The Economic Basis and Development of Fiscal Policy

Economic basis for Fiscal Policy

Fiscal policy is designed to influence the prevailing tax rates and the spending of the consumers within the country. This is when the government legislates changes to the prevailing tax rates to stimulate economic activity. This is usually done by reducing taxes using tax cuts to stimulate consumption, expenditure, and investment (Modjtahedi, 2011)

Policy and Challenges

Two types of fiscal policy, i.e., expansionary fiscal policy and contractionary fiscal policy exist. Expansionary fiscal policy, which is designed to encourage economic growth, is the most commonly employed by governments. Owing to its nature, the expansionary fiscal policy is predominantly employed in recessions by reducing taxes or increasing government expenditure. Contractionary fiscal policy, which is designed to slow economic growth, is rarely used by governments. Owing to its nature, it is mainly employed to reduce inflation. Contractionary fiscal policies reduce government expenditure and increase taxes (Mankiw, 2014).

Employing fiscal policy has been associated with a number of challenges. Fiscal policy has been found to be less effective in creating a stable economic environment compared to monetary policy. Tax cuts have been identified to be less effective in the long-term compared to increasing government expenditure.

Additionally, fiscal policy, in the form of legislating changes to taxes, is a lengthy process. Furthermore, when these changes to the taxes rates are successful, changes to expenditure also take a considerable amount of time to adjust accordingly owing to the independent spending habits of economic agents in the economy, i.e., government, households, individuals, companies, and business (McConnell, Brue, & Flynn, 2014). It is a gamble by the government as it can never guarantee that consumer expenditure will be directed towards the desired objective. Expansionary fiscal policy can increase inflation when used incorrectly. In cases where a shortage of resources is responsible for slow economic growth as opposed to lower demand, employing fiscal policy has the potential of increasing the level of inflation in the economy.

Development of fiscal policy

Tools used in implementing fiscal policy

As mentioned before, fiscal policy is realized and implemented through two main tools, i.e., taxes and government spending. Tax is the main source of revenue for the government, as such regulating the amount of taxes imposed on different aspects of the economy can either spur or slow economic growth in the long-run.

Government spending entails all activities that entail government salaries, transfer payments (also include welfare programs) subsidies, and public works projects. By increasing or reducing expenditure in these areas, the government can either spur or slow economic growth. This tool aims at directly increasing or decreasing the demand for goods and services to spur or slow economic growth. Government spending can be designed to influence the balance of trade to directly influence demand.

Economic tradeoffs in implementing Fiscal Policy

While implementing fiscal policy can be designed to positively affect the economy relative to the prevailing conditions, there are some economic tradeoffs associated with implementation. As discussed above, taxes are a vital tool for the implementation of fiscal policy. However, instituting tax cuts does not guarantee an immediate impact on consumer spending. Because individual economic agents make decisions independently to a large extent, consumers can opt to save the increase in disposable income in a recessionary period.

While the expansionary fiscal policy is designed to increase or spur economic growth and development, there exists a potential economic tradeoff where the crowding-out effect may be realized. As a result of the increase in government expenditure and the increase in competitors in different industries, the suppliers may exceed the market demand, leading to crowding out and a reduction of aggregate demand. Additionally, expansionary fiscal policy inherently leads to a fiscal deficit. However, there is an underlying limit to the amount of deficit that a government can tolerate in the long-run.

Political Challenges in implementing Fiscal Policy

Effectively and successfully employing fiscal policy is wrought with significant political challenges. Fiscal policy that is aimed at adjusting the prevailing tax rates is usually faced with a considerable amount of political backlash owing to the direct impact it has on consumer spending, except a reduction in taxes (Mankiw, 2014). Furthermore, implementing and realizing the impact of fiscal policy decisions may experience a lag.

Additionally because mandated programs, such as social security, Medicare, and Medicaid, are increasingly taking up a larger portion of the federal government’s budget, changing the mandatory budget is considerably difficult. Fiscal policy that directly affects the allocations to mandated programs requires an Act of Congress, a process, and procedure that entails lengthy and extensive lobbying and negotiations. As such, implementing fiscal policy is wrought with significant political challenges compared to implementing monetary policy.

Recent U.S. Ten-year Fiscal Policy History

Over the past 10 years, the lion’s share of the U.S. Government’s fiscal policy has been directed towards mandatory programs. Through mandatory fiscal policy, a predetermined level of government expenditure is required for critical government and welfare programs, such as Social Security, Medicaid, and Medicare. The share allocated to mandatory expenditure has been increasing over the past decade, inherently reducing the U.S. Government’s ability to use discretionary fiscal policy. This reduced ability to use discretionary fiscal policy is exacerbated by the fact that more than 50% of discretionary fiscal policy is directed towards defense.

Figure 1: Projected Growth of the U.S. Economy and Federal Spending for Major Mandatory Programs, Source: (United States Congressional Budget Office, 2007)

As Figure 1 above depicts, the U.S. Government has significantly increased its expenditure on the Medicare and Medicaid entitlement programs. Expenditure on Social Security has increased faster than the growth of gross domestic product (GDP). However, the current fiscal policy employed by the U.S. Government has been criticized to be unsustainable in the long-run. The current fiscal policy is heavily burdened by government expenditure on the entitlement programs, i.e., Medicare and Medicaid. Over the past ten years, healthcare spending per capita has grown an average 2.5 times (United States Government Accountability Office, 2007, p. 2). There is an increasing gap between the expected revenues from healthcare and the actual spending in the sector. This has resulted in massive budget deficits that are responsible for the country’s current debt position.

 

 

References

Mankiw, G. N. (2014). Princples of Macoreconomics (6th ed.). Mason, Ohio: South-Western Cengage Learning. Retrieved 1 May, from https://financeasim.files.wordpress.com/2014/01/principles-of-macroeconomics-n-gregory-mankiw.pdf

McConnell, C. R., Brue, S. L., & Flynn, S. M. (2014). Economics principles, problems, and policies (20th ed.). New York: McGraw-Hill.

Modjtahedi, B. (2011). Macroeconomics: Theory and Policy (3rd ed.). San Diego: Cognella.

United States Congressional Budget Office. (2007). The Budget and Economic Outlook: Fiscal Years 2008 to 2017. Washington, D.C.: Congress of the United States, Congressional Budget Office.

United States Government Accountability Office. (2007). The Nation’s Long-Term Fiscal Outlook August 2007 Update. Washington: United States Government Accountability Office. Retrieved from https://www.gao.gov/new.items/d071261r_2.pdf

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