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What Is Fiscal Policy?

Kiely Kuligowski
Kiely Kuligowski

Learn what fiscal policy is, how it affects the national economy, and how it affects small businesses.

Fiscal policy is a crucial part of American economics. Both the executive and legislative branches of the government determine fiscal policy and use it to influence the economy by adjusting revenue and spending levels.

Fiscal policy defined

Fiscal policy is based on the theories of British economist John Maynard Keynes, which hold that increasing or decreasing revenue (taxes) and expenditures (spending) levels influence inflation, employment, and the flow of money through the economic system. Fiscal policy is often used in combination with monetary policy, which, in the United States, is set by the Federal Reserve to influence the direction of the economy and meet economic goals.

Fiscal policy is paramount to successful economic management since taxes, spending, inflation and employment all factor into gross domestic product (GDP). This figure details the value of goods and services produced by a nation within a year.

To see how fiscal policy can affect the economy, consider a fiscal expansion that leads to rising demand, which, in turn, increases production. If this demand increase occurs in a high-employment economy, prices will vary. However, in a low-employment economy, this demand will lead to more employment and production but not necessarily price variation. The change in GDP depends on which of these situations applies.

Economy success factors

The success of the economy is commonly measured by a few factors including GDP. Another factor is aggregate demand, which is the sum of goods and services produced by a nation purchased at a certain price point. The aggregate demand curve dictates that at lower price levels, more goods and services are demanded, while there is less demand at higher price points.

Fiscal policy affects these measurements, with the goal to increase GDP and aggregate demand in a sustainable manner. According to Investopedia, it does this by changing three factors:

  • Business tax policy: Taxes that businesses pay to the government affects profits and the amount of investment. Lowering taxes increases aggregate demand and business investment spending.

  • Government spending: Aggregate demand is increased by the government's own spending.

  • Individual taxes: Taxes on individuals, such as income tax, affects their personal income and how much they can spend, injecting more money back into the economy.

Fiscal policy typically needs to be changed when an economy is running low on aggregate demand and unemployment levels are high.

The two main tools of fiscal policy are taxes and spending. Taxes influence the economy by determining how much money the government has to spend in certain areas and how much money individuals should spend. For example, if the government is trying to spur spending among consumers, it can decrease taxes. A cut in taxes provides families with extra money, which the government hopes will, in turn, be spent on goods and services, thus spurring the economy as a whole.

Spending is used as a tool for fiscal policy to drive government money to certain sectors needing an economic boost. Whoever receives those dollars will have extra money to spend – and, as with taxes, the government hopes that money will be spent on other goods and services.

The key is finding the right balance and making sure the economy doesn't lean too far either way. Prior to the Great Depression in the 1920s, the U.S. government took a very hands-off approach when it came to setting economic policy. Afterward, the U.S. government decided it needed to play a larger role in determining the direction of the economy. [Read related article: What Is Economics?]

Fiscal policy vs. monetary policy

As mentioned earlier, the United States relies on two types of policy to shape the economy: fiscal policy and monetary policy. Fiscal policy is used to influence the aggregate demand in a country, whereas monetary policy is used to control the amount of money available throughout the economy. The government may implement fiscal policy to shape the number of products and services that people can or will demand, whereas the central banks' monetary policy affects how much ability people have to demand these services.

That last point brings up another key distinction: The central banks set monetary policy, whereas the federal legislative and executive branches set federal fiscal policy (state and local legislative and executive branches set state and local fiscal policy). The Federal Reserve may take monetary policy actions to achieve price stability, full employment, and stable economic growth, whereas Congress and the White House will determine tax rates for corporations and individuals to work toward fiscal policy goals.

By definition, fiscal policy is thus political. That’s why it's worth noting that Congress has stated that monetary policy decisions should be apolitical. The only requirements that the Federal Reserve must follow when crafting monetary policy is to always prioritize maximum employment and price stability. At no point in its policy creation or execution may the Federal Reserve take any politically motivated actions.

