The use of government spending and taxation to influence the economy of a country is termed as Fiscal Policy. Whenever the government decides on what goods and services to purchase, on the transfer payments to distribute, or what taxes need to be collected, it is engaging in fiscal policy. The primary economic impact of any change in the government budget is felt by particular set of groups, for example, an income tax cut raises the disposable income of an individual. However, the general focus of discussions on fiscal policy deal with the effect of changes in the government budget on the overall economy. Although changes in taxes or spending that do not affect government revenue may be termed as fiscal policy and may have an impact on the aggregate level of output by changing the incentives that firms or individuals face, the term “fiscal policy” is usually used to describe the effect on the aggregate economy of the overall levels of spending and taxation, and more particularly, the disparity between them. At a macroeconomic level, changes in fiscal policy can have a major impact on:
• Aggregate demand
• Savings and investment
• Income distribution
• The distribution of resources and money supply
• The business cycles
• Tax rates
In the globalized economy, fiscal policy also has an impact on exchange rate and the trade balance. During fiscal expansion, the rise in interest rates due to government borrowing attracts foreign capital and investment. In their attempt to get more Indian currency to invest, foreigners bid up the price of the rupee, causing an exchange-rate appreciation in the short run. This appreciation makes imported goods cheaper in India and exports more expensive abroad, leading to a decline in the merchandise trade balance. As a result, imports increase and exports decline, and foreign investors acquire ownership of Indian assets (including government debt). However, in the long run, consistent government deficits and the accumulation of external debt can lead foreigners to see Indian assets as risky and can cause a deprecation of the exchange rate from a subsequent fall in future investments.
Fiscal policy also alters the burden of future taxes. During an expansionary fiscal policy, the government adds to its stock of debt. Since it will have to pay interest on this debt (or repay it) in future, the expansion today puts an additional burden on future taxpayers. Just as the government can use progressive taxation to transfer income between different income classes, it can run budget surpluses or deficits in order to transfer income between different generations as well.
Does Fiscal Policy Actually Work?
In the past, several countries have introduced packages of ‘fiscal stimulus’, by increasing the government spending or lowering taxes in order to boost demand and bring their economies out of recession. As a result, one could expect a certain degree of agreement within the economists on the effectiveness of fiscal policy. But nothing could be farther from the truth.
Ethan Ilzetzki and colleagues conducted a study on government spending and GDP of 20 high-income countries and 24 developing countries. Through this study, the team could derive estimates of the fiscal multiplier – a dollar increase in GDP caused by a one dollar increase in government spending, far more accurately than previous studies. The results showed that in high-income countries, an increase in government spending of 1% of GDP causes an immediate increase in GDP of 0.4% - a fiscal multiplier of 0.4. This implies a significant degree of ‘crowding out’ of private investment cause by the fiscal expansion. This means that, government fiscal activity is to some degree, discouraging private sector investments. On the other hand, in developing countries, the team found a fiscal multiplier of – 0.2. This means that fiscal economic activity fully crowds out private economic activity, indicating a decline in GDP in response to increase in government expenditure. This means that expansionary fiscal policy has a negative effect on GDP of developing countries.
Several other studies also show how response of Central Banks affect the implications of a fiscal expansion. In countries where Central banks are devoted to maintain a stable exchange rate, respond by lowering interest rates in response to an increase in government expenditure during the two years following a fiscal stimulus. This reinforces the fiscal stimulus and allows for the large fiscal multipliers. On the other hand, central banks which have an inflation target in mind, tend to increase interest rates. This is aimed to counteract the inflationary pressures caused by the fiscal expansion and increased aggregate demand. This however offsets the stimulative impact of fiscal policy and leads to the negligible effects of fiscal stimulus for countries with such a monetary policy. For policy-makers, these results indicate that the interaction between fiscal and monetary policy is a crucial determinant of the effects of fiscal stimulus.
Economists also note that the ability of fiscal policy to affect the output levels through aggregate demand dies off over time. The higher aggregate demand as a result of an expansionist policy, eventually translates only in higher prices and does not have an effect on output at all. This happens as the level of output in the long run, is determined not by demand but by the supply of factors of production i.e., capital, labor, and technology. These factors of production provide a “natural rate” of output around which business cycles and macroeconomic policies can cause only temporary fluctuations. Any policy measure to keep output above its natural rate by boosting aggregate demand policies will only lead to accelerating inflation. This gets accentuated with the “crowding out” of public credit as private firms do not invest in labor and technology to boost output. Not just this, expansionary fiscal policy can also alter the natural rate, and, ironically, lead to the long-run effects of fiscal expansion being opposite of the short-run effects. Expansionary policies will lead to higher output today, but will lower the natural rate of output below what it would have been in the future. Similarly, contractionary fiscal policy, though lowering the output level in the short run, will lead to higher output in the future.
However, fiscal policies are more often not guided by economic principles. Policy makers are often driven by votes which leads them to being enthusiastic about expansionary policies during recessions which are not matched effectively by contractionary policies during boom, primarily so as to not lose votes. Moreover, they can showcase the benefits of expansionary fiscal policy to their voters immediately, whereas postpone its costs (higher future taxes and economic growth) to the future.
Thus, the greatest obstacle, of using fiscal measures as powerful policy tools are not economical, but political.