Fiscal policy is the use of government spending and taxation to influence the economy towards positive direction. Governments typically use fiscal policy to promote strong and sustainable growth and reduce poverty. Taxes are engine of growth whereas spending is fruit of growth. If government wisely tax and spend an economy can develop.
There are two key economic policies: fiscal and monetary. Stabilization is the primary purpose of fiscal policy.
Besides providing goods and services like public safety, highways, or primary education, fiscal policy objectives vary. In the short term, governments may focus on macroeconomic stabilization—for example, expanding spending or cutting taxes to stimulate an ailing economy, or slashing spending or raising taxes to combat rising inflation or to help reduce external vulnerabilities. In the longer term, the aim may be to foster sustainable growth or reduce poverty with actions on the supply side to improve infrastructure or education. Although these objectives are broadly shared across countries, their relative importance differs, depending on country circumstances. In the short term, priorities may reflect the business cycle or response to a natural disaster or a spike in global food or fuel prices. In the longer term, the drivers can be development levels, demographics, or natural resource endowments. The desire to reduce poverty might lead a low-income country to tilt spending toward primary health care, whereas in an advanced economy, pension reforms might target looming long-term costs related to an aging population. In an oil-producing country, policymakers might aim to better align fiscal policy with broader macroeconomic developments by moderating procyclical spending—both by limiting bursts of spending when oil prices rise and by refraining from painful cuts when they drop.
Response to the global crisis
The global crisis that had its roots in the 2007 meltdown in the U.S. mortgage market is a good case study in fiscal policy. The crisis hurt economies around the globe, with financial sector difficulties and flagging confidence hitting private consumption, investment, and international trade (all of which affect output, GDP). Governments responded by trying to boost activity through two channels: automatic stabilizers and fiscal stimulus—that is, new discretionary spending or tax cuts. Stabilizers go into effect as tax revenues and expenditure levels change and do not depend on specific actions by the government. They operate in relation to the business cycle. For instance, as output slows or falls, the amount of taxes collected declines because corporate profits and taxpayers’ incomes fall, particularly under progressive tax structures where higher-income earners fall into higher-tax-rate brackets. Unemployment benefits and other social spending are also designed to rise during a downturn. These cyclical changes make fiscal policy automatically expansionary during downturns and contractionary during upturns.
Automatic stabilizers are linked to the size of the government, and tend to be larger in advanced economies. Where stabilizers are larger, there may be less need for stimulus—tax cuts, subsidies, or public works programs—since both approaches help to soften the effects of a downturn. Indeed, during the recent crisis, countries with larger stabilizers tended to resort less to discretionary measures. In addition, although discretionary measures can be tailored to stabilization needs, automatic stabilizers are not subject to implementation lags as discretionary measures often are. (It can take time, for example, to design, get approval for, and implement new road projects.) Moreover, automatic stabilizers—and their effects—are automatically withdrawn as conditions improve.
Fiscal ability to respond
The exact response ultimately depends on the fiscal space a government has available for new spending initiatives or tax cuts—that is, its access to additional financing at a reasonable cost or its ability to reorder its existing expenditures. Some governments were not in a position to respond with stimulus, because their potential creditors believed additional spending and borrowing would put too much pressure on inflation, foreign exchange reserves, or the exchange rate—or delay recovery by taking too many resources from the local private sector (also known as crowding out). Creditors may also have doubted some governments’ ability to spend wisely, to reverse stimulus once put in place, or to address long-standing concerns with underlying structural weaknesses in public finances (such as chronically low tax revenues due to a poor tax structure or evasion, weak control over the finances of local governments or state-owned enterprises, or rising health costs and aging populations).
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