Fiscal Policy Is Defined Economics Essay

Fiscal policy is concerned with all those arrangements which are adopted by the governments to collect the revenue and make the expenditures, so that the economic stability could be attained.

Objectives of Fiscal Policy:

To achieve desirable price level:

The stability of general prices is necessary for economic stability. The maintenance of a desirable price level has good effects on production, employment and national income. Fiscal policy should be used to remove; fluctuations in price level so that ideal level is maintained.

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To achieve desirable consumption level:

A desirable consumption level is important for political, social and economic consideration. Consumption can be affected by expenditure and tax policies of the government. Fiscal policy should be used to increase welfare of the economy through consumption level.

To achieve desirable employment level:

The efficient employment level is most important in determining the living standard of the people. It is necessary for political stability and for maximization of production. Fiscal policy should achieve this level.

To achieve desirable income distribution:

The distribution of income determines the type of economic activities the amount of savings. In this way, it is related to prices, consumption and employment. Income distribution should be equal to the most possible degree. Fiscal policy can achieve equality in distribution of income.

Increase in capital formation:

In under-developed countries deficiency of capital is the main reason for under-development. Large amounts are required for industry and economic development. Fiscal policy can divert resources and increase capital.

Fiscal Policy Impact

Fiscal policy usually involves changes in taxation and spending policies. Lower taxes mean more disposable income for consumers and more cash for businesses to invest in jobs and equipment. Stimulus-spending programs, which are short-term in nature and often involve infrastructure projects, can also help drive business demand by creating short-term jobs. Increasing income or consumption taxes usually mean less disposable income, which, over time, can decelerate business activity. In congressional testimony in early February 2011, Fed Chairman Ben Bernanke observed that the twin challenges of increasing budget deficits and the aging population must be addressed to sustain long-term growth. He suggested such measures as investments in research, education and new infrastructure.

How does fiscal policy works?

The fiscal policy works when the Government steps in and influences productivity levels. This is done by increasing or decreasing the public spending and either increasing or decreasing taxes. The process is supposed to help create more jobs and curb inflation.

Fiscal policy is based on Keynesian theory which states that government can influence macroeconomics productivity levels by increasing or decreasing tax levels and public spending.

Types of fiscal policy:

Contractionary Policy

Expansionary Policy:

Contractionary Policy:

Decreases in govt spending and increases in taxes for the purpose to decrease aggregate demand to control inflation incase of boom in economy.

This is done primarily through:

1. Increasing interest rates

2. Increasing reserve requirements

3. Reducing the money supply, directly or indirectly

This tool is used during high-growth periods of the business cycle, but does not have an immediate effect.


When both spending and the availability of money are high, prices start to rise – this is known as inflation. When a country is experiencing higher-than-anticipated inflation, the government might step in with a contractionary policy to try to slow down the economy. Their goal is to reduce spending by making it less attractive to acquire loans or by taking currency out of circulation, and thus reduce inflation. The effectiveness of these policies varies.

Increasing the interest rate at which the Federal Reserve lends will also increase the rates at which banks lend. When rates are higher, it is more expensive for individuals to obtain loans; this reduces spending.

Banks are required to keep a reserve of cash to meet withdrawal demands. If the reserve requirements are increased, there is less money for banks to lend out. Thus there is a lower money supply.

Central banks can borrow money from institutions or individuals in the form of bonds. If the interest paid on these bonds is increased, more investors will buy them. This will take money out of circulation. Central banks can also reduce the amount of money they lend out or call in existing debts to reduce the money supply.

Expansionary Policy:

Increase in govt spending of goods and services and decreasing in taxes to increase aggregate demand in case of recession.


Expansionary Policy is a useful tool for managing low-growth periods in the business cycle, but it also comes with risks. First and foremost, economists must know when to expand the money supply to avoid causing side effects like high inflation. There is also a time lag between when a policy move is made (whether expansionary or contractionary) and when it works its way through the economy. This makes up-to-the-minute analysis nearly impossible, even for the most seasoned economists.


