Fiscal policy is the governmental instrument or program, which aims to stabilize economic situation and to improve economic health of the country. It usually deals with the purchase of goods and services as well as with the transfer payments in the country. Therefore, it influences the type and the level of taxes, optimal for the economy. Governmental intervention through fiscal policy usually aims to affect unemployment level, economic output and the level of prices in the economy. If there is a fiscal surplus (the revenues exceed expenditures) or the level of deficit is decreasing, compared to the previous periods, fiscal policy attempts to reduce the surplus through raising taxes and reducing governmental spending (Dodge). Such policy is usually referred to as contractionary. The main focus of the contractionary fiscal policy is to decrease the disposable income of the private households through tax increase, and the disposable income of the recipients of governmental provisions, through a reduction in governmental spending. This policy reduces aggregate demand in the economy, lowers outputs and puts a pressure on employment, which eventually leads to a decrease in the prices. Therefore, contractionary fiscal policy lowers employment, output and inflation rate. It is usually implemented in the economies, which experience fast growth, in order to stabilize the situation and to reduce inflationary pressures.
In the conditions of an economic downturn GDP is decreasing, while the economy experiences high levels of deflation, unemployment and negative output growth. Fiscal balance in such economy is in deficit, which is indicated by the high level of spending compared to the revenues. In this case governments pursue an expansionary fiscal policy, which aims to enhance aggregate demand by lowering taxes and raising governmental spending (Dodge). The resulting increase in the aggregate demand improves employment levels, boosts income and output, however it also increases price level and inflation.
Although the effect of both contractionary and expansionary fiscal policies on the national income can be predicted, the magnitude of the impact can be only assessed using tax and government expenditure multipliers, as well as policy lags. Expenditure multiplier is calculated as 1/(1 - b), where b is referred to as marginal propensity to consume and can be determined by the proportion of the income consumers are willing to spend on goods and services. Thus, the change in income is determined by the change in governmental expenditures, multiplied by the marginal propensity to consume. Tax multiplier, on the other hand, is calculated as –b/(1 - b). The effect of the tax multiplier on the income is opposite to the one of the expenditure multiplier. However, fiscal policies cannot have an immediate effect on the economy due to inside and outside lags of the policy implementation. Inside lag refers to the time it takes to recognize the need for a certain action, while the outside lag measures the delay between policy implementation and its effects (Pailwar).
Fiscal policy usually contains two components: discretionary and non-discretionary. While the former includes manipulation of the governmental expenditures and tax levels, the latter is based on the existing features of the fiscal policy, which automatically regulate the situation in response to a change in the environment. Thus, if the level of unemployment decreases as a result of a recession, unemployment benefit payments increase, thus increasing governmental spending and aggregate demand (Pailwar).
Fiscal policy is an important instrument for economic control, which helps to stabilize the economy both in the periods of economic growth and during recessions. However, it is sometimes regarded as an obstacle of the economic growth due to the effect it has on restricting output and expansion (Klein).
Dodge, E. 5 Steps to a 5 AP Microeconomics and Macroeconomics . Columbus, OH: Mc-Graw-Hill, 2005.
Klein, P. A. Economics confronts the economy. Cheltenham, United Kingdom: Edward Elgar Publishing, 2006.
Pailwar, V. K. Economic Environment of Business. New Dehli, India: PHI Learning, 2008.