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What Is the Relationship between Fiscal Policy and Taxes?

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  • Written By: Esther Ejim
  • Edited By: Kaci Lane Hindman
  • Last Modified Date: 21 November 2016
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The relationship between fiscal policy and taxes is the fact that taxes are a form of fiscal policy utilized by the government to control or to manipulate the economy to a desired outcome. Precise application of this type of fiscal policy is dependent on the exact aim that the government is trying to achieve. Some of the outcomes of the manipulation of taxes as a form of fiscal policy include an increase or decrease on the level of aggregate demand, an incentive to workers, and a way of affecting favorable business decisions by companies.

A link between fiscal policy and taxes can be seen in the manner in which fiscal policy is used to control the total rate of demand for final goods and services in an economy. For instance, where the government observes that the level of consumption in the economy has become too high, it may increase the level of taxes in an effort to address this trend. Such an increase will not only increase the level of taxes that people and companies pay, but it will also reduce the excess liquidity in the economy by mopping up some of the excess money in circulation. When this happens, the resultant apparent scarcity of money will lead to a corresponding reduction in the rate of aggregate demand.

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Another link between fiscal policy and taxes is the manner in which taxes are used to influence businesses to behave in a desired manner. For instance, if the aim of the government is to encourage companies to employ more people, it may reduce the rate of their taxes in relation to the number of their employees. It may even grant them certain tax breaks or tax incentives for the employment of a certain number of employees. The benefit accruing to such companies might increase with the attainment of a certain milestone in relation to the employment of people.

Fiscal policy and taxes are further linked in this manner by governmental use of tax incentives to encourage companies to invest in certain desirable areas or industries. For instance, if the government is trying to encourage more companies to invest in the development of green products it might apply tax incentives, rebates or reductions to companies that invest in such products. Another way that fiscal policies and taxes are related is by the use of taxes to encourage more productivity in the economy through the reduction of the taxes on personal income.

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