In a general sense, fiscal policy is designed to target the total level of spending, the total composition of spending, or both within the context of the national economy. Fiscal policy is carried out by the legislative branch of the U.S. government and achieves the aforementioned by changing levels of government spending and taxation. Fiscal policy approaches levels and composition of spending in two primary ways:
- To increase demand and therefore economic growth, the government will introduce measures to cut taxes and increase spending (this results in a budget deficit).
- To reduce demand and therefore decrease inflation, the government will increase tax rates and cut spending (this will reduce the existing deficit and can sometimes result in (1) a balanced budget or (2) a budget surplus).
If the government reaches the conclusion that there is not enough business activity in the national economy, it can increase the amount of money it spends to spur growth (this is often referred to as a stimulus package). This spending activity most often takes the form of subsidies, tax credits, and infrastructure investments. If the government does not collect enough money in taxes, they can borrow money by issuing debt securities in the form of bonds (an especially popular funding mechanism at the municipal level). The process of governments issuing debt to finance initiatives is referred to as deficit spending.
Conversely, if the government decides to pull money out of the economy via tax hikes, they will slow business activities. This mechanism is typically employed to stymie inflation and can also be utilized to finance government projects or pay down existing deficits. However, it is important to keep in mind that governments are more likely to leverage fiscal policy to stimulate, rather than deter, economic growth. The use of fiscal policy to directly influence economic outcomes at the national level is one of the foundational elements of Keynesian economics.
When a government makes the decision to spend money or alter tax policies, it must be specific as to where money will be spent and what they will tax to finance the spending. In doing so, government fiscal policy has a significant amount of autonomy in regard to targeting specific communities, industries, investment projects, or commodities to encourage or discourage production. Though rooted in economic outcomes, the drivers for fiscal policy decisions are not entirely driven by economic factors. Political and social factors have played significant roles in influencing government spending regimes historically.
Ultimately, the name of the game for fiscal policy is targeting aggregate demand – the measurement of the total amount of demand for all goods and services produced in an economy. This is typically represented as the total amount of dollars exchanged for a set of goods or services at specific price during a specific period of time.
This is a doubled edged sword. On the one hand, companies in a targeted sector or set of sectors can experience enhanced revenues. On the other, if the economy is operating at or near full capacity, expansionary fiscal policy can ramp up inflation. Inflation, in turn, has the potential to diminish corporate margins in competitive industries. Moreover, inflation can have an adverse impact on those wed to a fixed income. The key takeaway here is that fiscal policy can have a profound impact on consumers – it can lead to increased or decreased employment outcomes while enhancing or diminishing purchasing power in the real economy.
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