There are two types of fiscal policy. The first and most widely-used is expansionary. It stimulates economic growth. It’s most critical to the contraction phase of the business cycle. That’s when voters are clamoring for relief from a recession.
How does it work? The government either spends more, cuts taxes or does both if it can. The idea is to put more money into consumers’ hands, so they spend more. That jump starts demand, which keeps businesses running and adds jobs. Politicians debate about which works better. Advocates of supply-side economics prefer tax cuts. They say it frees up businesses to hire more workers to pursue business ventures.
Advocates of demand-side economics say additional spending is more effective than tax cuts. Examples include public works projects, unemployment benefits, and food stamps. The money goes into the pockets of consumers, who go right out and buy the things businesses produce.
An expansionary fiscal policy is usually impossible for state and local government. That’s because they are mandated to keep a balanced budget. If they haven’t created a surplus during the boom times, they must cut spending to match lower tax revenue during a recession. That makes the contraction worse.
Fortunately, the federal government has no such constraints, so it can use expansionary policy when needed. Unfortunately, it also means Congress created budget deficits even during economic booms. That’s despite a national debt ceiling. As a result, the critical debt-to-GDP ratio has exceeded 100 percent.
The second type, contractionary fiscal policy, is rarely used. That’s because its goal is to slow economic growth. Why would you ever want to do that? One reason only, and that’s to stamp out inflation. That’s because the long-term impact of inflation can damage the standard of living as much as a recession.
The tools of contractionary fiscal policy are used in reverse. Taxes are increased, and spending is cut. You can imagine how wildly unpopular this is among voters. Thus, it’s hardly ever used. Fortunately, the contractionary monetary policy is effective in preventing inflation.