Fiscal policy is a key tool of macroeconomic policy, and consists of government spending and tax policy. When government expenditure on goods and services increases, or tax revenue collection decreases, it is called an expansionary or reflationary stance. Higher taxes or lower government expenditure is called contractionary policy. The effects of fiscal policy can be revenue neutral, which means any change in spending is balanced by an equal and opposite change in revenue collection. Even with a revenue neutral fiscal policy stance, however, the government has a powerful tool to affect both individuals and business by the type of spending or tax policy changes it makes.
Expansionary policies may result in a government budget deficit, though not always. If the economy is fairly healthy when spending increases, any budget surplus will be reduced, but not necessarily eliminated. A contractionary policy stance can result in budget surpluses, especially if the budget is already balanced. The effect on the budget deficit in either case, however, depends on the original budget as well as the magnitude and direction of the change in fiscal policy.
When the government increases spending without changing tax policy, aggregate demand shifts upward. This is an expansionary policy, leading to higher gross domestic product (GDP) and higher levels of employment and output in the sectors of the economy where the government is spending. Generally, the key recipients are the defense industry and related suppliers. There are additional trickle-down effects of fiscal policy as the workers in these industries spend more, boosting sales and hiring in all areas of the economy.
If the government lowers taxes while keeping spending constant, there will be a shift in either aggregate demand or supply, depending on which type of taxes have been lowered. If payroll taxes and individual income tax rates are lowered, consumers will have more income to spend on all types of goods and services, boosting aggregate demand. If corporate tax rates are lowered, businesses are likely to expand and hire more workers, expanding aggregate supply as more goods are produced. As these workers increase their own consumption of goods and services, aggregate demand also increases, resulting in both higher levels of GDP and prices.
If the economy is in a recession, expansionary effects of fiscal policy can put unemployed individuals back to work, with little or no effect on interest rates or inflation. If the economy is strong or unemployment is low, however, increased government expenditure can cause the economy to overheat, straining production capacity or causing wages to rise to fill job vacancies, which can result in inflation and higher interest rates. This is called crowding out, in which government expenditure forces out private spending and investment due to higher prices and interest rates. In an inflationary economy, the government often attempts to use fiscal policy to bring prices down, cutting its own spending or hiking tax rates.
Fiscal policy can be very finely tuned by targeting specific companies, individuals, or behaviors. For example, to stimulate the housing market the government may choose to give large tax deductions to people who purchase a house. To increase investment in agriculture, implementing low tax rates on farmers and agricultural businesses will have a positive effect. Conversely, governments can tax an undesired behavior, such as higher tax rates on certain business or goods, like cigarettes or alcohol.
Another of the effects of fiscal policy is in the composition of aggregate demand. GDP consists of government spending, business spending, individual consumption, and net exports. A fiscal policy of increased spending may result in government expenditures being a larger percentage of GDP. Targeted tax policy changes will result in a change in the proportion of output attributed to business or individual spending.
One key problem with the effects of fiscal policy is the lag from the time policy changes are implemented until individuals or businesses alter their behavior, and the secondary lag until behavioral changes affect the economy. If policy changes are thought to be short-lived, neither businesses nor individuals may change. In the case of special tax deductions, however, both people and business tend to act immediately to take advantage of what may be a temporary change.