Fiscal policy relates to a government’s ability to use expenditures and revenue collection to influence the overall economy. A contractionary fiscal policy allows a government to reduce the growth of an economy by limiting the amount of government expenditures. Most nations track the growth of their economy through the gross domestic product (GDP) measurement. One portion of GDP is government spending. During periods of slow demand or lower supply, a contractionary fiscal policy helps the government to not run up large budget deficits due to lower tax revenue collections.
In most developed countries that operate under a free market economy system, the government does not have the ability to acquire goods through direct action. The government and its agencies must purchase goods or services from the private sector. The government must set aside or appropriate funds for acquiring the items needed to run the government. This fiscal policy involves the use of funds and budgets that lawmakers hope will result in a balanced budget. When revenues begin to fall, a smart or efficient government will develop a contractionary fiscal policy to reduce non-essential expenditures. The purpose of this is to prevent running a deficit and having to borrow money to pay for purchases. Borrowing money — typically through the issuance of government bonds to investors — will result in interest owed to investors. This increases the expenditures for the government and the need to tax citizens more to pay off the debt.
Some governments may decide to raise taxes during a contractionary fiscal policy. Higher tax revenues will help keep the government running without cutting expenses for policies or other needs. A problem with raising taxes as part of a contractionary fiscal policy is that citizens of the country may not be able to pay any more money from their income. Overtaxing citizens will tend to retard the growth of individual income. Individuals will often avoid situations where they could increase their income, in order to avoid the higher taxes associated with current fiscal policy in the nation.
Another factor of a contractionary fiscal policy is to limit transfer payments. Government transfer payments include unemployment insurance, subsidies for housing or payments for the elderly. These reductions are often the least popular options in a contractionary period. Transfer payments do not really provide any benefit to the government, however, which is a reason for limiting these payments to individual citizens. Governments may simply suspend the payment schedule for these items until the government can enter a period of growth to offset the payments.