Expansionary Fiscal Policy: Definition, Examples

What Sets Bush and Obama Apart From Clinton

expansionary monetary policy
President Barack Obama extends his hand to former President George W. Bush (C) as former President Bill Clinton (L) looks on in the Rose Garden of the White House January 16, 2010. Photo by Mark Wilson/Getty Images

Definition: Expansionary fiscal policy is when the government expands the money supply in the economy. It uses budgetary tools to either increase spending or cut taxes. That provides consumers and businesses with more money to spend. 

In the United States, Congress must write legislation to create these measures. The president can start 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. The largest part of discretionary spending is the military budget. 

Congress can also increase payments in mandatory programs. This is more difficult because it requires a 62 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. That's because they reallocate funds from taxpayers to targeted demographic groups. But there is at least one transfer payment that's not part of a mandatory program. That's expanded unemployment benefits.

Congress must also pass legislation when it wants to cut taxes. There are many types of tax cuts. They include taxes on income, capital gains and dividends. It can also cut small businesses, payroll and corporate taxes. 

Purpose

The purpose of expansionary fiscal policy is to boost growth to a healthy economic level.

This 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

Tax cuts also occur during the expansionary phase of the business cycle.

That’s because a presidential candidate may promise it during a campaign. By the time he fulfills his promise, the recession may be over.

How It Works

Expansionary fiscal policy expands the amount of money in an economy. It puts more money into consumers' hands to give them more purchasing power. It uses subsidies,  transfers payments including welfare programs, and income tax cuts. It reduces unemployment by contracting public works or hiring new government workers. All these measures increase demand. That spurs consumer spending, which drives almost seventy percent 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. They use it for new investment and employees. For more, see  Do Tax Cuts Create Jobs?

The theory of supply-side economics recommends lowering corporate taxes instead of income taxes. That gives companies funds to hire more workers. It advocates lower capital gains taxes to increase business investment. But this type of trickle- down economics doesn't work unless tax rates are already 50 percent or higher.  For more, see What Does the Laffer Curve Really Say?.

Examples

The Obama administration used expansionary policy with the Economic Stimulus Act. The ARRA cut taxes, extended unemployment benefits and funded public works projects. In 2010, he continued many of these benefits with the Obama tax cuts. He also increased defense spending. All this occurred while tax receipts dropped thanks to the 2008 financial crisis. That's why the national debt increased so much under Obama.

The Bush Administration used expansive fiscal policy to end the 2001 recession. It cut income taxes with EGTRRA, which mailed out tax rebates. But the 9/11 terrorist attacks sent the economy back into a downturn. Bush boosted government defense spending with the War on Terror. He cut business taxes in 2003 with JGTRRA. By 2004, the economy was in good shape, with unemployment at just 5.4 percent.

But Bush continued expansionary policy, boosting defense spending with the War in Iraq.

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.  At first, it was working. But then FDR reduced New Deal spending to keep the budget balanced. That allowed the Depression to reappear in 1932. Roosevelt returned to expansionary fiscal policy to gear up for World War II. That massive spending finally ended the Depression.

Pros

Expansionary fiscal policy works fast if done correctly. For example, government spending should be directed towards hiring workers. That 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 expanding unemployment compensation. The unemployed are most likely to spend every dollar they get. Those in higher income brackets might use tax cuts to save or invest extra cash. That doesn't boost the economy. Find out why unemployment benefits are the best stimulus.

Most important, any form of expansionary fiscal policy restores the consumer and business confidence. They believe the government will take necessary steps to end the recession. That's critical for them to start spending again. Without confidence in that leadership, a recession could turn into a depression. Everyone would just stuff their money under their mattress

Cons

Tax cuts decrease government revenue. That creates a budget deficit and adds that's added to the debt. The tax cuts must be reversed when the economy recovers to pay down the debt. Otherwise, it grows to unsustainable levels. But, reversing tax cuts is often an unpopular political move.

The U.S. federal government has no limitation because it prints money. It can pay for the deficit by issuing new Treasury bills, notes and bonds. As a result, the national debt is almost $20 trillion. That's more than the country produces in a year. For more, see Debt to GDP Ratio.

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 sets up a dangerous situation because they will get voted out of office if the tax cuts are reversed.

The government often increases spending and lowers taxes even when the economy is doing fine. It shouldn't because it creates asset bubbles.  That leads to irrational exuberance and the peak phase of the business cycle. When the bubble bursts, you get contraction and recession. For more on how this works, see What Causes the Boom and Bust Cycle?

Expansionary vs. Contractionary Fiscal Policy

Expansionary policy is used more often than its opposite, contractionary fiscal policy. That's because voters like both tax cuts and more benefits. Therefore, politicians that implement expansionary policy get re-elected. 

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, which worsens the recession. That makes the recession worse.

Expansionary Fiscal Policy vs. Expansionary Monetary Policy

Expansionary monetary policy is when a nation's central bank increases the money supply. It's effective in adding more liquidity in a recession. It can also implement contractionary monetary policy, which raises rates and prevents inflation.

Monetary policy works faster than fiscal policy. The Federal Reserve votes to raise or lower the fed funds rates at its regular FOMC meetings. It may take about six months for the effect to percolate throughout the economy.

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