What is fiscal policy? 

What is fiscal policy? Fiscal policy is a term usually used in a political context when discussing the state of an economy. It refers to changes made by governments in relation to a country’s finances, usually in an attempt to stabilise a nation’s economy.

Key takeaways:

Where have you heard of fiscal policy?

Economies work in cycles with periods of economic growth followed by periods of economic uncertainty or recession. When this happens, you will often hear elected politicians discussing the need for changes to fiscal policy – and politicians who hope to be elected often make promises relating to fiscal policy in order to secure more votes. 

Amendments to fiscal policy can occur in two ways:

• Changes to government revenue collection (tax rises or cuts)

• Increasing or decreasing government expenditure

One of the notorious fiscal policy examples comes from former President George HW Bush at the 1988 Republican National Convention. As part of his acceptance speech for the Republican Party’s nomination for the upcoming election, the then Vice-President famously used the phrase: “Read my lips, no new taxes.” However, once in office, the United States’ economy went into a period of economic recession. As budget deficits rose alongside government spending in 1990, Bush soon found himself issuing a statement outlining that tax increases would be put into effect to try to reduce the federal budget deficit. Reneging on what was seen as one of his most vital campaign promises, Bush’s popularity among voters fell sharply – and he ended up losing the 1992 presidential election to Democratic nominee Bill Clinton.

What do you need to know about fiscal policy?

So, how does fiscal policy work? There are two main types of fiscal policy to be aware of, and each one is used at a different time, depending on whether the economy is in growth or recession.

• Expansionary fiscal policy

When an economy needs a boost during periods of economic recession, governments implement expansionary fiscal policy, meaning they can choose to increase government spending, decrease taxes, or both. Increases in government spending creates additional jobs, leading to lower unemployment and increased consumer spending, which boosts the economy. By the same logic, tax cuts result in increased disposable income for workers, again leading to increased consumer spending and a boost to the economy.

• Contractionary fiscal policy

Contractionary fiscal policy aims to slow down the economy and is implemented to slow the rate of inflation if a country’s gross domestic product (GDP) is growing at an unsustainable rate. Governments can either decrease spending, raise taxes, or a combination of both. As a result of increased taxes, consumers have less disposable income available, which leads to a reduction in consumer spending. Similarly, decreases in government spending leads to fewer public jobs, which slows down the economy and reduces inflation.