How much money should a government raise to cover its spending? How much taxes should it collect from the public? These are the basic questions about fiscal policy. With monetary policy, fiscal policy forms the macroeconomic policies that enable a country to achieve its economic goals. This article will learn more about the different types of fiscal policy in economics and their impact on the economy. Interested? Then read on!
What is fiscal policy?
Fiscal policy is one of the main pillars of government policy. It relies on John Maynard Keynes’ idea that the government can influence economic performance by changing the level of government spending or taxes.
Taxes are the primary source of government spending. The more tax revenue the government has, the more money it has available to fund public services. However, higher taxes can increase the burden on citizens and reduce their purchasing power.If a government wants to eradicate poverty and boost the economy, it can increase public spending to support those in need. However, this may not be the best way to increase employment, as people may become dependent on unemployment benefits and stop looking for work.To improve economic conditions, the government should constantly adjust tax rates and public spending to benefit all economy factors.
Types of fiscal policy in economics
What are the types of fiscal policy? Fiscal policy can be roughly divided into expansionary and contractionary fiscal policy. This section will examine the difference between expansionary fiscal policy and contractionary fiscal policy.
Expansionary fiscal policy
Expansionary fiscal policy uses tax cuts or increased government spending to regulate the economy. It is often used in times of recession or economic downturn.
Expansionary fiscal policy increases aggregate demand through tax cuts or increased government spending.
Aggregate demand measures the total demand for goods and services in an economy. It consists of four components:
- Consumption levels of households (C)
- Investments (I)
- Government spending (G)
- Exports Minus Imports (X - M)
The formula for aggregate demand is: AD = C + I + G + (X - M)
Higher aggregate demand indicates a healthier and more robust economy. On the other hand, lower aggregate demand means the economy is experiencing a recession or downturn. To learn more, read our explanation of Aggregate Demand.
Fiscal policy alters the level of government spending and taxation. An increase in government spending, a direct component of aggregate demand (AD), shifts the AD curve outward.
A tax cut also has an indirect effect on AD – through higher household disposable income leading to higher spending, which also shifts the AD curve outward, as shown in Figure 1 below.
Figure 1. Expansionary fiscal policy, StudySmarter Originals
As shown in Figure 1, the initial equilibrium of national income is where the aggregate demand curve AD1 and the aggregate supply curve SRAS1 intersect. Here, the output is Y1, and the price level is P1. When the government decides to cut taxes or increase spending, the aggregate demand curve shifts outward (from AD1 to AD2), and the economy reaches a new equilibrium output of Y2.
Contractionary fiscal policy
Contractionary fiscal policy is the opposite of expansionary fiscal policy. It uses higher taxes and lower government spending to regulate the economy.
Contractionary fiscal policy lowers aggregate demand by raising taxes or reducing government spending.
A decrease in government spending, a direct component of aggregate demand (AD), shifts the AD curve inward.
A tax increase also has an indirect effect on AD – through lower household disposable income leading to lower spending, which also shifts the AD curve inward, as shown in Figure 2 below.
Figure 2. Contractionary fiscal policy, StudySmarter Originals
As shown in Figure 2, the initial national income equilibrium is at the intersection of the aggregate demand curve AD1 and the aggregate supply curve SRAS1. Here, the output is Y1, and the price level is P1. When the government decides to raise taxes or cut spending, the aggregate demand curves shift inward (from AD1 to AD2). As a result, the economy moves to a new equilibrium output of Y2 with a price level of P2.
Effects of fiscal policy
The government has two ways to stimulate the economy: increasing aggregate demand through demand-side policies or improving aggregate supply and productivity through supply-side policies.
Demand-side policies include:
- Monetary policy policies, such as reduced interest rates
- Fiscal policy policies, such as tax cuts and increased government spending.
On the other hand, supply-side policies include:
- Interventionist supply-side policies
- Non-interventionist supply-side policies.
This article will consider only the demand-side effects and the supply-side effects of fiscal policy.
Demand-side effects of fiscal policy
The purpose of demand-side fiscal policies is to increase aggregate demand.
Demand-side fiscal policy uses government spending or taxes to increase aggregate demand in an economy.
Demand-side fiscal policy is adopted in times of recession to stimulate economic growth. By increasing government spending and lowering taxes, the government can encourage people to spend more. As a result, the demand for goods and services and the level of consumption increase. Companies can then generate more revenue, which allows them to increase production and hire more employees.
