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What is Fiscal Policy?

What is Fiscal Policy?

A fiscal policy definition is an important aspect of government spending. Here you can find a brief description of how such a definition is used.

Definition of Fiscal Policy

The definition of “Fiscal Policy” is the programs that a government undertakes to provide goods and services to its citizens and the way that a government finances those expenditures. A government’s fiscal policy has an important impact on a country’s financial strength and credit rating because it dictates the ways that a government collects and spends money and also influences the economy.

Expenditures and Taxation

Monies raised by governments to fund their operations are called “Taxes”. Spending programs by governments are called “Expenditures” in formal government budgets. Governments budget over a “Fiscal Period” that might not coincide with the calendar year, hence the term “fiscal policy”. There are two types of expenditures that influence a country’s fiscal policy: money spent on the delivery of goods and services and the transfer of funds to its citizens through other levels of government that are called “Transfer Payments”.

All of the taxes raised and money spent by a government have an effect on its economy. In a Communist or Socialist economy, the government owns the productive “Capital” or “Factors of Production” in its society, which are both physical assets and labour. In a Capitalist economy, private citizens or “Capitalists” control the factors of production and are called the “Private Sector”. Government in a predominately Capitalist society is usually restricted to providing limited goods and services such as national defence, emergency services and other things deemed to be done more efficiently by the “Public Sector”. Transfer payments like Social Security and Unemployment Insurance, which represent taxes collected from some citizens and given to others, are an increasing part of Western democracies’ budgets and fiscal policy.

Fiscal Policy and National Accounting

“Fiscal Policy” refers to the policies that a government uses to influence its economy through its spending and tax policies. The government or public sector is large enough in most Capitalist economies to dramatically influence its economy by changes in taxes or spending policies.
In a country’s “National Accounting”, the value of all goods and services in an economy are added up and called Gross Domestic Product (GDP). When GDP declines in real terms (actual or nominal GDP less price inflation is negative), an economy is said to be in “Recession”. A severe decline in GDP, like that during the 1930s, is called a “Depression”.

Keynesian Economic Stimulus

Governments can spend more during periods of economic weakness and contraction in an economy, helping to “stimulate” the economy and, by extension, consumer confidence. That is the principle behind the “Keynesian School“ of economics, named after John Maynard Keynes, the famous economist. Keynes believed that government spending should replace declining private demand when an economy is in Depression or Recession. The idea is that governments should borrow at low interest rates during a Recession to replace private demand that usually drops as people become afraid in the economic downturn. Keynes thought that governments should also repay their borrowed money as the economy improves.

Stimulus is controversial in a capitalist society. Conservative politicians believe that government should “tighten its belt” in a Recession just like its citizens and cut government spending. In the Great Depression of the 1930s, this is exactly what governments did which led to plunging demand and economic activity with very high levels of unemployment. Keynes observed this and published his General Theory of Employment, Interest and Money in 1936.
Keynes’ ideas became very influential and are the basis for much of current economic thought and policy. Interestingly, as Timothy Geithner recounts in Stress Test, “stimulus” became a negatively perceived policy in the United States in the aftermath of the credit crisis and the Great Recession.

Governments in democratic societies have many different and conflicting objectives, all of which affect their fiscal policies.

The problem with this school of thought is that from a political perspective, it’s very appealing to always spend money. It makes sense for governments to spend borrowed money during a downturn and to help people when they need assistance. It’s also very politically attractive to spend money and help people during a boom time or to try to redistribute goods from one group to another within society.

This is a very common objective of fiscal policy. Liberal politicians in Western democracies often try to redistribute resources to people living in poverty from people with high incomes. Even conservative politicians like to spend money on defence projects that benefit their supporters and constituents.

The catch is that the monies borrowed in a Recession are never repaid in a boom as Keynes intended. Everyone likes to spend, so “Tax and Spend” Liberals and Democrats combine with “Cut Tax and Spend” Conservatives and Republicans to run deficits and build up government debt levels.

Public Goods

The types of goods that governments typically provide are referred to as “Public Goods”. A good or a service is said to be a public good if it’s characterized by an “Externality” or influence other than its price or value. Governments are expected to be able to ascertain the optimal amount of the public good to be supplied and to be able to collect the funds needed to provide it.

How a government judges what is “optimal” and what is “fair” is a very complicated and an extremely political exercise. These kinds of normative questions are answered in a democracy by the citizens voting in an election that selects the government. Socialist and communist societies did this by “Central Planning” through a large bureaucracy without market-based allocation of capital. This has been thoroughly rejected as inefficient, as even Communist China now allows free markets and private capital.

Methods of Taxation and Fiscal Policy

In order to secure financing for its expenditures, the government relies on two methods: taxation and borrowing.

Taxation takes many forms in developed countries, including taxes on personal and corporate income, so-called value-added taxation, and the collection of royalties or taxes on specific sets of goods.

Borrowing involves governments issuing Treasury Bills (T-Bills) or longer term Treasury Bonds (T-Bonds) to fund their “Deficits”, the excess of expenditures over tax and other revenues. After the credit crisis in 2008 the Federal Reserve (Fed) and other central banks bought bonds issued by their governments in a policy called “Quantitative Easing”. This resulted, in the United States, in the Federal Reserve buying more Treasury Bonds than were issued by the U.S. Treasury. This effectively meant the Fed ended up financing the entire deficit and bidding up the price of the existing float of T-Bonds. Quantitative Easing was designed to lower long-term interest rates and to encourage economic activity, so it is a form of both monetary and fiscal policy.

Summary of Fiscal Policy Definition and Objectives

In summary, the definition of fiscal policy is the taxation, finance and spending programs that governments use to affect the economy. Governments in democratic societies have many different and conflicting objectives, all of which affect their fiscal policies. They may use fiscal policy to moderate the down phase of the business and economic cycle by seeking to maintain employment and boost economic growth. They also may use fiscal policy to improve the living standards of their citizens for political or social reasons.

The definition of fiscal policy is complicated but it is a very important concept to understand. Fiscal policy has a huge impact on the overall environment in which people work and invest so it is very important to Joe and Suzy Q Public.

4 years ago

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