Types of fiscal policy

There are two main types of fiscal policy: expansionary and contractionary.

Expansionary fiscal policy

Expansionary fiscal policy, designed to stimulate the economy, is most often used during a recession, times of high unemployment or other low periods of the business cycle. It entails the government spending more money, lowering taxes or both.

The goal of expansionary fiscal policy is to put more money in the hands of consumers so they spend more and stimulate the economy. Explained in economic language, the goal of expansionary fiscal policy is to bolster aggregate demand in cases when private demand has decreased.

Contractionary fiscal policy

Contractionary fiscal policy is used to slow economic growth, such as when inflation is growing too rapidly. The opposite of expansionary fiscal policy, contractionary fiscal policy raises taxes and cuts spending. As consumers pay more taxes, they have less money to spend, and economic stimulation and growth slow.

Under contractionary fiscal policies, the economy usually grows by no more than 3% per year. Above this growth rate, negative economic consequences such as inflation, asset bubbles, increased unemployment and even recessions may occur.

Setting fiscal policy

Today's U.S. fiscal policies are tied to each year's federal budget. The federal budget spells out the government's spending plans for the fiscal year and how it plans to pay for that spending, such as through new or existing taxes. The budget is developed through a collaborative effort between the president and Congress.

The president will first submit a budget to Congress that sets the tone for the coming year's fiscal policy by outlining how much money the government should spend on public needs, such as defense and healthcare; how much the government should collect in tax revenues; and how much of a deficit, or surplus, is projected. Congress then reviews the president's budget request and develops its own budget resolutions, which set broad levels for spending and taxation. Once the resolutions are approved, legislators start the appropriations process, which spells out where each dollar will be spent. The president must sign those appropriations bills before they can be enacted.

How fiscal policy affects business

Businesses directly see the effects of an economy's fiscal policy, whether it's in the form of spending or taxation. Fiscal policy can have the four following effects on business:

1. Investment opportunities

Businesses can see investment opportunities from government spending as well as private investment. This commonly happens during an expansionary policy, when more money is flowing into the economy from the government and from other sources since taxation is also low. When a balance between price and demand are met, then businesses can expect to thrive and grow. [Read related: Best Small Business Accounting Software]

2. Slower growth

A contractionary financial policy may kick in to prevent inflation when that balance is broken and demand (and prices) fall. Businesses typically rein in their growth due to rising taxes and take measures to stay in the black with less money flowing through the economy.

3. Taxation changes

Depending on their location, businesses face several levels of taxation, including local, state and federal. Businesses must contend with how their state and local government taxes them and how it interweaves with federal fiscal policy.

4. Unemployment rates

A major objective of fiscal policy is to minimize unemployment. For example, the government can lower taxes to put more money back in consumers' pockets. As such, people may be able to spend more money, and companies may face increased demand. With increased demand may come additional production tasks for companies to complete, and businesses can respond by creating more jobs and hiring more employees. As such, with proper fiscal policy in place, a low unemployment rate may gradually increase.

How you can react to fiscal policy changes

Changes in fiscal policies can be a lot for many small businesses to handle, because they often lack the resources to quickly adjust to the changes like larger corporations are able to.

"As a group, small businesses are resilient because we have to be … changes in fiscal policy, particularly at the federal level, expose us to what we dislike the most: uncertainty," said Mike Catania, chief technology officer at PromotionCode.

According to Investopedia, fiscal policy impacts the amount of taxation on future generations of individuals and businesses. Government spending that leads to greater deficits means that taxation will eventually have to increase to pay interest. Inversely, when the government runs on a surplus, taxes must eventually be lowered.

Additional reporting by Max Freedman.

Kiely Kuligowski
Kiely Kuligowski,
Business News Daily Writer
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Kiely is a staff writer based in New York City. She worked as a marketing copywriter after graduating with her bachelor’s in English from Miami University (OH) and now writes on small business, social media, and marketing. You can reach her on Twitter or by email.