Fiscal Policy

Fiscal policy refers to the balance of taxation and government expenditure used by government to alter the trajectory of economic growth. Most economists agree that government expenditure is a powerful short-term stimulator and long-term detriment to economic growth; effectively, it is “borrowing from the future” for the sake of the present. Government expenditure is also considered to be somewhat inflationary; as employment rises and businesses hire more employees and increase wages to take advantage of the short-term stimulus, inflation ultimately results. Unnecessarily high relative government spending is analogous to a central bank maintaining unnecessarily low relative interest rates: short-term economic growth spikes, but over time, capital will leave the country instead of paying for large accumulated government deficits.

Taxes

There are two main types of taxes :- Sales and “value-added” taxes, which tax consumption; and income taxes, which tax a percentage of income. Taxes have the effect of reducing demand via increasing prices (if it’s a sales tax) or disposable income (if it taxes income).

Fiscal Policy

Fiscal policy utilizes various combinations of taxes and expenditure to regulate economic activity. Generally, sales taxes are more efficient than income taxes, because sales taxes encourage saving at the expense of present consumption. Some level of government intervention is necessary, but as a rule, it should be viewed as a last resort. In markets and commodities which have a reasonably competitive private equilibrium, government intervention (whether via higher taxes or regulation on that sector) tend to reduce overall economic well-being over time. Deficit spending, in which government expenditures outpace revenues, increases aggregate demand in the short term, but (all other things being equal) reduces long-run demand once the deficit spending passes the point of unsustainability.

Reductions of taxes and increases in government spending act as a stimulus, much as lower interest rates do. However, if capital flows do not respond to expansionary fiscal policy, then at some unknown future point, the policy’s effects are temporary in nature. Similarly, reductions in government spending and higher taxes act as contractionary forces.