Discretionary fiscal policy is a change in government spending or taxes. Its purpose is to expand or shrink the economy as needed.
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 have to be done by enacting new laws. These laws must be passed by both the Senate and the House of Representatives. But the president has the power to change how tax laws are implemented. He can send directives to the Internal Revenue Service to adjust the enforcement of rules and regulations.
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. Spending on public works construction is one of the four best ways to create jobs.
Job creation gives people more money to spend, boosting demand. According to Keynesian economic theory, that increases economic growth.
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 American Recovery and Reinvestment 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. Studies show that unemployment benefits are the best stimulus.
Supply-side economics says that a tax cut is the best way 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% for supply-side economics to work. Tax cuts are not 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%. 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 2% to 3% 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.
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. The Federal Reserve created many other tools to fight the Great Recession. When working together, fiscal and monetary policy control 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 Fed 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.