| 1. |
Fiscal policy is the manipulation
by the Federal government of its expenditures and tax receipts in order to
expand or contract the economy; and by doing this manipulation
the Federal government
either increases
its real output (and employment) or decreases its rate of inflation.
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| 2. |
The Employment Act of 1946 set the goals of
fiscal policy in the United States and provided for a Council of Economic Advisers to the
president and the Joint Economic Committee.
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| 3. |
Discretionary fiscal policy involves changes in
government spending or taxation by Congress which is designed to change the level of real
GDP
employment
incomes
or the price level. Specific action needs to be taken by Congress to initiate
this policy
in contrast to nondiscretionary fiscal policy that occurs automatically (see
item 4 below).
- Expansionary fiscal policy is generally used to
counteract the negative economic effects of a recession or cyclical downturn in the
economy (a decline in real GDP and rising unemployment). The purpose of the policy is to
stimulate the economy by increasing aggregate demand. Three policy options are used: an
increase in government spending; a reduction in taxes (which increases consumer spending);
or a combination of an increase in government spending and a tax reduction. These policy
actions will create a budget deficit if the budget were in balance before the policy
actions were taken. The stimulative effect on the economy from the initial increase in
spending from the policy change will be increased by the multiplier effect.
- Contractionary fiscal policy is a restrictive
form of fiscal policy generally used to control demand-pull inflation. The purpose of this
policy is to reduce aggregate demand pressures that increase the price level. Three policy
options are used: a decrease in government spending; an increase in taxes (which reduces
consumer spending); or a combination of a reduction in government spending and a tax
increase. If the government budget is balanced before the policy actions are taken
it
will create a budget surplus. The contractionary effect on the economy from the initial
reduction in spending from the policy actions will be reinforced by the multiplier effect.
- In addition to the size of the deficit or
surplus
the manner in which government finances its deficit or disposes of its surplus
affects the level of total spending in the economy.
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- To finance a deficit
the government can either
borrow money from the public or issue new money to creditors
with the latter action being
more expansionary.
- Budget surpluses may be used for debt reduction
or the funds may be impounded
with the latter action being more contractionary.
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- Whether government purchases or taxes should be
altered to reduce recession and inflation depends to a large extent on whether an
expansion or a contraction of the public sector is desired.
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| 4. |
In the U.S. economy
net tax revenues (tax
revenues minus government transfer payments) are not a fixed amount or lump sum; they
increase as the GDP rises and decrease as the GDP falls.
- This net tax system serves as a built-in
stabilizer of the economy because it reduces purchasing power during periods of inflation
and expands purchasing during periods of recession.
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- As GDP increases
the average tax rates will
increase in progressive systems
remain constant in proportional systems
and decrease in
regressive systems; there is more built-in stability for the economy in progressive tax
systems.
- (Built-in stabilizers can only reduce and cannot
eliminate economic fluctuations.
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- The full-employment budget is a better index than
the actual budget of the direction of government fiscal policy because it indicates what
the Federal budget deficit or surplus would be if the economy were to operate at full
employment. In the case of a budget deficit
the full employment budget
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- removes the cyclical portion that is produced by
swings in the business cycle
and
- reveals the size of the structural deficit
indicating how expansionary fiscal policy was that year.
- Historical comparisons between the actual budget
and full-employment budget show which years the discretionary fiscal policy has been
expansionary in recent decades.
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- The large annual deficit the United States has
experienced since the 1980s has led to calls for a balanced-budget amendment. In its
strict form
this amendment would eliminate the use of discretionary fiscal policy to
counter recessions and would be contractionary at a time when expansionary fiscal policy
is needed.
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| 5 |
Certain problems
criticisms
and complications
arise in enacting and applying fiscal policy.
- There will be problems of timing because it
requires time to recognize the need for fiscal policy
to take the appropriate steps in
the Congress
and for the action taken there to affect output
employment
and the rate of
inflation in the economy.
- There will also be political problems because
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- the economy has goals other than full employment
and stable prices
- the fiscal policies of state and local government
run counter to Federal fiscal policy
- there is an expansionary bias (for budget
deficits and against surpluses)
- there may be a political business cycle (if
politicians lower taxes and increase expenditures before and then do the opposite after
elections).
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- An expansionary fiscal policy may
by raising the
level of interest rates in the economy
reduce (or crowd out) investment spending and
weaken the effect of the policy on real GDP; but this crowding-out effect may be small and
can be offset by an expansion in the nation’s money supply.
- The effect of an expansionary fiscal policy on
the real GDP will also be weakened to the extent that it results in a rise in the price
level (inflation). Aggregate demand and aggregate supply curves can be used to show how
crowding out and inflation weaken the effects of an expansionary fiscal policy on real
GDP.
- The connection of the domestic economy to a world
economy means that fiscal policy may be inappropriate or less effective because of
aggregate demand shocks from the world economy or a net export effect that counteracts or
reinforces domestic fiscal policy.
- But an expansionary fiscal policy that includes a
reduction in taxes (tax rates) may
by increasing aggregate supply in the economy
expand
real GDP (and employment)
and reduce inflation. Many economists
however
are skeptical
about these supply-side effects.
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