Definition of Fiscal Policy

Fiscal policy is a government’s attempt to change economic activity by changing government expenditures, taxation and borrowing, and lending policies. A government can choose to change spending on highways, defense, education, public works, and social programs. A government can change tax rates, tax systems, and taxation to certain groups. If a government spends more than it receives in tax revenue, it borrows the difference. 

Keynesian Economics and Fiscal Policy

The two policies that governments can use to influence the economy are fiscal policy and monetary policy. Fiscal policy is covered in this unit. Monetary policy is covered in Unit 9. Keynes supported both policies, but believed that fiscal policy is more effective. According to Keynes, governments should primarily increase spending when the economy experiences a recessionary gap. He stated that governments can also lower taxes to stimulate the economy, but he preferred increases in government spending because governments spend all of their money whereas citizens may save part of their tax benefits. Conversely, governments should decrease spending and/or raise taxes when the economy experiences an inflationary gap. Many politicians, influenced by Keynes’s encouragement to run deficits to stimulate the economy, support active fiscal policy. Since Keynesian economics became popular in the 1930s and beyond, government spending has increased significantly. Politicians often cater to special interest groups, because it translates into more votes and possible campaign donations. Consequently, government spending often increases even during expansions.

Classical Economics and Fiscal Policy

Classical economists and supporters of classical schools of thought (for example, neo-classical and Austrian economists), disagree with Keynesian fiscal policy. According to classical economists, efforts to change the demand side of the economy may benefit an economy in the short run, but causes harm in the long run. Increases in government spending lead to increases in the money supply, or increases in a nation’s debt, or increases in taxation. Increases in the money supply equate to inflation. Increases in interest rates lead to decreases in borrowing and decreases in private spending. And increases in taxation lead to decreases in private consumption and savings.

Keynes argued that a rapidly growing economy during times of full employment causes inflation. Classical economists disagree. They believe that increases in the money supply equate to inflation, and long-term increases in the price level are impossible without increases in the money supply. Classical economists, and in particular the so-called monetarists, believe that inflation can be slowed or avoided by decreasing the rate of growth in the money supply. Classical economists do not believe that active fiscal policy is beneficial to the economy in the long run.

According to the classical school, proper fiscal policy is when the government creates an economic environment in which private properties are well-protected, and households and businesses have maximum incentive to produce and innovate. Government spending should be limited to defense, a judicial system, fire and police protection, infrastructure, education, transportation and a small and efficient administrative system. Taxes should be relatively low and regulations minimal.

Fiscal Policy Lags

In addition to the long-run disadvantages of active fiscal policy mentioned in the previous paragraph, neo-classical economists and monetarists believe that lags in the economy hamper the effectiveness of government policy. There are three lags: the information lag, the policy lag, and the impact lag.

The information lag is the period of time during which the economy changes and economists find out that it changes. For example, if in March of this year the economy slows down, economists may not receive accurate data to determine the slowdown until June of this year.

The policy lag is the period of time during which the information is received and politicians come to a decision to take action. If the information about the slowdown is received in June, it may be January of the following year before politicians change fiscal policy (increase government spending and/or decrease taxes).

The impact lag is the period of time during which politicians have taken action and the impact of the action is actually felt in the economy. If politicians took action in January, the impact may not be felt until April or May.

The three lags combined means that it may take approximately 13 or 14 months from the beginning of the slowdown until fiscal policy takes effect. At that time, the economy may have already begun an expansion on its own, and the policy may be counter-effective. This is another reason why classical, neo-classical, and monetarist economists support limited government involvement in the economy.