Fiscal policy lags are the result of delays in recognizing problems with the economy and applying solutions. Governments employ fiscal policy to lower unemployment, limit inflation, reduce the impact of business cycles, and facilitate economic growth. Such goals are accomplished via government expenditure, business grants or loans, and revenue collection through taxation. Expansionary fiscal policy stimulates the economy by lowering taxes, increasing government spending, and providing more transfer payments to businesses in order to combat unemployment and increase aggregate demand. Contractionary fiscal policy involves a government decreasing its spending and raising taxes in order to prevent inflation by slowing economic growth.
There is a time delay between the development of an economic issue requiring expansionary or contractionary fiscal policy and a government's recognition and institution of a solution to the problem. These delays are known as fiscal policy lags. Inside lag and outside lag are the main categories of fiscal policy lags. Recognition, decision, and implementation are three subcategories of inside lag. Impact is a term used to describe outside policy lags. Time lags are an issue for government officials and policymakers because they inhibit the efficacy of economic plans of action and may cause more harm than good if implemented too late in the business cycle.
The amount of time that lapses between the development of economic trouble and the reaction of government officials is known as an inside lag. Recognition fiscal policy lags represent the time it takes for an economic issue to be delineated. Macroeconomic policy advisers must procure and evaluate economic data before highlighting the cause of economic distress. Unfortunately, figures related to inflation and unemployment are generally not available instantaneously. Advisers also have to evaluate several months of data to ensure an accurate prognosis.
Decision lags reflect the delay that occurs from the time the problem is identified until the time the government mobilizes. Centrally planned economies have relatively short decision lags. In democracies, decision lags are longer because legislatures must debate, amend, and vote on a proper course of action. If the legislature or head of state cannot come to a consensus, fiscal policy lags can be even longer.
Once a decision has been made regarding fiscal policy, there is a delay in the execution of it. These implementation lags are long and tedious due to the bureaucratic nature of most government agencies. For example, changes in government spending require affected departments to alter their budgets and adjust their spending habits. The providing of grants or transfer payments usually entail applications and interviews and require agencies to ensure they are in compliance with various laws. Revenue from new taxation is typically not generated until the subsequent year.
Outside fiscal policy lags represent the period between the implementation and the reaping of economic benefits. These impact lags are due to the fact that government changes must cycle through every aspect of the economy. For example, a government grant may induce a business to hire more workers and increase production. Consequently, consumer demand brought about by newly hired workers leads to further increases in production and hiring. Such cycles must work their way through all sectors and industries of an economy before the full impact of the fiscal policy will be felt.