Economics Terms A-Z - The most important terms in economics.

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Economics Terms A-Z

Fiscal Policy

Government authorities use taxes and/or government spending to control and stabilize the economic activity of a country. This is known as fiscal policy. The government has different instruments available to influence the economic activity of a country if it feels that this might be necessary. 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 us 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 buy goods and services, for instance, when they construct roads, buildings or other infrastructure or when they hire new employees and workers to perform different services. An increase in government spending - assuming that the money is spent on nationally produced goods and services – translates into a direct increase in the demand for nationally produced goods and services. Firms will raise production and hire additional workers to meet the 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. First, of course, aggregate output will increase by the same amount but that is not all. Production will increase by more than the initial increase in government spending because the increase in income generated by the initial stimulus will further increase demand. Why is that the case?  Firms will sell more, because of the increased demand and make higher revenues. Part of this revenue they keep as profits and another part is used to pay their workers. Hence, the incomes of the workers and the entrepreneurs increase. Additionally, some workers who were formerly unemployed have a job and an income now and can therefore buy more goods and services. This in turn increases again the income in certain sectors and thereby aggregate demand. This effect is also known as the multiplier effect. The magnitude of the multiplier effect crucially depends on the marginal propensity to consume (mpc) of the households, i.e., on the fraction of income that households consume and do not save. If you spend 80% of each € 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 € that they earn, the multiplier will be equal to 2.

So, on the one hand, an increase in government spending will increase 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 describes the following phenomenon: to finance the increase in government spending, the government must borrow funds. This increase 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 own savings may not be able or willing to borrow money at this high 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 are tax cuts. Tax reductions may stimulate private consumption if the tax cut leads to a direct increase in the disposable income of the households. Households earn an income, part of which they pay to the government in the form of taxes. The remaining income is called disposable income and is split between consumption and savings. Hence, a decrease in taxes increases the disposable income of the private households. Part of this additional income the households will spend on goods and services. This increase in demand can only be met if firms increase production and 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 and analogously so will tax cuts that are not accompanied by a decrease in spending. High levels of debt are problematic for a variety of reasons. Among others, high levels of debt will result in high debt interest payments or could cause the crowding out effect that we mentioned above. Besides this, the effects of tax cuts or an increase in government spending heavily depend on the type of tax cut or government spending. For example, the effect of a reduction of the income tax will not be the same as the effect of a reduction of the value added tax. Similarly, government spending can benefit some sectors more than others and the type of spending determines the overall effect on the economy.  

Further reading

For policy makers it is important to have an idea which types of fiscal policies work best. Consequently, empirical economists have spent a lot of effort trying to analyse 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, where productive government spending is defined as the sum of expenditure on education, health, defence, housing, economic affairs and general public services. Non-productive government spending in the form of social security or recreation expenditure tend to hinder economic growth.

Good to know

During the COVID-19 pandemic many countries have reacted with severe lockdown measures to stop the expansion of the virus which at the same time have severe economic consequences such as rising unemployment and decreasing production. The measures to prevent COVID-19 from spreading differ from country to country as do the public policies to protect the economy. The International Monetary Fund (IMF) provides on his website a policy tracker with information on the main economic responses governments are taking to limit the economic impact of the COVID-19 pandemic. In this tracker, which includes 196 countries, you can have a look at the fiscal policies different countries have taken as a response to the crisis.