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 the 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. In response to the Depression, the government launch a number of programs inspired by the ideas of economist John Maynard Keynes to put Americans to work and stimulate economic recovery. It was thus seen, that the government could take action to combat the negative phases of business cycles, raise employment, and stimulate growth. The government intervening to help the economy during the Great Depression is an example of fiscal policy. Fiscal policy can also take on other forms besides government spending such as altering tax rates. What actions are taken will depend on the political philosophy of those in power and the unique situation.

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 affect inflation (the Federal Reserve aims for a healthy level of 2%), 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 January 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, government spending can also have ripple effects that spread throughout the wider economy. In November 2021, Congress passed the Infrastructure Investment and Jobs Act, a signature piece of legislation by the Biden administration., The act called for $1 trillion of federal spending to rebuild roads and bridges, expand public transit, expand high-speed internet, and replace lead pipes to improve drinking water. It was also expected to curb deficit spending by $204 billion,

An analysis of the law by Moody's predicted that the new law "will strengthen long-term economic growth," especially for middle and lower-income Americans. The report also cast doubt on the inflationary effects of the legislation, noting that "the fiscal support it provides will ensure the economy only returns to full employment from the recession caused by the COVID-19 pandemic."

Ultimately, the increase in spending was followed by sharp increases in economic activity and employment, according to a two-year retrospective by the Brookings Institution. By 2023, the federal government had already granted $300 billion of allocated funding, with unemployment falling to historical lows in the construction and utilities industries.

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.