Who Does Fiscal Policy Affect?

Unfortunately, the effects of any fiscal policy are not the same on everyone. Depending on the political orientations and goals of the policymakers, a tax cut could affect only the middle class, which is typically the largest economic group. In times of economic decline and rising taxation, it is this same group that may have to pay more taxes than the wealthier upper-class.

Similarly, when a government decides to adjust its spending, its policy may affect only a specific group of people. A decision to build a new bridge, for example, will give work and more income to hundreds of construction workers. A decision to spend money on building a new space shuttle, on the other hand, benefits only a small, specialized pool of experts, which would not do much to increase aggregate employment levels.

How fiscal policy affects the macro economy?

In the following ways fiscal policy affect the macro economy.

Fiscal policy and aggregate demand:

The most immediate effect of fiscal policy is to change the aggregate demand for goods and services. A fiscal expansion, for example, raises aggregate demand through one of two channels. First, if the government increases its purchases but keeps taxes constant, it increases demand directly. Second, if the government cuts taxes or increases transfer payments, households’ disposable income rises, and they will spend more on consumption. This rise in consumption will in turn raise aggregate demand.

Fiscal policy crowding out private sector:

Fiscal policy also changes the composition of aggregate demand. When the government runs a deficit, it meets some of its expenses by issuing bonds in doing so; it competes with private borrowers for money loaned by savers. Holding other things constant, a fiscal expansion will raise interest rate and “crowd out” some private investment thus reducing the fraction of output composed of private investment.

Exchange Rate:

Fiscal policy also affects the exchange rate and the trade balance. In the case of a fiscal expansion, the rise in interest rates due to government borrowing attracts foreign capital. In their attempt to get more dollars to invest, foreigners bid up the price of the dollar, causing an exchange-rate appreciation in the short run. This appreciation makes imported goods cheaper in the United States and exports more expensive abroad, leading to a decline of the merchandise trade balance. Foreigners sell more to the United States than they buy from it and, in return, acquire ownership of local govt. assets (including government debt). In the long run, however, the accumulation of external debt that results from persistent government deficits can lead foreigners to distrust U.S. assets and can cause a deprecation of the exchange rate.

Level of output:

Fiscal policy is an important tool for managing the economy because of its ability to affect the total amount of output produced that is, gross domestic product. The first impact of a fiscal expansion is to raise the demand for goods and services. This greater demand leads to increases in both output and prices. The degree to which higher demand increases output and prices depends, in turn, on the state of the business cycle. If the economy is in recession, with unused productive capacity and unemployed workers, then increases in demand will lead mostly to more output without changing the price level. If the economy is at full employment, by contrast, a fiscal expansion will have more effect on prices and less impact on total output.

This ability of fiscal policy to affect output by affecting aggregate demand makes it a potential tool for economic stabilization. In a recession, the government can run an expansionary fiscal policy, thus helping to restore output to its normal level and to put unemployed workers back to work. During a boom, when inflation is perceived to be a greater problem than unemployment the government can run a budget surplus, helping to slow down the economy. Such a countercyclical policy would lead to a budget that was balanced on average.

Effect on Economy:

Fiscal policy also affects the economy by changing incentives. Taxing an activity tends to discourage that activity. A high marginal tax rate on income reduces people’s incentive to earn income. By reducing the level of taxation, or even by keeping the level the same but reducing marginal tax rate and reducing allowed deductions, the government can increase output. “Supply-side” economists argue that reductions in tax rates have a large effect on the amount of labor supplied, and thus on output Incentive effects of taxes also play a role on the demand side. Policies such as investment tax credits, for example, can greatly influence the demand for capital goods.

