Fiscal Policy Types, Objectives, and Tools
How Congress Manipulates the Economy
Fiscal policy is how Congress and other elected officials influence the economy using spending and taxation. It is used in conjunction with the monetary policy implemented by central banks, and it influences the economy using the money supply and interest rates.
The objective of fiscal policy is to create healthy economic growth. Ideally, the economy should grow between 2%–3% a year, unemployment will be at its natural rate of 3.5%–4.5%, and inflation will be at its target rate of 2%. The business cycle will be in the expansion phase.
Expansionary Fiscal Policy
There are two types of fiscal policy. The most widely-used is expansionary, which stimulates economic growth. Congress uses it to end the contraction phase of the business cycle when voters are clamoring for relief from a recession. The government either spends more, cuts taxes, or both. The idea is to put more money into consumers' hands, so they spend more. The increased demand forces businesses to add jobs to increase supply.
Politicians debate about which works better. Advocates of supply-side economics prefer tax cuts because they say it frees up businesses to hire more workers to pursue business ventures. Advocates of demand-side economics say additional spending is more effective than tax cuts. Examples include public works projects, unemployment benefits, and food stamps. The money goes into the pockets of consumers, who go right out and buy the things businesses produce.
An expansionary fiscal policy is impossible for state and local governments because they are mandated to keep a balanced budget. If they haven't created a surplus during the boom times, they must cut spending to match lower tax revenue during a recession. That makes the contraction worse. Fortunately, the federal government has no such constraints; it's free to use expansionary policy whenever it's needed. Unfortunately, it also means Congress created budget deficits even during economic booms—despite a national debt ceiling. As a result, the critical debt-to-gross domestic product ratio has exceeded 100%.
Contractionary Fiscal Policy
The second type of fiscal policy is contractionary fiscal policy, which is rarely used. Its goal is to slow economic growth and stamp out inflation. The long-term impact of inflation can damage the standard of living as much as a recession. The tools of contractionary fiscal policy are used in reverse. Taxes are increased, and spending is cut. You can imagine how wildly unpopular this is among voters. Only lame duck politicians could afford to implement contractionary policy.
The first tool is taxation. That includes income, capital gains from investments, property, and sales. Taxes provide the income that funds the government. The downside of taxes is that whatever or whoever is taxed has less income to spend on themselves, which is why taxes are unpopular.
The second tool is government spending—which includes subsidies, welfare programs, public works projects, and government salaries. Whoever receives the funds has more money to spend, which increases demand and economic growth.
The federal government is losing its ability to use discretionary fiscal policy because each year more of the budget must go to mandated programs. As the population ages, the costs of Medicare, Medicaid, and Social Security are rising. Changing the mandatory budget requires an Act of Congress, and that takes a long time. One exception was the American Recovery and Reinvestment Act. Congress passed it quickly to stop the Great Recession.
Fiscal Policy vs. Monetary Policy
Monetary policy is the process by which a nation changes the money supply. The country’s monetary authority increases supply with expansionary monetary policy and decreases it with contractionary monetary policy. It has many tools it can use, but it primarily relies on raising or lowering the fed funds rate. This benchmark rates then guides all others.
When interest rates are high, the money supply contracts, the economy cools down, and inflation is prevented. When interest rates are low, the money supply expands, the economy heats up, and a recession is usually avoided.
Monetary policy works faster than fiscal policy. The Fed votes to raise or lower rates at its regular Federal Open Market Committee meeting but may take about six months for the impact of the rate cut to percolate throughout the economy. Lawmakers should coordinate fiscal policy with monetary policy, but they usually don't because their fiscal policy reflects the priorities of individual lawmakers. They focus on the needs of their constituencies.
These local needs often overrule national economic priorities, and as a result, fiscal policy often runs counter to what the economy needs. Central banks are forced to use monetary policy to offset poorly planned fiscal policy.
Current Budget Spending
Congress outlines U.S. fiscal policy priorities in each year's federal budget. By far, the largest portion of budget spending is mandatory, which means that existing laws dictate how much will be spent. Most of this is for Social Security, Medicare, and Medicaid entitlement programs. The remaining portion of spending is discretionary, and more than half of this goes toward defense. The current fiscal policy has created the massive U.S. debt level.
Until the Great Depression, most fiscal policies followed the laissez-faire economic theory. Politicians believed that they must not interfere with capitalism in a free market economy, but Franklin D. Roosevelt (FDR) changed that by promising a New Deal to end the Depression. He followed the Keynesian economic theory, which said government spending could end the Depression by stimulating consumer demand. He exemplified expansionary fiscal policy by spending to build roads, bridges, and dams. The federal government hired millions, putting people back to work, and they spent their income on personal goods, driving demand.
FDR ended the Depression in 1934 when the economy grew 10.8%. It then increased by 8.9% in 1935 and 12.9% in 1936. But in 1937, FDR worried about balancing the budget. He used contractionary fiscal policy, and cut government spending, and in 1938, the economy decreased by 3.3%.
In 1939, FDR renewed an expansionary fiscal policy to gear up American involvement in World War II. He spent 30 times more in 1943 on the war than he did in 1933 on the New Deal. That aggressive level of expansionary fiscal policy ended the Depression for good.