Definition: Fiscal policy is the government’s way of monitoring and affecting the economy by adjusting spending limits and tax rates. In other words, it’s how the government influences the economy.
What Does Fiscal Policy Mean?
In the short-term, fiscal policy affects mainly the aggregate demand. In the long-term, it affects consumers’ saving and investment activities and the overall long-term growth of the economy. Government spending on goods and services includes the remuneration of those employed in the public sector, the payment of pensions to those retired of the public sector, public investments in infrastructure as well as investments in government agencies, farming, research and so on.
Government revenue is mainly incurred by direct taxes and indirect taxes. Direct taxes include the income tax; the real estate transfer tax; the property tax; the inheritance tax; tax donations, and parental benefits. Indirect taxes include the value added tax; sales taxes, and import duties. Other sources of government revenue are the profits of public companies and the fines imposed on offenders regarding fees applicable to the use of public services.
The government uses both of these activities to influence consumer spending habits and bank lending practices to either contract or expand the economy.
Let’s look at an example.
The fiscal policy is not only about deficits, surpluses, and balanced budgets, but it is also directed towards other aspects of the economy such as liquidity and interest rates. Through fiscal policy, the state aims to regulate inflation, unemployment rates, and adjust interest rates to fuel economic growth. Therefore, beyond its macroeconomic dimension, it can influence society in a positive or negative way. How is this happening?
If a government imposes high tax rates on highly profitable businesses or highly-paid individuals, it may cause a slowdown in economic growth and boost unemployment. Businesses won’t be able to pay their employees because they need the money to pay the taxes. Therefore, more people will end up with a lower income or unemployed. In addition, businesses will have to raise their prices in order to increase their profits and be able to pay off their taxes. Higher prices will strengthen inflation, whereas tax revenues will shrink. Finally, investment activity and labor supply might also be negatively affected.
Thus, the government uses these tools to prevent drastic up and down swings in the economy. It tries to depress bubbles before they burst and increase economic activity during times of recession.