Fiscal Policy: Balancing Between Tax Rates and Public Spending

What Is Fiscal Policy?

Fiscal policy is the use of spending levels and tax rates to influence a nation's economy. It is the sister strategy to monetary policy, where a government or central bank influences an economy by adjusting the nation's money supply. These two policies are used in various combinations to direct a country's economic goals. Here's a look at how fiscal policy works, how it must be monitored, and how its implementation may affect different people in an economy.

Before the Great Depression, which lasted from 1929 until America's entry into World War II, the government's approach to the economy was largely laissez-faire. Following World War II, it was determined that the government had to take a proactive role in the economy to regulate unemployment, business cycles, inflation, and the cost of money. By using a mix of monetary and fiscal policies (depending on the political orientations and the philosophies of those in power at a particular time, one policy may dominate over another), governments can control economic activity.

How Fiscal Policy Works

Fiscal policy is based on the theories of British economist John Maynard Keynes. Also known as Keynesian economics, this theory basically states that governments can influence macroeconomic productivity levels by increasing or decreasing tax levels and public spending. This influence, in turn, can curb inflation (generally considered to be healthy when between 2% and 3%), increase employment, and maintain a healthy value of money.

Fiscal policy plays a very important role in managing a country's economy. For example, in 2012 many worried that the fiscal cliff, a simultaneous increase in tax rates and cuts in government spending set to occur in January 2013, would send the U.S. economy back into recession. The U.S. Congress avoided this problem by passing the American Taxpayer Relief Act of 2012 on Jan. 1, 2013.

Balancing Act Between Tax Rates and Public Spending

The central idea of fiscal policy is to find a level of public spending that stimulates economic demand without creating an undue tax burden. For example, stimulating a stagnant economy by increasing spending or lowering taxes, also known as expansionary fiscal policy, runs the risk of causing inflation to rise. This is because an increase in the amount of money in the economy, followed by an increase in consumer demand, can result in a decrease in the value of money—meaning that it would take more money to buy something that has not changed in value.

Let's say that an economy has slowed down. Unemployment levels are up, consumer spending is down, and businesses are not making substantial profits. A government may decide to fuel the economy's engine by decreasing taxation, which gives consumers more spending money while increasing government spending in the form of buying services from the market (such as building roads or schools). By paying for such services, the government creates jobs and wages that are in turn pumped into the economy. Pumping money into the economy by decreasing taxation and increasing government spending is also known as "pump priming." In the meantime, overall unemployment levels will fall.

With more money in the economy and less taxes to pay, consumer demand for goods and services increases. This, in turn, rekindles businesses and turns the cycle around from stagnant to active.

If, however, there are no reins on this process, the increase in economic productivity can cross over a very fine line and lead to too much money in the market. This excess in supply decreases the value of money while pushing up prices (because of the increase in demand for consumer products). Hence, inflation exceeds the reasonable level.

For this reason, fine-tuning the economy through fiscal policy alone can be a difficult, if not improbable, means to reach economic goals.

When the Economy Needs to Be Curbed

When inflation is too strong, the economy may need a slowdown. In such a situation, a government can use fiscal policy to increase taxes to suck money out of the economy. Fiscal policy could also dictate a decrease in government spending and thereby decrease the money in circulation.

Of course, the possible negative effects of such a policy, in the long run, could be a sluggish economy and high unemployment levels. Nonetheless, the process continues as the government uses its fiscal policy to fine-tune spending and taxation levels, with the goal of evening out the business cycles.

Who Does Fiscal Policy Affect?

Unfortunately, the effects of any fiscal policy are not the same for everyone. Depending on the political orientations and goals of the policymakers, a tax cut could affect only the middle class, which is typically the largest economic group. In times of economic decline and rising taxation, it is this same group that may have to pay more taxes than the wealthier upper class.

Similarly, when a government decides to adjust its spending, its policy may affect only a specific group of people. A decision to build a new bridge, for example, will give work and more income to hundreds of construction workers. A decision to spend money on building a new space shuttle, on the other hand, benefits only a small, specialized pool of experts, which would not do much to increase aggregate employment levels.

That said, the markets also react to fiscal policy. Stocks rose on Dec. 21, 2017, for the first time in three days following passage of the Trump administration's $1.5 trillion U.S. tax bill, the Tax Cuts and Jobs Act. The Dow Jones Industrial Average gained 99 points or 0.4%, the S&P 500 Index rose 0.25%, and the Nasdaq Composite Index was up 0.14%.

The tax overhaul is forecast to raise the federal deficit by hundreds of billions of dollars—and perhaps as much as $2 trillion—over the next 10 years. Estimates vary depending on assumptions about how much economic growth the law will spur. The law cuts corporate tax rates permanently by creating a single corporate tax rate of 21% and repeals the corporate alternative minimum tax.

The law also retains the current structure of seven individual income tax brackets, but in most cases it lowers the rates: the top rate falls from 39.6% to 37%, while the 33% bracket falls to 32%, the 28% bracket to 24%, the 25% bracket to 22%, and the 15% bracket to 12%. The lowest bracket remains at 10%, and the 35% bracket is also unchanged. These changes are set to expire after 2025.

The Bottom Line

One of the biggest obstacles facing policymakers is deciding how much involvement the government should have in the economy. Indeed, there have been various degrees of interference by the government over the years. But for the most part, it is accepted that a degree of government involvement is necessary to sustain a vibrant economy, which affects the economic well-being of the population.