Fiscal Policy: Understanding Economics Terms

fiscal policy

Economics is a subject filled with many complexities. It is a labyrinth of bewildering details and terms that are hard to understand. Even economists sometimes have difficulty defining what it truly means.

Yet, economics and what we understand about the economy has an effect on our daily lives.

A very simple way of defining the term “economics” is:

Economics is an analysis of how people or certain groups of people use their resources.

One of those resources is money, but there are other things which can also have an effect on economics.

This article will give you a better idea about what fiscal policy is. This is a term we often hear about in the news and in government reports. But is it something that you fully understand?

Reading this article will give you a better understanding of what fiscal policy is. You will also understand how you could be affected by it in your own life.


What is Fiscal Policy?


fiscal policy

Fiscal policy is the measure used by a government to adjust its tax rates and spending levels. This allows it to observe and influence the nation’s economy. The fiscal policy is like a sister-type strategy to the monetary policy.

Monetary policy is set by a central bank in order to impact the money supply of a nation. In the US, fiscal policy is determined by the government, whereas monetary policy is administered by the Federal Reserve. Both policies are used in combination to guide a country to reach its economic targets.

Until the end of World War II, the US government had a different approach towards economics than it does today. Prior to this time, the approach used was known as laissez-faire. This means that the government didn’t get directly involved with business.

After the war, it was determined that a more proactive approach would be needed in the future. In addition to regulating the value of money and inflation rates, they decided that unemployment also needed to be regulated. This then led to a much more hands-on approach by the government in the nation’s economy.

The specific types of fiscal policies a government uses will vary, depending on the administration in office and its political orientation. But in any case, governments now use a combination of fiscal and monetary policy. This allows them to regulate economic growth and development.


How Does Fiscal Policy Work?


John Maynard Keynes was a British economist and fiscal policy is based largely on his writings. His approach is sometimes known as Keynesian economi​​cs. The basic premise of his theory is that governments can guide macroeconomic efficiency levels.

This is done by either decreasing or increasing public spending and tax levels. Using their influence in this way can help to limit inflation. An inflation rate between two and three percent is considered to be the most healthy.

It also helps bring employment levels up while ensuring monetary value remains strong. Looking at that, you can understand what an important role the fiscal policy has in managing the economy of the country.


Facts About Fiscal Policy


So we now know that fiscal policy is when the government uses spending and taxes to influence the economy. This means that the government has the power to influence parameters such as wealth distribution resource allocation. They are also able to affect overall demand, and the level of economic activity.

There are two types of taxes: revenue (tax on earnings) and excise (tax on manufactured goods). By lowering the excise tax, an increase in economic activity would be seen.

Another example of government influence would be when it makes changes to the welfare system. This can be used as a way to impact upon the economy. For example, if the government lowers subsidies it can direct spending toward different areas.

Fiscal policy is cyclical in nature. It takes time for the effects of policy changes to impact the economy.

Some believe that implementing fiscal policies is not the right approach. They feel that the value of money is more important, and that this should be the government’s focus instead.


Fiscal Policy is a Balancing Act


fiscal policy - economic stat

Making fiscal policy work is a balancing act involving public spending and tax rates.

For example, a government decides to stimulate an economy which is stagnant. It does this by lowering taxes which leads to increased spending. But in doing so, it runs the risk of rising inflation.

This means that economic stimulation can lead to a drop in the value of money. Simply put, this would cause a higher price or value for something that has not actually changed in cost.

When an economy slows down and unemployment is high, consumers generally spend less. This means businesses are not making a profit. In this situation, a government may opt to energize the economy by decreasing taxes.

Doing this gives consumers more cash to spend, which in turn allows the government to increase its spending. The government can then put money into purchasing services from the market. These services might include things such as the building of schools and roads.

This type of investment in infrastructure helps to create jobs. The money earned is then pumped back into the economy when people spend their pay. Using such tactics is often referred to as “pump priming.” 

An additional benefit to this type of economic stimulation is a drop in unemployment levels.

As the amount of money in the economy increases, tax rates can be lowered. This results in further increases in spending as consumers have more funds to pay for goods and services.


Monitoring Fiscal Policy


This is a process that needs to have tight reins on it. When the economy is boosted in this way, there is a fine line that needs to be maintained. Crossing this line can lead to the market having too much money, and a rise in inflation.

When there is too much money in the economy, the value of the money decreases. At the same time, prices are raised due to an increase in consumer demand for products. This causes inflation to rise beyond a reasonable level.

Therefore, close monitoring is required to maintain an effective economy. Without it the line between an effective economy and one infected by inflation easily becomes blurred. This is why fiscal policy is used in combination with monetary policy.


Who Is Affected By Fiscal Policy?


fiscal policy - piggy bank

The use of fiscal policy affects people in different ways. For example the political position and objectives of policymakers might lead to tax cuts only affecting the middle class.

The middle class is typically the largest class within an economy; this is often the reason why it is targeted. When the economy declines and taxes increase, they end up paying more in taxes than the wealthier upper class.

Likewise when a government chooses to make changes to spending then its policy usually affects only a specific economic group.

Opting to build roads or a bridges will result in jobs for hundreds of construction workers. However, if they choose to build a new space shuttle this would only benefit a small specialized group. It would do little to increase aggregate levels of employment.

Fiscal policy also causes a reaction in the stock market. Immediately following the passage of the Tax Cuts and Jobs Act in December 2017, there was a rise in stock prices.


An Example of Fiscal Policy


Let’s take a closer look at the policy mentioned above as a specific example of a government fiscal policy.

The Tax Cuts and Jobs Act of 2017 was designed to address both tax revenues and employment rates in the US. This overhaul of taxes has been forecast to give the federal deficit a rise of billions of dollars.

The law means that corporate taxes have been permanently cut through the creation of a single tax rate of 21 percent. This abolishes the alternative corporate minimum tax.

The existing seven personal income tax brackets have been retained by the law. The difference is that most rates have now been lowered. The majority of the tax brackets have seen between a one and a four percent decrease. The lowest bracket and the 35 percent brackets have been left unchanged.

Summary

Fiscal policy is a hotly debated topic; people argue about how much influence a government should have over the economy. This is one of the biggest obstacles faced by policymakers. Different governments have had different approaches, and the degree of interference by governments varies.


To sustain an economy which is vibrant and healthy, most people accept that it is necessary for government involvement. At the end of the day, the population’s well-being can depend upon it.


It is always good to have a basic level of knowledge about economics terms, as economic policies can have a great effect on our daily lives. This new understanding might also influence how you place your next vote in the election.


Check out candidates’ thoughts and views on fiscal policy to see if their ideas match yours. Through better knowledge of economics, your vote may help lead to policies which you think are best.