Which approach to fiscal policy involves and increase in taxation and decrease in spending?

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Definition of Fiscal Policy:
The purpose of Fiscal Policy
Expansionary (or loose) fiscal policy
Diagram showing effect of expansionary fiscal policy
Deflationary (or tight) fiscal policy
UK fiscal policy
Fine tuning – fiscal policy
Terms relating to fiscal policy
Criticism of fiscal policy
Evaluation of fiscal policy
US fiscal policy

Definition of Fiscal Policy:

Fiscal policy involves the use of government spending and taxation to manage the economy. Here is a quick video that explains Fiscal Policy in more detail:

Every economy journeys through business cycles. Expansionary periods occur when businesses thrive, income levels increase, and consumers and businesses spend more money. Increasing demands enable businesses to increase their prices. Unfortunately, expansions must end and recessions may follow when a country’s production decreases, resulting in workers losing their jobs. The resulting dip in consumer income leads to further declines in consumer purchases. Fiscal policy is used by the government to influence the business cycle by changing tax policies, spending policies, or both. Economists generally agree that in time the economy will correct itself and reach long-run equilibrium, but how long will it take? John Maynard Keynes promoted an activist, expansionary fiscal policy that focused on manipulating aggregate demand. He developed Keynesian economics during the Great Depression to explain the Depression and identify a strategy to return to prosperity. During recessionary periods, Keynesians advocate increasing aggregate demand with government spending to pull an economy out of the doldrums sooner. Keynesian policies were endorsed by President Franklin Roosevelt in establishing the New Deal, which most economists believe helped pull the US out of the Great Depression. Of course, the government spending to finance the weaponry and troops in World War II also helped increase the aggregate demand. Keynes’ views still influence policymakers today. During recessions, the government uses expansionary fiscal policy to boost aggregate demand by providing consumers and businesses more money to spend. Social Security, Medicare, and unemployment insurance are examples of government paying consumers directly. Consumers then use the money to purchase more goods and services. Reducing the tax burden is another way to increase the money consumers and businesses can spend, by reducing the amount taxpayers pay the government. An increase in government spending is more direct. Here the government can target a demographic group or industry it wants to help. For example, an increase in unemployment insurance helps the unemployed. During his campaign, President Trump expressed his intent on investing in the US infrastructure. Companies and workers employed in building or repairing the US’s infrastructure directly benefit, but the benefits are shared because the workers use their added income to purchase more of the goods and services from unrelated businesses.

Graph 1 illustrates how an increase in aggregate demand during a recession generates an increase in an economy’s real gross domestic product (RGDP). Assume the government cuts taxes while increasing spending, causing an increase in the aggregate demand from AD1 to AD2. SRAS is the short-run aggregate supply curve and represents the aggregated amount producers would produce at a given price level over a short period. The LRAS is the long-run aggregate supply curve. It is the long-run potential of an economy. (For a more thorough explanation of aggregate demand and aggregate supply please visit our lessons describing the aggregate supply and demand model in the Managing the Economy catalog.) When the economy is performing at RGDP1, production is less than optimal. Workers and other resources are under-utilized. Increasing the aggregate demand to AD2 puts these resources back to work.

Graph 1

However, there is a cost. The price level would increase from PL1 to PL2. The increase in the price level is minimal when production occurs on the flatter portion of the SRAS curve. This helps explain why the fiscal stimulus following the Great Recession did not generate much inflation. However, inflationary pressures would increase if the government continued to use an expansionary fiscal policy after reaching the long-run equilibrium. Demand would exceed the normal capacity of factories, resulting in the need to pay higher wages to either attract workers away from competitors or pay workers overtime. Inflation would become a problem. This is seen in Graph 2 where the expansionary fiscal policy continues beyond the LRAS. In this case, there is a small increase in RGDP from RGDP1 to RGDP2, but a large increase in the price level from PL1 to PL2. When the economy is overheated, or at the peak of a business cycle, inflation frequently becomes a concern. During these periods an economy's output is beyond its long-term capacity.

