Fiscal Policy

Fiscal policy refers to the spending and taxing policies of the federal government. Fiscal policy can influence total demand in the economy by changing taxes and government spending. Expansionary fiscal policy, for example, implements tax cuts, increases government spending, or both, to increase economic activity during business downturns. Fiscal policy can also affect incentives to work, save, invest, and innovate. Changes in taxes on capital, for example, affect the after-tax return on investment in physical assets and thus the incentive for capital accumulation.

Automatic stabilizers act as buffers when the economy weakens by automatically reducing taxes and increasing government spending. Mandatory spending for programs such as unemployment insurance, food stamps, welfare programs, and Medicaid increases when the economy slows down because benefit criteria depend upon income or employment status. These transfer payments help consumers maintain spending. The tax system as a whole also acts as an automatic stabilizer. In an economic slump, personal income and corporate profits are lower, so tax payments fall, thus helping to reduce the decline in after-tax incomes that might otherwise occur. Government revenues from excise and other sales-based taxes also fall when purchases decline. In fact, taxes typically change by a larger proportion than GDP, primarily because average income tax rates fall with income levels. This feature of the tax system makes after-tax income more stable than pretax income, which helps insulate consumption spending from changes in income.

Discretionary policy refers to new changes in spending and taxes. Classic examples of discretionary fiscal policy include the 2001 tax cut intended to stimulate spending and economic expansion, and the income tax surcharge of 1968 designed to curb rising inflation. Because the change in total expenditures determines whether policy has been expansionary or contractionary, it is difficult to attribute expansionary fiscal policy to specific acts of spending. For example, increased highway spending is expansionary only if it is not offset by a decline in some other appropriation. Nevertheless, net changes in discretionary spending by federal, state, and local governments can have significant effects on the overall economy.

Discretionary fiscal policy can also have a dramatic influence on the economy through its effects on the federal deficit. As shown in Figure 16.5, long-term budget balance projections differ widely under various policy assumptions. For example, if discretionary federal spending grows with GDP, projected surpluses will gradually diminish and be eliminated by 2059. Projected surpluses will be eliminated more quickly with tax cuts, like that passed in 2001, or with more rapid spending increases.

economic expectations

Anticipated financial considerations

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