"Fiscal policy" refers to decisions the U.S. government makes about spending and collecting taxes and how these policy changes influence the economy. When the government makes financial decisions, it has to consider the effect those decisions will have on businesses, consumers, foreign markets and other interested entities.
Learn what fiscal policy is, how it works and how the government uses it to influence the U.S. economy.
What Is Fiscal Policy?
"Fiscal policy" is the term used to describe the actions a government takes to influence an economy by purchasing products and services from businesses and collecting taxes. It also refers to the economic intent behind the decisions for how the money is used.
Governments lower taxes and raise spending to boost the economy if needed; typically, they spend on infrastructure projects that create jobs and income and social programs.
If the economy is doing well, it can reduce spending and increase taxes. Businesses create enough jobs at these times so officials can reduce the amount spent on goods and services from the private sector.
How Fiscal Policy Works
Economies follow an oscillating pattern where they expand, peak, contract, and trough. This pattern is often called the business or economic cycle. When an economy is experiencing growth—expanding—employment rates and consumer income are generally higher. Business profits are high, investors are happy, and the population spends more on luxury and non-necessity items.
When the economy contracts, investors begin to turn to capital preservation strategies, businesses start cutting expenses, and unemployment tends to rise. Consumers generally have less income and begin to save more than they spend.
Fiscal policy is used in conjunction with the monetary policies of the Federal Reserve (the Fed), which uses the supply of money and interest rates to influence inflation and lending.
The objectives of fiscal and monetary policy are to control the expansion and contraction of the economy. During a recession, the government works to keep money in the accounts of businesses and consumers, and The Fed works to increase lending and spending. In a boom, they do the opposite.
The government has two tools it uses when implementing fiscal policy. The first tool is collecting taxes on business and personal income, capital gains, property, and sales. Taxes provide the revenue that funds the government.
The second tool is government spending—funds are directed into subsidies, welfare programs, public works, infrastructure projects, and government jobs. Government spending puts more money back into the economy, which increases demand for products and services.
Types of Fiscal Policy
Legislators can take two types of measures to control economic swings—discretionary fiscal policies and automatic stabilizers. Automatic stabilizers are tools built into federal budgets that adjust taxes and spending. They create automated fiscal actions if specific economic conditions are met.
Discretionary fiscal policies are the measures most commonly referred to when fiscal policy is talked about. The government has two types of discretionary fiscal policy options—expansionary and contractionary.
Each type of fiscal policy is used during different phases of the economic cycle to stop or slow recessions and booms.
Expansionary Fiscal Policy
Expansionary fiscal policy involves the measures taken by the government to put more money back into the economy. This generally creates demand for products and services. It creates jobs and increases profits—stimulating economic growth.
Congress uses it to slow the contraction phase of the business cycle—usually called a "recession." The government either spends more, cuts taxes, or does both. The idea is to put more money into consumers' hands to induce them to spend more. The increased demand forces businesses to add jobs to increase supply, output, and consumer spending.
The second type of fiscal policy is contractionary, used during economic booms. Since expansions can also be dangerous for an economy, the government tries to slow them down they become too intense.
Too much growth can fuel investor exuberance and overconfidence (as well as greed), creating market bubbles or other unforeseen economic dangers. Contractionary fiscal policies are enacted to try to slow growth to a more manageable level and control inflation.
The government begins collecting more taxes and reduces spending to keep investment prices down and to raise the unemployment rate. The economy needs a certain amount of unemployed workers for businesses to hire—if companies can't find workers, production growth slows down.
The Fed views a small increase in inflation to be a potentially good thing for the economy.
The U.S. economy tends to spend more time expanding than contracting. This means the government uses contractionary fiscal policies more than it does expansionary fiscal policies.
Fiscal Policy vs. Monetary Policy
Monetary policy differs from fiscal policy in that decisions are made to change the U.S dollar's purchasing power, and interest rates are managed to influence the economy. The Federal Open Market Committee (FOMC) creates changes that increase or decrease the supply of money or the federal funds rate—the interest rate that influences all others.
The Federal Reserve (the Fed) has several tools to increase and decrease interest rates or the dollar value. Most common are raising or lowering the "interest on excess reserves" (IOER) and "overnight reverse repurchase" agreements (ON RRP). These two tools are used at the same time to influence the federal funds rate.
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 more quickly than fiscal policy. The Federal Open Market Committee meets eight times per year and votes to raise or lower rates. However, it can take up to six months for rate changes to impact the economy.
History of Fiscal Policy in the U.S.
Until the Great Depression, most fiscal policies followed the laissez-faire economic theory. Politicians believed they shouldn't interfere with capitalism in a free market economy, but Franklin D. Roosevelt (FDR) changed that by promising a New Deal to end the Great Depression.
Roosevelt's plans implemented expansionary fiscal policies by spending to build roads, bridges, and dams. The federal government hired millions of workers for these projects.
In 1934 the economy grew by 10.8%. It increased by 8.9% in 1935 and again by 12.9% in 1936. To slow the growth, FDR implemented contractionary fiscal policies, which cut government spending. By 1938, the economy had decreased by 3.3%.
The depression might have ended, but unemployment was still high during the 1940s with many people looking for work after war-time production had begun to shut down. Congress passed the Employment Act of 1946 to give the government the ability to enact policies to keep employment and production high.
Fiscal policies generally take the form of funding from the government to accomplish policy objectives.
In 1978, Congress passed the Full Employment and Balanced Growth Act (Humphrey-Hawkins Act), amending the Employment Act of 1946. This law set target goals of reducing the unemployment rate to less than 3% for people over age 20 and keeping inflation under 3%—with the additional purpose of reducing inflation by 1988 to zero.
The Humphrey-Hawkins Act was expansionary. It also tried to use federal assistance to expand private and public employment while building stockpiles of materials and commodities in an attempt to fuel growth.
President George W. Bush enacted the Economic Growth and Tax Relief Reconciliation Act of 2001 and the Jobs and Growth Tax Relief Act of 2003. The intent behind these two laws was to cut taxes to stimulate economic growth. However, the tax cuts truly only benefitted the top one-fifth of households and created mediocre growth at best.
Current Fiscal Policy
The coronavirus impacted the U.S. and global economy, causing businesses to shut down and people to lose jobs. The U.S. economy drifted into a contractionary state.
To stabilize financial markets and provide backstop liquidity, the Federal Reserve implemented a massive monetary easing program. Simultaneously, to stimulate the economy when restrictions kept most people at home, Congress took expansionary measures by passing the Coronavirus Aid, Relief, and Economic Security (CARES) Act to provide emergency funding for small businesses and workers hit hard by the virus.
Economic impact payments were sent out to households to help with expenses; businesses received help via the Paycheck Protection Program (PPP) to help them cover overhead and keep employees working.
In March 2021, the American Rescue Plan Act sent another round of impact payments to Americans and extended unemployment insurance. It also provided funding for food, health care, education improvements, and small businesses as the pandemic eased its grip.