Graph 2

Long-distance runners must pace themselves. They can sprint for short periods but tire and ultimately hurt their performance. The same is true with an economy. Economists use similar terms such as “tired”, “overheated”, and “spent” to describe this phase. During these periods, manufacturers may defer maintenance to continue meeting demand. Workers may tire and become less productive when working overtime for extended periods. Contractionary fiscal policy is used to slow the rates of economic growth and inflation during these overheated periods. Spending is reduced and taxes are increased. The effect is the opposite of expansionary fiscal policy. The table below summarizes the actions and reasons for expansionary and contractionary fiscal policy.

A shortcoming of fiscal policy is the time it takes to implement a policy. Timing is crucial. Economists frequently disagree on whether the economy is approaching a recession, or whether inflationary pressures are short-term or long-term. After recognition, there may be a lag in deciding the best course of action. Assume the economy is in a recession. Some in Congress may believe the economy is showing signs of recovering on its own and would promote doing nothing to stimulate the economy. Others may favor tax cuts to stimulate the economy, while others would push for increases in government spending. Getting the government to agree on a course of action may take months. Compromises may be made, which may dilute the policy. By the time a fiscal policy is enacted, the economy may have recovered. The stimulus Congress imposed may in fact be counter-productive and inflationary! It is also possible that as a recession worsens, a watered-down policy may prove insufficient. Finally, there is an operational lag. Even if a new policy is passed, it takes time to implement. Consumers must “feel” wealthier to spend. Businesses must recognize the need to invest before they actually invest. This process may take many months. Furthermore, it is much easier for the government to spend than to cut spending. For example, Social Security is the largest budget item, but most elected officials say cutting Social Security is not a viable option. Likewise, the deduction of mortgage interest is a large tax break – but reducing the deduction is rarely considered as a contractionary tool. The result has been continued expansionary policies and a growing national debt. Adding to the national debt raises interest rates which “crowds out” private investment because higher rates discourage some business investments. Future generations are obligated to pay back the debt – again taking money away from investments that could promote long-term economic growth. Business Cycles
Aggregate Supply and Demand – Macroeconomic Equilibrium
Fiscal Policy – Managing The Economy by Taxing and Spending
Gross Domestic Product – Measuring an Economy's Performance
Monetary Policy – The Power of an Interest Rate
The Federal Budget and Managing The National Debt

Definition of fiscal policy

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.

AD is the total level of planned expenditure in an economy (AD = C+ I + G + X – M)

The purpose of Fiscal Policy

Stimulate economic growth in a period of a recession.
Keep inflation low (the UK government has a target of 2%)
Fiscal policy aims to stabilise economic growth, avoiding a boom and bust economic cycle.

Fiscal policy is often used in conjunction with monetary policy. In fact, governments often prefer monetary policy for stabilising the economy.

Expansionary (or loose) fiscal policy

This involves increasing AD.
Therefore the government will increase spending (G) and cut taxes (T). Lower taxes will increase consumers spending because they have more disposable income (C)
This will tend to worsen the government budget deficit, and the government will need to increase borrowing.

Diagram showing effect of expansionary fiscal policy

Deflationary (or tight) fiscal policy

This involves decreasing AD.
Therefore the government will cut government spending (G) and/or increase taxes. Higher taxes will reduce consumer spending (C)
Tight fiscal policy will tend to cause an improvement in the government budget deficit.

Diagram showing the effect of tight fiscal policy

UK fiscal policy

UK Budget deficit

In 2009, the government pursued expansionary fiscal policy. In response to a deep recession (GDP fell 6%) the government cut VAT in a bid to boost consumer spending. This caused a big rise in government borrowing (2009-10). (Government borrowing also rose because of the recession leading to lower tax revenue)

When the new coalition government came into power in May 2010, they argued the deficit was too high and then announced plans to reduce government borrowing. This involved spending limits. These austerity measures were a factor in causing lower economic growth in 2011 and 2012.