Automatic stabilizers:

Automatic stabilizers Programs that automatically expand fiscal policy during recessions and contract it during booms are one form of countercyclical fiscal policy. Unemployment insurance, on which the government spends more during recessions (when the unemployment rate is high), is an example of an automatic stabilizer. Similarly, because taxes are roughly proportional to wages and profit, the amount of taxes collected is higher during a boom than during a recession. Thus, the tax code also acts as an automatic stabilizer.

Burden of taxes:

Fiscal policy also changes the burden of future taxes. When the government runs an expansionary fiscal policy, it adds to its stock of debt. Because the government will have to pay interest on this debt (or repay it) in future years, expansionary fiscal policy today imposes an additional burden on future taxpayers. Just as the government can use taxes to transfer income between different classes, it can run surpluses or deficits in order to transfer income between different generations

Effect of Tax Cut on Consumer Spending

Tax Cut:

A tax cut is a reduction in taxes. The immediate effects of a tax cut are a decrease in the real income of the government and an increase in the real income of those whose tax rate has been lowered. Tax cuts may provide individuals and corporations with incentive investments which stimulate economic activity. Politically Conservative opinion-makers have theorized that this can generate additional taxable income which could generate more revenue than was collected at the higher rate.

The Historical Lessons of Lower Tax Rates:

There is a distinct pattern throughout American history: When tax rates are reduced, the economy’s growth rate improves and living standards increase. Good tax policy has a number of interesting side effects. For instance, history tells us that tax revenues grow and “rich” taxpayers pay more tax when marginal tax rates are slashed. This means lower income citizens bear a lower share of the tax burden a consequence that should lead class-warfare politicians to support lower tax rates.

Conversely, periods of higher tax rates are associated with subpar economic performance and stagnant tax revenues. In other words, when politicians attempt to “soak the rich,” the rest of us take a bath. Examining the three major United States episodes of tax rate reductions can prove useful lessons.

The tax cuts of the 1920s:

Tax rates were slashed dramatically during the 1920s, dropping from over 70 percent to less than 25 percent. Personal income tax revenues increased substantially during the 1920s, despite the reduction in rates. Revenues rose from $719 million in 1921 to $1164 million in 1928, an increase of more than 61 percent.

Types of Tax cut:

These are two types of tax cut.

Permanent tax cut

Temporary tax cut

Permanent tax cut:

Permanent tax cut is reducing tax for long time period in case of permanent tax cut households will perceive a larger increase in their life time disposable income and so will likely increase their desired consumption.

Temporary tax cut:

Temporary tax cut is reducing tax for short run. A temporary tax cut apply when economy is at full employment will alter household life time disposable income relatively little and so might have little effect on consumption. The most important illustration of this effect is a temporary investment subsidy, but it could also apply to a temporary sales tax holiday or any design where spending is required to obtain the subsidy and is for a limited Duration.

Tax cut example:

For 2011, the IRS reduced the amount of Social Security tax liability of employees and self-employed individuals by 2 percent. Employees only have 4.2 percent (instead of the standard 6.2 percent) deducted from their pay, and self-employed individuals only pay 10.4 percent, rather than the standard 12.4 percent.

Summary of IRS for 2001:

This group…

Pays about…

The richest 5%

53% ($470 Billion) of the total income tax revenue

The next 20%

30% ($260 Billion)

The next 25%

13% ($120 Billion)

The bottom 50%

4% ($35 Billion)

Tax cut effect on consumer spending:

Effect of Tax Cut on Individual Saving

Effect of Tax Cut on Households

Effect of Tax Cut on Consumption

Effect of Tax Cut on Disposable Income

Effect of Tax Cut on Aggregate Demand

Effect of Tax Cut on Aggregate Supply

Effect of Tax Cut For Increase Investment

Effect of Tax Cut on Individual Saving:

Some people don’t spend the additional money which tax cuts create. They save it in their bank accounts. Which create increasing pool of savings for individuals.

Effect of Tax Cut on Households:

Whenever taxes are cut, people keep more of their own money at homes. So ultimately household personal revenue increase

Effect of Tax Cut on Consumption:

When taxes are reduced then household income will increase and there desired for consumption of more goods increases accordingly.

