Expansionary Fiscal Policy

by Obaidullah Jan, ACA, CFA

Expansionary fiscal policy is a form of fiscal policy that involves decreasing taxes, increasing government expenditures or both in order to fight recessionary pressures.

A decrease in taxes means that households have more disposal income to spend. Higher disposal income increases consumption which increases GDP. Further, a decrease in taxes communicates to the businesses that the government is interested in reviving the economy. It increases their confidence which in turn increases the private investment component of GDP.

Since government expenditures form a component of GDP, an increase in government expenditures increases GDP directly. Further, such an increase also results in indirect increase in consumption and other components of GDP.

The bottom line is that increase in GDP resulting from a decrease in taxes and increase in government expenditures is much more than the initial decrease in taxes or increase in government expenditures due to the multiplier effect.


Example 1

Abigail Noble is an economist assisting the IMF in developing policy recommendations for different economies. Currently she is meeting with finance ministers of newly formed states of Sacramento and Salamia. Sacramento has inflation rate of 7% as compared to historical average of 3%, unemployment rate of 2% as compared with natural unemployment rate of 4%, budget deficit of 5% and a GDP growth rate of 6% as compared with average growth rate of 3%. Salamia on the other hand has 1% inflation, 8% unemployment as compared to historical average of 4%, budget surplus of 4% and GDP growth rate of 1.5%. For which country Abigail would most likely recommend expansionary fiscal policy?

Low inflation, high unemployment, a budget surplus and low growth rate indicates that Salamia is facing recessionary pressures which makes it an ideal candidate for expansionary fiscal policy. Salamia can achieve this by either decreasing taxes, increasing its government expenditures or both. This will eliminate the budget surplus, increase growth rate, increase inflation and decrease unemployment rate. Sacramento on the other hand, is facing inflationary pressures and expansionary fiscal policy will only worsen her problems.

Example 2

It is early 2008 and US auto industry is in deep recession. David Weil and Chad Brooks are students of economics at a university in Detroit. David recommends that government should increase tax on utilities sector to bail out the auto industry. He believes this will help increase GDP. Chad does not seem to agree. Critique David's statement.

The strategy proposed by David is less likely to provide any stimulus to the economy. The increase in government expenditures is financed by increase in taxes. These actions are expected to have opposite effect on GDP. An increase in government expenditure will tend to increase GDP by increasing auto industry profits and sales while the increase in taxes will reduce GDP by decreasing utilities industry profits. The precise effect can be calculated by taking into account the fiscal and tax multipliers.