Fine tuning – fiscal policy

Definition of Fine Tuning: This involves maintaining a steady rate of economic growth by using fiscal policy. For example, if growth is below the trend rate of growth, the government can cut tax to boost spending and economic growth. If growth is too fast and inflationary, the government can increase income tax to slow down consumer spending and reduce economic growth.
In theory, the government can make incremental changes to spending and taxation levels to slow down or speed up the economy.

Difficulties of fine tuning

In the real world, fine tuning is difficult to achieve due to several factors.

Time lags. It takes several months for government spending to feed its way into the economy. By the time government spending increases it may be too late.
Political costs. Raising taxes to reduce inflation will impose political costs as people will not like the idea of higher taxes. Before an election it would be hard for government to raise taxes – merely to fine tune economic growth rate.
Difficulty of forecasting. Fine tuning requires good information about current state of economy and likely forecasts of growth. Governments may struggle to know the extent of the output gap.

Terms relating to fiscal policy

Fiscal Stance: This refers to whether the government is increasing AD or decreasing AD, e.g. expansionary or tight fiscal policy
Automatic fiscal stabilisers – If the economy is growing, people will automatically pay more taxes ( VAT and Income tax) and the Government will spend less on unemployment benefits. The increased T and lower G will act as a check on AD. But, in a recession, the opposite will occur with tax revenue falling but increased government spending on benefits, this will help increase AD
Discretionary fiscal stabilisers – This is a deliberate attempt by the government to affect AD and stabilise the economy, e.g. in a boom the government will increase taxes to reduce inflation.
Primary budget deficit – a measure of government spending – tax receipts but ignoring interest payments on the debt.
The multiplier effect. When an increase in injections causes a bigger final increase in Real GDP.

Injections (J) – This is an increase of expenditure in the circular flow, it includes govt spending(G), Exports (X) and Investment (I)
Withdrawals (W) – This is leakages from the circular flow This is household income that is not spent on the circular flow. It includes: Net savings (S) + Net Taxes (T) + Net Imports (M)

Criticism of fiscal policy

The government may have poor information about the state of the economy and struggle to have the best information about what the economy needs.
Time lags. To increase government spending will take time. It could take several months for a government decision to filter through into the economy and actually affect AD. By then it may be too late.
Crowding out. Some economists argue that expansionary fiscal policy (higher government spending) will not increase AD because the higher government spending will crowd out the private sector. This is because the government have to borrow from the private sector who will then have lower funds for private investment.
Government spending is inefficient. Free market economists argue that higher government spending will tend to be wasted on inefficient spending projects. Also, it can then be difficult to reduce spending in the future because interest groups put political pressure on maintaining stimulus spending as permanent.
Higher borrowing costs. Under certain conditions, expansionary fiscal policy can lead to higher bond yields, increasing the cost of debt repayments.

Criticisms of Fiscal Policy – More detail on criticisms of fiscal policy

Evaluation of fiscal policy

The success of fiscal policy will depend on several factors, such as

It depends on the size of the multiplier. If the multiplier effect is large, then changes in government spending will have a bigger effect on overall demand.
It depends on the state of the economy. Fiscal policy is most effective in a deep recession where monetary policy is insufficient to boost demand. In a deep recession (liquidity trap). Higher government spending will not cause crowding out because the private sector saving has increased substantially. See: Liquidity trap and fiscal policy – why fiscal policy is more important during a liquidity trap.
It depends on other factors in the economy. For example, if the government pursue expansionary fiscal policy, but interest rates rise, and the global economy is in a recession, it may be insufficient to boost demand.
Bond yields. If there is concern over the state of government finances, the government may not be able to borrow to finance fiscal policy. Countries in the Eurozone experienced this problem in the 2008-13 recession.

Brief history of fiscal policy

Keynes advocated the use of fiscal policy as a way to stimulate economies during the great depression.
Fiscal Policy was particularly used in the 50s and 60s to stabilise economic cycles. These policies were broadly referred to as ‘Keynesian’
In the 1970s and 80s governments tended to prefer monetary policy for influencing the economy. Fiscal policy became more prominent during the great depression of 2008-13