Effect of Tax Cut on Disposable Income:

Income tax cuts results an increase worker’s disposable income they will now take more money at home for fulfilling their necessities.

Effect of Tax Cut on Aggregate Demand:

The GDP of an economy is composed of five components consumer expenditure, government expenditure, investment, exports and imports. With the exception of imports, an increase in any of these components will increase GDP. After a tax cut, it is expected that people’s disposable income would increase, thereby increasing the amount spend on consumption. This increase in consumption occurs on the demand side, and in turn increases GDP.

Effect of Tax Cut on Aggregate Supply:

On the supply side, a tax may reduce consumer and producer surplus. Consumer surplus is the amount people are able to pay for items, minus the amount they are willing to pay. Similarly, producer surplus is the amount a producer charges for a product, minus the amount the producer needs to charge in order to obtain a profit. Upon a reduction of a value-added tax, supply will intersect demand at a smaller price. This increases the equilibrium output level, and thus increases GDP.

Effect of Tax Cut for Increase Investment:

Instead of simply saving their extra money in the bank, tax cuts also give people more money to invest in stocks. When coupled with the rising employment and industrial growth created during periods of lower taxes, it helps increase stock prices, which in turn creates new wealth for investors.

Other Factors of Tax Cut:

Tax Cut Effect on Economy

Tax Cut Effect on Government Debt

Tax Cut Effect on Fiscal Deficit

Tax Cut Effect on Business

Tax Cut Effect on Employment

Help For Families

Tax Cut Effect on Economy:

When taxes are cut, people have more money. In economic terms, this means that money can be invested in the economy. When this is done, jobs are created, the economy grows and tax revenue increases due to the economic activity. The basic idea is that tax cuts spur investment and give incentives to invest and take risks. The resultant economic activity then pays for the tax cut with higher revenue

Tax Cut Effect on GovernmentDebt:

Tax cuts can potentially increase government debt by reducing tax revenue. The government relies on tax revenue to pay off its debts and continue running its programs.if tax cut not offset by cuts in spending then debt load of the government will increase.

Tax Cut Effect on Fiscal Deficit:

A reduction in taxes also means less revenue for the government at all levels, which generally leads to lower government spending, higher deficits or both.

Tax Cut Effect on Business:

When government policymakers decide to cut taxes on businesses, businesses have more money to spend and invest. As businesses begin to take on new investment projects

Tax Cut Effect on Employment:

As consumers have more money to spend, they create additional demand, especially for “big ticket” items such as cars and major appliances. To meet this demand, many employers hire additional workers. As these new workers enter the labor force, the income taxes on their wages help offset some of the revenue lost when the tax cuts were originally passed.

Help For Families:

Tax cuts can help families who are having financial difficulties return to financial stability. Low-income families and families with high amounts of debt may have difficulty paying bills and covering costs of basic necessities like food and utilities. Tax cuts that allow workers to take home extra money can potentially allow such families to pay expenses that they might otherwise not be able to afford. Financially stable families also stand to benefit from tax cuts by saving or investing extra income.


Government Programs

Entitlement Spending

Infrastructure Growth

Public Servants

Public Debt

Fiscal Deficit

Government Programs:

The drawback of tax cut is that it can result in the downsizing or cutting of important government programs. Governments fund in a variety of important programs such as public education, infrastructure updates and social welfare. Tax cuts can reduce the benefits received from such programs. If a government cut taxes on gasoline, it might not have sufficient funds to maintain transportation infrastructure, which could result in poor road conditions.

Entitlement Spending:

Certain tax cuts can reduce the amount of money available for social programs. While wealthy taxpayers get to keep more of their income after taxes, but the poor citizens receive smaller benefits out of it. And government budgets also shrink in this way.

