Discretionary Fiscal Policy

How It Differs from Discretionary Monetary Policy

Discretionary fiscal policy
President Barack Obama shakes hands with Speaker Paul Ryan of Wisconsin before the State of the Union address before a joint session of Congress on Capitol Hill in Washington, Tuesday, Jan. 12, 2016. (AP Photo/Evan Vucci) (Photo by Pool/WHITE HOUSE POOL (ISP POOL IMAGES)/Corbis/VCG via Getty Images

Definition: Discretionary fiscal policy is a change in government spending or taxes. Its purpose is to expand or shrink the economy as needed. 

Tools

Discretionary fiscal policy uses two tools. They are the budget process and the tax code. The first tool is the discretionary portion of the U.S. budget. Congress determines this type of spending with appropriations bills each year. The largest is the military budget.

All other federal departments are part of discretionary spending too. 

The budget also contains mandatory spending. This includes payments from Social Security, Medicare, Medicaid, Obamacare and interest payments on the national debt. Congress mandates these programs. They are the law of the land. Congress must vote to amend or revoke the relevant law to change these programs. Therefore, changes in the mandatory budget are very difficult. For that reason, it isn't a tool of discretionary fiscal policy. 

The second tool is the tax code.  It includes taxes on workers' incomes, corporate profits, imports and other excise fees. Only Congress has the power to change the tax code. Congress’ changes to the tax code has to be done by enacting new laws. These laws must be passed by both the Senate and the House of Representatives. But the president can change how it is implemented. He can send directives to the Internal Revenue Service to change how the tax laws are enforced.

 

Types

There are two types of discretionary fiscal policy. The first is expansionary fiscal policy. It’s when the federal government increases spending or decreases taxes. When spending is increased, it creates jobs. It happens directly through public works programs or indirectly through contractors.

Job creation gives people more money to spend. That boosts demand, which increases economic growth. Find out the four best ways to create jobs.

When the government cuts taxes, it puts money directly into the pockets of business and families. They have more money to spend. This also boosts demand and drives growth. When spending and tax cuts are done at the same time, it puts the pedal to the metal. That's why the Economic Stimulus Act ended the Great Recession in just a few months. It used a combination of public works, tax cuts and unemployment benefits to save or create 640,000 jobs between March and October 2009. Here's why unemployment benefits are the best stimulus.

Supply-side economics says that a tax cut is the best ways to stimulate the economy. Stronger economic growth will make up for the government revenue lost. That's because it generates a larger tax base. But tax cuts only work if taxes were high in the first place. According to the underlying economic theory, the Laffer Curve, the highest tax rate must be above 50 percent for supply-side economics to work. Find out if tax cuts are the best way to create jobs.

Expansionary fiscal policy creates a budget deficit. This is one of its downsides.

It’s because the government spends more than it receives in taxes. Often there’s no penalty until the debt-to-GDP ratio nears 100 percent. At that point, investors start to worry the government won't repay its sovereign debt. They won’t be as eager to buy U.S. Treasurys or other sovereign debt. They will demand higher interest rates. This makes the debt even more expensive to pay back. It can create a downward spiral. For example, look at the Greek debt crisis. 

Contractionary fiscal policy is when the government cuts spending or raises taxes. It slows economic growth. A spending cut means less money goes toward government contractors and employees. That then reduces job growth. 

When Congress raises taxes, it also slows growth. Higher taxes reduce the amount of disposable income available for families or businesses to spend.

It decreases demand and slows economic growth. 

Discretionary fiscal policy should work as a counterweight to the business cycle. During the expansion phase, Congress and the president should cut spending and programs to cool down the economy. If done well, the reward is an ideal economic growth rate of around two to three percent a year.

Instead, politicians keep spending and cutting taxes regardless of where we are in the boom and bust cycle. If they do it during a boom, it overstimulates the economy and creates asset bubbles, and leads to a more devastating bust. It’s one reason for the 2008 financial crisis.

Unfortunately, democracy itself ensures an expansionary discretionary fiscal policy Why? Because lawmakers get elected, and re-elected by spending money and lowering taxes. That's how they reward voters, special interest groups and those who donate to campaigns. Everyone says they want to see the budget cut, just not their portion of the budget.

Discretionary Fiscal Policy versus Monetary Policy

At its best, discretionary fiscal policy should work in alignment with monetary policy enacted by the Federal Reserve. If the economy is growing too fast, fiscal policy can apply the brakes by raising taxes or cutting spending. At the same time, the Fed should enact contractionary monetary policy. It does this by raising the fed funds rate or through its open market operations. Here's more on the Fed's tools and how they work.

If the economy is in a recession, discretionary fiscal policy can lower taxes and increase spending while the Fed enacts an expansionary monetary policy. It will be done by lowering the fed funds rate or through quantitative easing. When working together, fiscal and monetary policy take the pain out of the stages of the business cycle.

Since the 1990s, politicians have enacted expansive fiscal policy no matter what. That means it's up to the Fed alone to manage the business cycle. A relentless expansionary fiscal policy forces the Federal Reserve to use contractionary monetary policy as a brake when the economy is booming. Higher interest rates reduce capital and liquidity, especially for small businesses and the housing market. That ties the hands of the Fed, reducing its flexibility.