Chapter 26: Fiscal Policy

Effects of Changing Taxes & Spending, Challenges of Fiscal Policy, Deficits, Surpluses, Debt, Appropriate Fiscal Policies under Certain Economic Circumstances

Fiscal Policy Tools

What is Fiscal Policy?

Most often refers to deliberate actions by governments to change taxes, spending on products & transfer payments to influence economic conditions. Fiscal policy also includes tax & spending changes undertaken for other reasons.

Government spending is financed through taxes & borrowing. Revenues are almost all taxes on individuals & businesses. The largest portion of federal revenues is from income taxes on individuals.

What is it meant by Government Surplus & Deficit?

  • Deficit: Government spending exceeds tax revenue, and must borrow to cover the shortfall.
  • Surplus: Government spending is less than tax revenue.

What is the Earned Income Tax Credit (EITC)?

A refundable tax credit, so if the credit you qualify for is more than what you owe in taxes, you get the additional amount back in your tax refund. 2 Requirements for EITC:

  • Must have earned income from a job.
  • Can’t make more than a certain amount of money (to ensure the EITC helps those who need it).

Temporary Tax Changes

Temporary tax changes aren’t as successful since it only affects current income & not future income.

Supply Shocks using Policy

There are 2 choices for policy in a supply shock: (1) increase spending, thus decreasing unemployment and increasing inflation further, or (2) decrease spending, thus reducing inflation and increasing unemployment further. Either way, we make one problem worse in our attempt to make one problem better.

But there may be a way to do it; if policy can increase aggregate supply, both unemployment & inflation will fall. These effects are all beneficial, so policies that increase aggregate supply support a strong economy in both recessions and booms.

What is Supply-Side Economics?

The idea that taxes can increase aggregate supply by creating incentives to work, save & invest.

There is little doubt that lower taxes do have supply-side effects – individuals respond to incentives. The debate among economists and politicians is over how much they respond, and we really do not know that with much precision.

What is a Capital Gains Tax?

A tax on increases in asset values, currently 15% on gains of assets held over 1 year for most people. Supply-side economics is also includes cutting the tax rate on capital gains.

Regulation & Supply-Side Economics

Many business leaders say that they invest less because of the high cost of complying with business regulations, along with a lack of clarity with respect to regulations. Clearer and predictable regulation can act as a supply-side measure if it encourages businesses to take risks and invest in new projects.

Problems with Implementing Fiscal Policy

Crowding Out Private Investment

One challenge is that stimulative fiscal policy can crowd out private sector investment. Federal spending increases which causes a multiplied increase in total spending. That causes an increase in the demand for money. Interest rates rise. Investment spending falls. But we also know that as total spending & real GDP increase, investment spending will increase. So what happens to investment spending?

If we are near or past full-employment output, there will likely be small positive effects on investment. On net, output might fall. If we’re in a recession, the positive effect on investment may be much larger & the net effect is likely to be positive.

​If the increased interest rate effect is larger than the direct increased investment spending, then overall investment declines. Economists say that investment then is “crowded out.” If the total spending creating a need for increased capacity is greater than the interest rate effect, then there will be more investment, and economists use the term “crowding in.”

As government increases its borrowing resulting from the increased deficits, banks can increase their interest rates. Some businesses then begin to cut back on investment. With an economy that has more slack in it, banks may not be fully loaned out and interest rates may not increase as much.

Political Considerations

A second challenge is that fiscal policy is implemented with lags. Tax changes can be implemented quickly, while changes in government spending take a long time. There are two reasons for this. First, spending must be agreed upon prior to a congressional vote. Second, even after Congress passes spending plans, their implementation can take months or even years.

Biases in Fiscal Policy

Given the political ease, it may be politically easier to stimulate the economy than to slow it down. Thus there may be a bias toward creating inflationary conditions.

Automatic Stablizers

Our tax system and, to a lesser extent, our government spending on transfer payments act as automatic stabilizers. An increase in spending will not have the full-multiplied effect that it otherwise would because some of the effect is diverted into income taxes and not spent. Thus the multiplier is smaller because of income taxes. And as spending rises and more people go to work, transfer payments for unemployment compensation and welfare begin to fall. This also offsets some of the multiplied effect of the initial change in spending. This also works in reverse.

Budget Deficits & Debt

What is Federal Debt?

The sum of all the past federal budget deficits and surpluses.

Budget Surpluses or Deficits

Subtract spending on products & transfer payments from revenues. If the result is a negative number, the government has a budget deficit. If it is a positive number, the government has a surplus.

Myths & Realities about Deficits & Debt

Deficits Cause Inflation

They can, if we’re at full employment & taxes are lowered or government spending increases, total spending will rise & will cause inflation. But if we are in a recession, then decreased taxes & increased spending will cause the economy to return to full-employment with little inflation. So whether or not deficits cause inflation depends upon current economic conditions.


Large and growing deficits will add the debt. The argument goes that we will never be able to pay the debt back. If indeed we could not pay it back or could not make the interest payments on the debt, then the U.S. government would be in bankruptcy.

Passing Debt onto Children

We do pass debt onto children but we also pass on assets along with our debt. We borrow primarily from ourselves. Future generations are responsible for making interest payments but those future generations also own the bonds representing the assets through pension funds, insurance policies, & financial investments. To the extent that bonds are owned by individuals and institutions abroad, there will be future obligations to make interest payments to people outside of our borders.

Individuals Cannot Run Continual Deficits

Individuals are different from governments. Governments live on and can tax people. But individuals do borrow, and some even increase their borrowing over time. It’s not an uncommon for adults to take out larger mortgages on more expensive homes as they are financially more successful.

Real Costs of Debts

Increased government debt can prevent future fiscal policy. Specifically, as debt increases, so does the cost of making interest payments. To pay this cost, the government must raise taxes or decrease spending, thus leaving fewer funds for expansionary fiscal policy.

How should we define Debt & Deficits?

What is Inflation Accounting?

Many would argue that the definitions are wrong. It is not the total amount of debt that counts, but the real value of the debt.

Debt as a Percentage of Income

Others would argue that we should look at debt as a percentage of GDP. If the percentage is increasing, then perhaps we should be concerned. If it is falling, even if the absolute amount is rising, the debt is less important.

Debt for Investment Purposes

If the government is simply borrowing to finance consumption-type purchases, then future generations will not be better off as a result. However, if the government is borrowing to finance education, highways, research and development, then future generations may well be better off.

A Simplified Model

Assume economy is in long-run equilibrium & there’s no government spending/taxes & net exports.

GDP = Consumption + Investment

Total Income = Consumption + Savings

∴ GDP = Total Income

C + I = C + S

∴ I = S

Now we’ll include government spending.

C + I + G = C + S + T

I + G = S + T

I = S + (T – G)

If G is greater than tax revenue (T), investment falls. If T is greater than G, then investments rise.

Summary of Effect of Fiscal Policy

Summary of Monetary & Fiscal Policy Effectiveness

Arguments Against Using Monetary or Fiscal Policy

2 Key Components

  1. The economy left alone will eventually return to the potential level as wages fall.
  2. The use of monetary or fiscal policy will cause higher prices at full employment than if we just let the economy adjust on its own.


If we use active policy, we may make a mistake given forecasting difficulties, lag times, and the tendency to stimulate the economy too much.


If the cause of the short-run equilibrium below full-employment output is a negative supply shock, then the active use of monetary and fiscal policy will make one already bad problem worse.

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