Fiscal Deficit:

Due to tax cut government revenue decreases if the government expenditure increases than the government revenue fiscal deficit creates.

Infrastructure Growth:

Government taxes support a wide range of vital infrastructure, including roads, bridges and dams. Governments build and maintain parks and public recreation areas with tax income. Cuts in taxes reduce the government’s ability to perform these vital services. Governments can finance infrastructure projects with bond offerings or other debt but they need tax income to repay the debts.

Public Servants:

Public servants include police officers, firefighters, public-school teachers, park maintenance crews and a host of other government employees they are paid out of tax revenue lower tax income will decrease their salary and government reduce the number of public servants in a salary budget shorts falls.

Government Debt:

Government pay their debt from tax revenue due to tax cut government have less money to repay their debt. So government borrows from different institution to meet the situation of fiscal deficit their cost of borrowing increases.

Fiscal policy effects on interest rate:

Fiscal policy has a clear effect upon output. But there is a secondary, less readily apparent fiscal policy effect on the interest rate

Basically, expansionary fiscal policy pushes interest rates up, while contractionary fiscal policy pulls interest rates down. The rationale behind this relationship is fairly straightforward. When output increases, the price level tends to increase as well. This relationship between the real output and the price level is implicit. According to the theory of money demand, as the price level rises, people demand more money to purchase goods and services. Given that there is no change in the money supply, this increased demand for money leads to an increase in the interest rate. The opposite is the case with contractionary fiscal policy. When output decreases, the price level tends to fall as well. Again, this relationship between the real output and the price level is implicit. According to the theory of money demand, as the price level falls, people demand less money to purchase goods and services. Given that there is no change in the money supply, this decreased demand for money leads to a decrease in the interest rate. This is how fiscal policy affects the interest rate.

Fiscal policy effects on capital inflow:

Fiscal policy also affects the exchange rate and the trade balance. In the case of a fiscal expansion, the rise in interest rates due to government borrowing attracts foreign capital. In their attempt to get more dollars to invest, foreigners bid up the price of the dollar, causing an exchange-rate appreciation in the short run. This appreciation makes imported goods cheaper in the Pakistan and exports more expensive abroad, leading to a decline of the merchandise trade balance.

Definition of ‘Capital Formation’

Capital formation refers to net additions of capital stock such as equipment, buildings and other intermediate goods. A nation uses capital stock in combination with labour to provide services and produce goods .An increase in this capital stock is known as capital formation.

Effects on Capital Formation:

In recent years it has often been argued that high fiscal deficit is affecting capital formation in the economy by reducing private investment through an increase in interest rate and also through reduction in public sector’s own investment arising out of ever increasing consumption expenditure.

Also, the persistence of high fiscal deficits and ever increasing debt service payments are considered as one of the major constraints for the government at any level to undertake the necessary expenditures for productive capital formation. In other words, high fiscal deficit is affecting capital formation in the economy both by reducing private investment through an increase in interest rate and also through reduction in the public sector’s own investment arising out of ever-increasing consumption expenditure.A closely related issue is the relation between private saving and capital formation when money and other government liabilities are alternatives to real capital in individual portfolios.The possibility of excess saving when individuals will not hold capital unless its yield exceeds some Minimum required return. When the return on capital is too low, an Increase in saving only reduces aggregate demand. If prices are flexible downward, this causes deflation until the increased value of balances causes a sufficient reduction in saving; if prices cannot fall, the excess saving results in unemployment. The large unprecedented government deficits in recent years have stimulated speculation about their adverse affects on inflation and private capital formation. While it is clear that deficits may have no adverse effect in an economy with sufficient unemployed resources, the effects of a deficit when there is full employment are less clear.


Two conclusion drive from the effect of tax changes on consumer spending

Consumer will be more likely to boost spending if the change in tax liability is permanent

If tax cut temporary Consumer will wait to increase spending until a tax change affect their take home pay.

Consumer spending will react more strongly to a permanent than to a temporary tax change

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