Expansionary fiscal policy is when the government expands the money supply in the economy using budgetary tools to either increase spending or cut taxes—both of which provide consumers and businesses with more money to spend.
In the United States, the president influences the process, but Congress must author and pass the bills. Congress has two types of spending. The first is through the annual discretionary spending bill process. It can also increase benefits payments in mandatory programs, which is more difficult because it requires a 60-vote majority in the Senate to pass. The largest mandatory programs are Social Security, Medicare, and welfare programs. Sometimes these payments are called transfer payments because they reallocate funds from taxpayers to targeted demographic groups.
Congress must also pass legislation when it wants to cut taxes. There are many types of tax cuts, including taxes on income, capital gains, dividends, small businesses, payroll, and corporate taxes.
The Purpose of Expansionary Fiscal Policy
The purpose of expansionary fiscal policy is to boost growth to a healthy economic level, which is needed during the contractionary phase of the business cycle. The government wants to reduce unemployment, increase consumer demand, and avoid a recession. If a recession has already occurred, then it seeks to end the recession and prevent a depression.
How Expansionary Fiscal Policy Works
By using subsidies, transfer payments (including welfare programs), and income tax cuts, expansionary fiscal policy puts more money into consumers' hands to give them more purchasing power. It also reduces unemployment by contracting public works or hiring new government workers, both of which increase demand and spurs consumer spending, which drives almost 70% of the economy. The other three components of gross domestic product are government spending, net exports, and business investment.
Corporate tax cuts put more money into businesses' hands, which the government hopes will be put toward new investments and increasing employment. In that way, tax cuts create jobs, but if the company already has enough cash, it may use the cut to buy back stocks or purchase new companies. The theory of supply-side economics recommends lowering corporate taxes instead of income taxes, and advocates for lower capital gains taxes to increase business investment. The Laffer Curve states that this type of trickle-down economics only works if tax rates are already 50% or higher.
Examples of Expansionary Fiscal Policy
The Trump administration used expansionary policy with the Tax Cuts and Jobs Act and also increased discretionary spending—especially for defense.
The Obama administration used expansionary policy with the Economic Stimulus Act. The American Recovery and Reinvestment Act cut taxes, extended unemployment benefits, and funded public works projects. The law, which was enacted in 2009, was meant to stimulate the weakening economy, costing $787 billion in tax cuts and government spending. All this occurred while tax receipts dropped, thanks to the 2008 financial crisis.
The Bush administration used an expansive fiscal policy to end the 2001 recession and cut income taxes with the Economic Growth and Tax Relief Reconciliation Act, which mailed out tax rebates. Unfortunately, the 9/11 terrorist attacks sent the economy back into a downturn. Bush launched the War on Terror and cut business taxes in 2003 with the Jobs and Growth Tax Relief Reconciliation Act. By 2004, the economy was in good shape, with unemployment at just 5.4%.
President John F. Kennedy used expansionary policy to stimulate the economy out of the 1960 recession. He promised to sustain the policy until the recession was over, regardless of the impact on the debt.
President Franklin D. Roosevelt used expansionary policy to end the Great Depression. It worked at first, but then FDR reduced New Deal spending to keep the budget balanced, which allowed the Depression to reappear in 1932. Roosevelt returned to expansionary fiscal policy to gear up for World War II.
Pros of Expansionary Policy
Expansionary fiscal policy works fast if done correctly. For example, government spending should be directed toward hiring workers, which immediately creates jobs and lowers unemployment. Tax cuts can put money into the hands of consumers if the government can send out rebate checks right away. The fastest method is to expand unemployment compensation. The unemployed are most likely to spend every dollar they get, while those in higher income brackets are more likely to use tax cuts to save or invest—which doesn't boost the economy.
Most important, expansionary fiscal policy restores consumer and business confidence. They believe the government will take the necessary steps to end the recession, which is critical for them to start spending again. Without confidence in that leadership, everyone would stuff their money under a mattress.
Cons of Expansionary Policy
The main drawback is that tax cuts decrease government revenue, which can create a budget deficit that's added to the debt. Although reversing tax cuts is often an unpopular political move, it must be done when the economy recovers to pay down the debt. Otherwise, it grows to unsustainable levels. The Treasury Department prints paper currency and mints coins. The Federal Reserve manages monetary policy to keep debt from spiraling out of control. The national debt is more than $30 trillion—which is more than the country produces in a year. When the debt-to-GDP ratio is more than 100%, investors get worried, buy fewer bonds, and send interest rates higher. All of which can slow economic growth.
Politicians often use expansionary fiscal policy for reasons other than its real purpose. For example, they might cut taxes to become more popular with voters before an election. That's dangerous because it creates asset bubbles, and when the bubble bursts, you get a downturn. It's called the boom and bust cycle.
Expansionary vs. Contractionary Fiscal Policy
Expansionary policy is used more often than its opposite, contractionary fiscal policy. Voters like both tax cuts and more benefits, and as a result, politicians that use expansionary policy tend to be more likable. State and local governments in the United States have balanced budget laws; they cannot spend more than they receive in taxes. That's a good discipline, but it also reduces lawmakers' ability to boost economic growth in a recession. If they don't have a surplus on hand, they have to cut spending when tax revenues are lower. In this scenario, cutting spending worsens the recession.
Expansionary Monetary Policy
Expansionary monetary policy is when a nation's central bank increases the money supply, and this method works faster than fiscal policy. The Federal Reserve can quickly vote to raise or lower the fed funds rates at its regular Federal Open Market Committee meetings, but it may take about six months for the effect to percolate throughout the economy. The Fed can also implement contractionary monetary policy to raise rates and prevent inflation.
Frequently Asked Questions (FAQs)
When is expansionary fiscal policy used?
Governments typically use expansionary fiscal policy during a recession (or to stave off a recession). When the economy transitions out of a recession into an expansion, the government shifts to a more contractionary fiscal policy stance.
What does expansionary fiscal policy do to interest rates?
Expansionary fiscal policy tends to push interest rates up. In the real world, the Federal Reserve steps in to mediate the impacts that expansionary fiscal policy has on the interest rate environment.