Fiscal policy is a form of economic policy that involves changing government spending and taxes in order to achieve growth while keeping inflation in check. It is also termed as discretionary fiscal policy.
Together with monetary policy, fiscal policy tools are used to keep the economy steady and save it, as much as possible, from ups and downs. While monetary policy is implemented by the central bank, fiscal policy is implemented by the government. Since fiscal policy is based on legislation, it typically takes lot more time in affecting the economy as compared to monetary policy.
When the economy is in facing recessionary pressures, the government provides stimulus to the economy by either decreasing taxes or increasing its expenditures or taking both the steps simultaneously. On the other hand, if the economy is facing inflationary pressures, the government attempts to reduce inflation by either increasing taxes or decreasing its expenditures or doing both.
It is early 2008 and unemployment rate in the US is 5%. Crystal Hall works as an economist with the Congressional Budget Office. Based on some economic indicators, she forecasts that unemployment rate is expected to reach 10% if the government does not intervene. Inflation is expected to hit zero. One of the senators is interested in motivating the Senate to make necessary changes in taxes and government expenditures and has requested Crystal to present a report on the issue. In the report she suggests that the government should decrease taxes and increase its expenditures in order to help the economy fight recession. Critique her statement.
Crystal is right. Increasing unemployment rate means that the economy is under severe recessionary pressures. High unemployment rate also means there will be less income available with households to consume. Lower sales due to lower consumption means businesses will not be interested in making any new investments. Lower consumption and lower investment by businesses will lead to a drop in GDP. If the government wants to sustain the GDP and save the economy from recession, it must either reduce taxes or increase its expenditures or do both. A decrease in taxes will increase the disposable income which will help in maintaining consumption. Lower taxes will help businesses feel confident in the economy's resilience and this will encourage investments. An increase in government expenditures will have a multiplier effect on the economy. Both actions will help sustain the GDP level.
Written by Obaidullah Jan, ACA, CFA