However, reliance on demand-side fiscal policy can increase government borrowing, as lower taxes require the government to borrow more from other countries to cover the cost of public services.
Supply-side effects of fiscal policy
Supply-side fiscal policy aims to increase the aggregate supply and productivity of an economy.
Supply-side fiscal policy uses privatisation, deregulation, tax cuts, and free trade agreements to increase aggregate supply and economic efficiency.
An example of supply-side fiscal policy is a cut in income tax. The tax cut will motivate workers to work longer because they can earn more with lower taxes. As a result, the level of productivity and output will rise.There are two types of supply-side fiscal policy: interventionist and non-interventionist.
Non-interventionist supply-side policies include:
- Tax cuts – to create an incentive to work, save, and invest
- Welfare benefit cuts – to lower incentive to seek unemployment
- Privatisation – shifts ownership of publicly owned assets to the private sector.
Interventionist supply-side policies include:
- Government provision for private sector firms
- Government provisions for training, education, and infrastructure.
The main difference between interventionist and non-interventionist supply-side policies is that the former increases the role of government and decreases the role of the market, while the latter increases the role of the market and prevents government interference in markets. Both interventionist and non-interventionist policies are factors that lead to an outward shift in the long-run aggregate supply curve (LRAS).
Diagram of supply-side effects of fiscal policy
Suppose that the UK government decided to implement tax cuts in the economy to improve worker productivity. Figure 1 illustrates the effects of such a measure.
Figure 3. Supply-side effects of fiscal policies, StudySmarter Originals
As shown in Figure 3, in the short run, the tax cut motivates workers to work longer hours, contributing to higher productivity and output. Accordingly, the short-run aggregate supply curve (SRAS) shifts from SRAS1 to the right to SRAS2. In the long run, the tax cut causes the long-run aggregate supply curve (LRAS) of the economy to shift to the right from LRAS1 to LRAS2. The level of the economy’s productive capacity rises from Y1 to Y2, while the price level falls from P1 to P2.
Multiplier and crowding-out effects of fiscal policy
In general, the effectiveness of fiscal policy can be measured by the multiplier and the risk of crowding out.
The multiplier
The multiplier measures the change between a component of aggregate demand (consumption, government spending, or business investment) and the resulting change in national income (GDP).
We can distinguish three different types of multipliers: the government multiplier, the investment multiplier, and the tax multiplier. From this, we can derive the following:
- The larger the government spending multiplier, the smaller the increase in government spending required to achieve the desired increase in national income.
- The larger the tax multiplier, the smaller the tax cut required to achieve the desired increase in national income.
- The larger the investment multiplier, the smaller the increase in investment required to achieve the desired increase in national income.
If the multiplier is large enough to have a significant effect on the real output of an economy, then the use of tax policy by governments is relatively effective. If, on the other hand, the multiplier is too small to have any effect at all on the real output of an economy, then the fiscal policy has little effect.
The crowding-out effect
The crowding-out effect is when public sector spending or government spending crowds out private sector spending, which results in little or no increase in aggregate demand.
In macroeconomic theory, it is impossible to use real resources in the public and private sectors simultaneously. However, if governments use increasingly more factors of production in the public sector, the output produced in the private sector must fall. We can look at the crowding-out effect analytically using the diagram if we assume the economy is producing at the production possibility frontier.
Figure 4. Crowding-out effect, StudySmarter Originals
Figure 4 shows the possible maximum amount of output that can be produced in an economy with a combination of public and private sector output. The points on the production possibility frontier represent these possible output combinations.
To learn more about the production possibility frontier, read our explanation on Production Possibility Curves.
Suppose there is full employment in the economy at point A. Now the government has decided to increase public spending, which would raise the value of PU1 to PU2.Since public sector spending has increased, this increase will displace or ‘crowd out’ private sector spending as it decreases from PR1 to PR2, causing the economy to move from point A to point B.However, if the economy is producing at less than full employment or within the production possibility frontier (at point C), then an increase in public spending would absorb some of the economy’s capacity without using the resources available in the private sector.
As public sector spending has increased, this increase will then displace private sector spending or ‘crowd it out’ as it reduces from PR1 to PR2. This subsequently causes the economy to move from point A to point B.
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