Government success in implementing fiscal policy depends on its familiarity with the advantages and disadvantages of fiscal policy. This guide looks deeply into what fiscal policy is and the pros and cons of fiscal policy implementation.
Table of Contents
- Fiscal Policy Meaning
- Fiscal Policy History
- How does Fiscal Policy Works?
- Fiscal Policy Formula
- Examples and Types of Fiscal Policy
- Advantages and Disadvantages of Fiscal policy
- Advantages of Fiscal Policy
- Disadvantages of Fiscal Policy
- How Do Individual Businesses React to Different Changes in Fiscal Policy?
- References
Fiscal Policy Meaning
Fiscal policy is the control intervention by a government through government expenditure and taxation to regulate and influence a nation’s economy. It’s usually combined with monetary policy, which is how central banks manage the liquidity of commercial banks to stimulate economic control.
Combining these two policies proves effective in controlling an economy and achieving economic goals. The main goals of the fiscal and monetary policies are to achieve and maintain full employment, get economic growth at a steady and rising growth rate, and stabilize wages and prices.
Fiscal Policy History
It wasn’t until the early 1930s, during the great depression, that new fiscal policy ideas emerged. Before then, it was generally accepted that the only appropriate fiscal policy the government could adopt and use was to maintain a balanced budget. In this classical view of the economy, the balance of payments (B.O.P) determined the money supply. This meant that a temporary fall in revenue would reduce government expenditure to match the payments.
In addition to that, any recession would end once the balance of payments was improved enough to increase the money supply once again. However, the great depression of the 1930s revealed huge flaws in the existing fiscal policies.[1] The severity of these events gave rise to a set of new ideas. Economist John Maynard Keynes, a British economist in the 1800s and the 1900s, stated that governments should be able to influence their economy to offset the contraction and expansion of the economy.
The British government relied on the classical theory of economy, hoping that the economy would return to its normal state of equilibrium after the depression on its own. Keynes, however, rejected that idea. He argued that once an economy has reached that downturn level, a rise in fear and gloom from businesses will cause an extended period of depressed economy and unemployment. His theory revolved around a countercyclical fiscal policy.
Managing team projects automated for you
Increase the ROI of your team
How does Fiscal Policy Works?
The ultimate objective of the fiscal is to use government spending and taxation to influence and maintain a stable economy.[2] Policymakers use monetary policy and fiscal policy as their main tools. They change the rates of taxes depending on the economic weather and their spending to either reduce or increase the supply of money in the nation.
In addition to that, they also change the degree of and form of borrowing money. This could either be domestic borrowing from citizens to reduce the supply of money in a nation or international borrowing to increase the money supply, both of which stabilize the economy.
Governments influence the economy based on their expenditure, and the basic national income accounting that measures outputs describes this well.
Fiscal Policy Formula
| Gross domestic product (GDP) = Consumption(C) + Investments (I) + Government (G) + Exports(X) – Imports (M) |
GDP=C+I+G+X-M
GDP represents the value of all final goods produced in an economy. This equation reveals how the government controls and influences economic activity by increasing or decreasing tax rates and the citizens’ consumption and spending to regulate inflation.
Examples and Types of Fiscal Policy
The three types of fiscal policy are neutral, expansionary, and contractionary.
1. The Neutral Fiscal Policy
This type of policy is usually taken when an economy is at equilibrium. Government spending is fully funded by taxes collected; therefore, government spending equals taxation. For neutral fiscal policy, government expenditure is not designated to produce any effect on the economy.
Under this policy, government expenditure is limited depending on the taxes collected. since it’s not easy to know how much tax collection will yield annually, governments forecast future taxes to make economic plans.
2. Expansionary Fiscal Policy
This kind of policy is set when the government is spending more than the taxes collected. It is usually used during recessions when there are high levels of unemployment and the majority of the businesses are not doing to increase the level of economic activity in a nation. This is done to increase the money supply in a nation, where all these will boost the economy and increase economic activities in a nation.
3. Contractionary Fiscal Policy
Contractionary fiscal policy is the opposite of expansionary policy. Unlike the expansionary policy, which is set during recessions when the economy is slow and lagging, a contractionary fiscal policy is designated to slow down the economic activity. Reducing economic activity reduces demand for goods and services hence reducing inflation.
In this situation, taxes have to be raised, and the government has to reduce its spending. This is because the velocity of the money supply is high, and consumers have too much money in their hands to spend. They, therefore, need to pay more taxes hence reducing the spending they have been doing.
Advantages and Disadvantages of Fiscal policy
Advantages of Fiscal Policy
1. Provides investment opportunities
Businesses and investors identify an opportunity when there is an expansionary policy since the government allows more money to flow into the economy. They also benefit from this since the government has lowered taxes, so it’s easier to explore new opportunities where they can expect to grow and thrive.
2. Changes in taxation
The government will change the taxation rates from time to time to mitigate inflation. Businesses thrive more when the taxes have been lowered, and a huge money supply is available.
3. A rise in living standards and employment
As more money flows into an economy and taxes reduce, businesses get the opportunity to hire more people. Therefore, this will lead to a low unemployment rate, which may arise, and a rise in living standards while reducing poverty levels.
Disadvantages of Fiscal Policy
1. Slows economic activities
When the contractionary policy is implemented, it slows down inflation, taxes are raised, and the growth of businesses is slowed down. Contractionary fiscal policy may also lead to the total death of new businesses which cannot keep up with the current economic events.
2. Increase in unemployment rates
During a contractionary policy, when taxes are raised and the money supply is reduced, industries and businesses react by laying off some employees. This is done to mitigate and reduce the cost of production in that period and maximize profits. This will increase the rate of unemployment and poverty in a nation.
How Do Individual Businesses React to Different Changes in Fiscal Policy?
Unlike larger businesses, smaller businesses are often more affected by fiscal policies because they lack adequate resources to adjust. Individual small businesses should aim to form groups that will allow them to utilize resources offered by the government fully.
As the popular saying goes, ‘no man is an island’ together, many small businesses will profit from the increased money supply from the government. Furthermore, in case of a crisis, when tax rates are increased and the money supply has been reduced due to reduced government spending, these businesses will be able to look out for each other and prevent death for some of their own.
Related Articles:
References
1. Crafts, N., & Fearon, P. (2010). Lessons from the 1930s great depression. Oxford Review of Economic Policy, 26(3), 285-317.
2. Chishti, M. Z., Ahmad, M., Rehman, A., & Khan, M. K. (2021). Mitigations pathways towards sustainable development: assessing the influence of fiscal and monetary policies on carbon emissions in BRICS economies. Journal of Cleaner Production, 292, 126035.
Disclosure: We may receive affiliate compensation for some of the links below at no cost to you if you decide to purchase a paid plan. You can read our affiliate disclosure in our privacy policy. This site is not intending to provide financial advice. This is for entertainment only.
