision and legislative lags involved in introducing a new tax or spending package. They reduce business-cycle fluctuations rather than eliminate them. How strongly they work depends on the generosity of unemployment benefits, the progressivity of the tax system and how much recipients change their consumption. A severe recession may still call for deliberate government action.