Government authorities use taxes and/or government spending to influence the economy  of a country. This is known as fiscal policy. The government can use various tools to influence a country's economy if it thinks it's needed.

During recessions or in times of economic crisis, for instance, production is low and unemployment rates are high. To stimulate economic growth the government may use tax cuts or an increase in government spending. These types of measures are known as expansionary fiscal policy.

Let’s first see how an increase in government spending can accelerate economic growth. Part of the aggregate demand in an economy comes directly from the money spent by the government.

Like private households and firms, governments themselves can buy goods and services and participate in the labor market. For instance, when governments set out to construct roads or other infrastructure, they hire private companies to do so, putting government money back into the economy directly (and increasing aggregate demand). Further,  when governments  attempt to hire new employees and workers to perform different services, they increase the demand for labor.

If a government increases spending on nationally produced goods and services - such as construction of the aforementioned roads - this will translate into a direct increase in aggregate demand. Firms will raise production and hire additional workers to meet this demand. Thus, an increase in government spending leads to an increase in output (GDP) and a decrease in unemployment.

One important question is by how much output will increase if the government decides to spend an additional million euros. Of course, aggregate output will increase by at least the same amount (in this case one million euros), but that’s not all. The initial stimulus will generate an increase in income which in turn will increase demand. From there, the production will rise by more than that initial increase in government spending.

Why is that the case?  Firms will sell more because of the increased demand and make higher revenues. Part of this revenue they will keep as profits and part will be used to pay their workers. Hence, the incomes of the workers and business owners increase. 

Because of increased demand, firms might be induced to hire new workers. Then, some workers who were formerly unemployed will gain a job and an income. They can therefore buy more goods and services. This in turn increases again the income in certain sectors and thereby aggregate demand. This effect – that government spending can increase aggregate demand by more than the amount spent – is known as the multiplier effect.

The magnitude of the multiplier effect crucially depends on the marginal propensity to consume (MPC) of the households in the economy. This term refers to the fraction of income that households consume and do not save.

For example, say you spend 80% of each euro that you earn while the remaining 20% you deposit in your bank account and save for later. Your marginal propensity to consume is equal to 0.8, and your marginal propensity to save is equal to 0.2.

In a simplistic world (without income taxes or imports) an increase of 1 million in government spending will increase GDP by: Change in gdp = Change in government spending * multiplier = 1,000,000 \(\frac{1}{1-mpc}\). The term \(\frac{1}{1-mpc}\) is the multiplier. If households consume 80% of their income, the multiplier will be equal to 5 (\(\frac{1}{1-0.8}\)).

Clearly, the higher the marginal propensity to consume, the higher will be the multiplier effect. If, for example, households only consume 50% of each euro that they earn, the multiplier will be equal to 2.

So, on the one hand, an increase in government spending will boost GDP by more than the initial increase in spending due to the multiplier effect. On the other hand, however, an increase in government spending may cause a "crowding out" effect which will hinder growth.

The crowding out effect works in the following manner: to finance the increase in government spending, the government must borrow funds. This rise in the demand for loanable funds will cause the price of money, i.e., the interest rate, to increase. 

At a higher interest rate, it will be less attractive to borrow money and more attractive to lend money. Firms and households with savings will prefer to lend the money instead of spending or investing the money. Those without their own savings may not be able or willing to borrow money at this higher interest rate.

If households and firms borrow less money, they cannot invest in new structures, buildings or machinery. Thus, public investment displaces (or crowds out) private investment.

Another instrument of fiscal policy is tax law. Tax reductions may stimulate private consumption if the tax cut leads to a direct increase in households’ disposable income. Part of this additional income the households will spend on goods and services (the other part will be saved). This, in turn, increases demand.

This increase in demand can only be met if firms increase production. In order to do so, they will have to hire more workers. So, production increases and unemployment decreases.

Another channel through which tax reductions may stimulate economic growth is the impact tax cuts have on the investment activity of firms. Tax cuts may stimulate investment, and an increase in investment leads to an increase in the demand for goods and services. Hence, production will increase and unemployment decrease.

Now you may wonder what are the downsides of the fiscal policies we just described. The main problem is the increase in public debt. An increase in government spending without an increase in taxes will increase the budget deficit. In a similar manner, tax cuts that are not accompanied by a decrease in spending will also increase the deficit.

High levels of debt are problematic for a variety of reasons. The government might face high debt interest payments in the future, which could necessitate raising taxes at the cost of output. Debt can also cause the crowding out effect that we mentioned above. The type of tax cut or government spending will determine its effects.

For example, the effect of a reduction of the income tax will be different from the effect of a reduction of the value added tax. Similarly, government spending can benefit some sectors more than others. Additionally, the type of spending determines the overall effect on the economy.

Further reading

For policy makers, it’s important to have an idea which types of fiscal policies work best for the goal in question. Consequently, empirical economists have spent a lot of effort trying to analyze and quantify the effects of different types of fiscal policies on growth and employment.

Kneller, Bleaney and Gemmell, for example, studied fiscal policy in a panel of 22 OECD countries for the years 1970-95. The authors found in “Fiscal policy and growth: evidence from OECD countries” (Journal of Public Economics, 1999) that government expenditure only fosters growth if it is productive. Meaning, if it is defined as the sum of expenditure on education, health, defense, housing, economic affairs and general public services.

Meanwhile, the authors found that non-productive government spending in the form of social security or recreation expenditure tends to hinder economic growth.

Good to know

During the COVID-19 pandemic many countries reacted with severe lockdown measures to stop the expansion of the virus. These actions had severe economic consequences such as rising unemployment and decreasing production.

The measures to prevent COVID-19 from spreading differ from country to country as did the public policies implemented to protect the economy. The International Monetary Fund provides on its website a policy tracker. It contains information on the main economic responses governments are taking to limit the economic impact of the COVID-19 pandemic. With it, you can have a look at the fiscal policies taken by several different countries as a response to the crisis.