Fiscal Policy Definition, Purpose, Objectives, Types, Pros and Cons
- March 12, 2021
- Posted by: AMSE
- Category: Forex Trading
One of the first fiscal policy measures undertaken by the Kennedy administration in the 1960s was an investment tax credit. An investment tax credit allows a firm to reduce its tax liability by a percentage of the investment it undertakes during a particular period. With an investment tax credit of 10%, for example, a firm that engaged in $1 million worth of investment during a year could reduce its tax liability for that year by $100,000. The investment tax credit introduced by the Kennedy administration was later repealed. It was reintroduced during the Reagan administration in 1981, then abolished by the Tax Reform Act of 1986.
- Importers can decide to become exporters, and the reverse is also true.
- Still, fiscal policy hasn’t been as effective in countering inflation as many economists hoped.
- The government might issue tax stimulus rebates to increase aggregate demand and fuel economic growth.
- Changes in transfer payments, like changes in income taxes, alter the disposable personal income of households and thus affect their consumption, which is a component of aggregate demand.
- Government spending is fully funded by taxes collected; therefore, government spending equals taxation.
- Fiscal policy’s adaptability addresses emerging challenges effectively.
Effective government spending can keep the economy from shrinking too much, which keeps people employed and businesses open. Governments likewise use fiscal policy to respond to natural disasters, spikes in food or fuel prices or to help citizens deal with problems such as expensive health care. Contractionary fiscal policy is the opposite of expansionary policy.
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Like monetary policy, it can be used in an effort to close a recessionary or an inflationary gap. During periods of economic growth, tax yields rise and spending on welfare payments https://1investing.in/ fall, pushing the public finances towards a surplus. During periods of economic slowdown, tax yields fall and welfare payments rise, pushing the economy towards a fiscal deficit.
The purpose of government expenditure
Keynes argued expansionary fiscal policy is necessary in a recession because of the excess private sector saving which arises due to the paradox of thrift. Expansionary fiscal policy enables unused savings to be used and idle resources to be put into work. Many politicians have found it unfavorable to raise taxes and cut government spending during an economic boom, even when the economy shows signs of overheating. In addition, so-called “automatic stabilizers” in the economy have inhibited the government from taking a more discretionary approach to fiscal policy. Inflation is often treated as a negative from an outside perspective because it causes the price of goods and services to rise. Having a small amount of it is actually healthy for a growing economy because it encourages investment activities.
Central government borrowing
These primarily include changes to levels of taxation and government spending. To cool down an overheating economy, taxes may be raised and spending decreased. The International Monetary Fund (IMF) says fiscal policy is when governments use spending, interest rates and taxes to influence the economy. Typical goals are to reduce poverty and stimulate strong, sustainable economic growth. Certain government expenditure and taxation policies tend to insulate individuals from the impact of shocks to the economy. It typically works on a national level, but not at a global level.
To stimulate a faltering economy, the central bank will cut interest rates, making it less expensive to borrow while increasing the money supply. If the economy is growing too rapidly, the central bank can implement a tight monetary policy by raising interest rates and removing money from circulation. Fiscal policy involves the government changing the levels of taxation and government spending in order to influence aggregate demand (AD) and the level of economic activity. Fiscal policies that could be used to close an inflationary gap include reductions in government purchases and transfer payments and increases in taxes. Expansionary fiscal policy can directly create jobs and economic activity by injecting demand into the economy.
An Overview of Monetary Policy
A contractionary fiscal policy might involve a reduction in government purchases or transfer payments, an increase in taxes, or a mix of all three to shift the aggregate demand curve to the left. Basically, expansionary fiscal policy pushes interest rates up, while
contractionary fiscal policy pulls interest rates down. The rationale behind
this relationship is fairly straightforward. When output increases, the price
level tends to increase as well. This relationship between the real
output and the price level is implicit. According to the theory of money
demand, as the price level rises, people demand more money to purchase goods
This could be the case when interest rates are already low, but the economy still needs stimulating, as occurred throughout the advanced economies following the financial crisis and consequent global recession. Public policymakers thus face differing incentives relating to whether to engage in expansionary or contractionary fiscal policy. Therefore, the preferred tool for reining in unsustainable growth is usually a contractionary monetary policy. Monetary policy involves the Federal Reserve raising interest rates and restraining the supply of money and credit in order to rein in inflation.
Effects Have a Time Lag
If these traditional measures fall short, central banks can undertake unconventional monetary policies such as quantitative easing (QE). Fiscal policy, on the other hand, determines the way in which the central government earns money through taxation and how it spends money. To stimulate the economy, a government will cut tax rates while increasing its own spending; while to cool down an overheating economy, it will raise taxes and cut back on spending. Monetary policy involves the management of the money supply and interest rates by central banks.
For example, the ProShares Short Bitcoin ETF (BITI) enables investors to short Bitcoin, meaning the price of the ETF rises when Bitcoin falls and vice versa. Any government program that tends to reduce fluctuations in GDP automatically is called an automatic stabilizer. Automatic stabilizers tend to increase GDP when it is falling and reduce GDP when it is rising. Borrowing to fund spending will add to the national debt and can create an excessive debt burden for future generations. Public spending can be targeted to achieve a wide range of specific economic objectives, such as reducing unemployment, achieving more equity, road building, action against poverty, and re-building city centres.
A reduction in the investment tax credit, or an increase in corporate income tax rates, will reduce investment and shift the aggregate demand curve to the left. As we begin to look at deliberate government efforts to stabilize the economy through fiscal policy choices, we note that most of the government’s taxing and spending is for purposes other than economic stabilization. For example, the increase in defense spending in the early 1980s under President Ronald Reagan and in the administration of George W. Bush were undertaken primarily to promote national security. That the increased spending affected real GDP and employment was a by-product. The effect of such changes on real GDP and the price level is secondary, but it cannot be ignored.
Whether it’s a struggling sector, a burgeoning industry, or a specific demographic, fiscal measures can be tailored to address precise challenges or opportunities. Conversely, cutbacks in areas can signal a shift in priorities, often with ripple effects throughout the economy. It’s not just about how much a government spends but where it allocates its resources. Infrastructure, healthcare, defense, education—the choices are vast, each with its ramifications on the economy. Full employment doesn’t mean a zero unemployment rate but rather when all available labor resources are being used efficiently. If more money is available in circulation, then the value of each unit is worth less if demand levels remain the same.
While it can be used effectively to reduce budget deficits, combat unemployment and increase domestic consumption, it usually takes some time to be implemented and can give rise to conflicts between objectives. This kind of policy is set when the government is spending more than the taxes collected. It is usually used during recessions when there are high levels of unemployment and the majority of the businesses are not doing to increase the level of economic activity in a nation.
Our focus here, however, is on discretionary fiscal policy that is undertaken with the intention of stabilizing the economy. As we have seen, the tax cuts introduced by the Bush administration were justified as expansionary measures. While expansionary and contractionary fiscal policy both directly affect the
national income, the ultimate change in output is not always equal to the policy
The advantage of using fiscal policy is that it will help to reduce the budget deficit. During a recession, out-of-work individuals can receive income assistance through unemployment insurance. On a larger economic scale, this program can help prevent disposable incomes from dropping to low levels that risk further slowing the economy.