What is fiscal policy?
Fiscal policy refers to the use of government spending and taxation to influence the level of aggregate demand, employment and economic activity. A government’s budget records its planned spending on goods, services and transfers, and its revenue from taxes and other sources.
Government revenue: taxation
Taxes are compulsory charges levied by the government to finance public expenditure. They can be classified as:
- Direct taxes – levied on incomes and profits (e.g. income tax, corporation tax). They can be progressive (higher rates for higher incomes), proportional (flat rate) or regressive (lower rates for higher incomes).
- Indirect taxes – levied on expenditure (e.g. value added tax, excise duties). These are regressive because a higher proportion of low‑income earners’ income is spent on consumption.
Government expenditure
Governments spend on current expenditure (wages, pensions, social security) and capital expenditure (infrastructure, schools, hospitals). Spending priorities depend on political objectives and economic conditions.
Expansionary vs contractionary fiscal policy
Fiscal policy can be used to manage aggregate demand:
| Policy stance | Description | Likely impact |
|---|---|---|
| Expansionary (loose) | Increase government spending and/or cut taxes to boost aggregate demand. | Higher output and employment; may lead to demand‑pull inflation or a larger budget deficit. |
| Contractionary (tight) | Reduce government spending and/or raise taxes to reduce aggregate demand. | Used to control inflation and reduce a current account deficit; may increase unemployment and slow growth. |
Strengths and limitations
- Targeted spending on infrastructure and education can raise long‑run productive capacity.
- Fiscal policy can stabilise the economy in a recession but may be subject to long decision and implementation lags.
- Large budget deficits require borrowing, which increases public debt and may crowd out private investment.
- The effectiveness depends on the marginal propensity to consume and the state of the economy (whether there is spare capacity).
Examples and applications
In response to the 2020 COVID‑19 pandemic, governments worldwide enacted expansionary fiscal policy. Many provided wage subsidies, increased healthcare spending and offered cash transfers to households. These measures helped support incomes and prevent a deeper recession, but they also led to record budget deficits.
By contrast, some European countries adopted austerity (contractionary fiscal policy) after the 2010 sovereign debt crisis. They raised taxes and cut public spending to reduce deficits. While these steps improved fiscal balances, critics argue they prolonged unemployment and slowed recovery.
Fiscal policy debates often revolve around the multiplier effect – the idea that government spending can have a magnified impact on national income. If households spend a large fraction of any additional income, expansionary fiscal policy can generate significant economic activity; if they save it, the effect is smaller.
