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Fiscal policy is the use of tax and spending practices to influence the macroeconomy. As discussed in the chapter on Gross Domestic Product, the economy goes through slowdowns and also through periods of rapid growth. Fiscal policy aims to keep the economy on a relatively steady growth path by boosting economic activity during slowdowns and putting the brakes on the economy when growth is unsustainably high.
The government has control over both taxes and government spending. When the government uses fiscal policy to increase the amount of money available to the populace, this is called expansionary fiscal policy. Its goal is to boost GDP growth. Examples of expansionary policy include lowering taxes and raising government spending. When the government uses fiscal policy to decrease the amount of money available to the populace, this is called contractionary fiscal policy. Its goal is to slow GDP growth. Examples of contractionary policy include increasing taxes and lowering government spending.
If we look at the effects of fiscal policy on the economy as a whole, we see that expansionary fiscal policy increases the output, or national income, while contractionary fiscal policy decreases the output or national income. Ideally, expansionary and contractionary fiscal policy will be complementary elements of a countercyclical fiscal policy, one that seeks to moderate the economy’s downturns and growth surges to maintain as steady a growth level as possible.
Time Lags
Fiscal policy actions are generally subject to lags between the time when a problem first arises (an economic slowdown or the start of runaway growth) and the time when the corrective policy starts taking effect. There are three reasons for this. First, it takes time for an economic problem to be noticed. Second, it takes time for policymakers to decide which policy or policy rule to adopt. Finally, once the policy or policy rule is approved, it takes time for it to affect the economy. In the end, lags create significant delays in the progression from problem to solution in macroeconomic policy.
If lags are so long that the economy corrects itself before the macroeconomic policies take effect, then the policies can actually worsen the situation. For instance, if the government uses fiscal policy to stimulate the economy, but the economy begins to correct itself before the policy takes effect, then the economy will be over-stimulated, resulting in possible inflation.
The problem of time lags can be minimized by automatic stabilizers, policies and programs that dampen swings in the GDP growth rate automatically, without policymakers’ involvement, thereby eliminating lags due to the time it takes to detect a problem and the time it takes to decide on a solution. The two main forms of automatic stabilizers are (1) taxes on income and (2) government assistance for low-income households. Taxes on income go up when income goes up, thereby drawing off some of consumers’ spending power and discouraging runaway consumption; conversely, taxes on income go down when income goes down, putting more money in consumers’ hands. Assistance problems have the same effect: when more people are out of work, they inject more money into the economy, and when fewer people are out of work, the assistance programs dial back the cash flow.
Fiscal policy to keep the economy on a steady course sounds like a good thing. However, there are those who believe that the economy should be left largely alone, on the grounds that intervention has costs and is just as likely to make the situation worse as it is to make it better. The pro-interventionist approach is often called Keynesian economics, in tribute to the British economist who popularized it, John Maynard Keynes (1883–1946). The anti-interventionist approach, which dates back to the 17th century, is sometimes called laissez-faire economics, after a French expression meaning (roughly) “to leave alone.”
Spending Multipliers
While expansionary and contractionary fiscal policy both directly affect the national income, there are factors that increase or decrease the efficacy of fiscal policy. These multipliers are based on the population's willingness to consume. The marginal propensity to consume, or MPC, is a measure of that willingness. It is defined as the amount of an additional dollar of income that a consumer will spend on goods and services. The MPC can have a value between 0 and 1. A small MPC represents a large amount of savings and a small amount of consumption. A large MPC represents a small amount of savings and a large amount of consumption.
When a tax decrease occurs, consumers will spend part of the money and save part of it. The money they spend is income for the people they pay, so the cycle repeats. After many cycles, in theory, the total change in national income as a result of a change in tax policy is equal to the tax multiplier,\( -MPC/(1 - MPC)\), times the positive or negative change in taxes. Suppose an MPC of 0.8, for example: of every extra dollar, 80 cents is spent on consumption. Then a $20 tax cut will produce –$20 million (negative because it is a cut) times \(–0.8/(1 – 0.8) = –4\), or $80 million in additional consumer spending. With an MPC of 0.2, on the other hand, a $20 tax cut will produce –$20 million times \(–0.2/(1 – 0.2) = –0.25\), or just $5 million in additional consumer spending.
There is also a multiplier for government spending. When the government increases purchases, it directly increases output, or national income. But when the government spends more, the populace receives more. That is, because the population is the target of increased government spending, personal incomes, and thus consumption, increase. Once again, this leads to several cycles of increased consumer spending. The total change in output as a result of a change in government purchases is equal to government spending times the government spending multiplier, \(1 / (1 - MPC)\). With an MPC of 0.8, $20 million in government adds $20 million times \(1/(1 - 0.8)=5\), or $100 million to the national income. (Unlike the tax multiplier, the spending multiplier is always greater than 1.)
Crowding Out
In reality, government spending does not change output quite so much as the government spending multiplier implies. The reason is that when the government increases spending, private investment falls. This is called crowding out, because government spending tends to replace, or crowd out, private investment.
There are two reasons why this happens. The first is that the total level of output is to some degree fixed by the factors of production. When more production factors are tied up in government-funded projects, fewer are available for privately funded projects. The other reason is that an increase in government spending usually requires an increase in government borrowing. When the government increases its demand for loanable funds, the shift in overall demand drives interest rates up, making it more expensive for private firms to borrow money to fund their projects—and therefore fewer private projects are undertaken.
