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What Is Fiscal Policy?

image for AndreyPopov / Getty Images
AndreyPopov / Getty Images

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 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.

The success of the economy is commonly measured by a few factors, including gross domestic product (GDP), which is the value of goods and services produced by a nation within a year. 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.

There are two main types of fiscal policy: expansionary and contractionary. 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 is to put more money in the hands of consumers so they spend more and stimulate the economy.

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.

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.

Businesses directly see the effects of an economy's fiscal policy whether it's in the form of spending or taxation. 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]

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.

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.

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.

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