Fiscal policy is set and carried out by the U.S. Congress (the House of Representatives and Senate) and the President. It focuses on how the federal government collects money (mainly through taxes) and how it spends that money.
Most government revenue comes from taxation. You’re probably most familiar with income taxes. The Internal Revenue Service (IRS) collected roughly $2.0 trillion in 2021. Even with that amount of revenue, the federal government spent more than it collected, which is known as deficit spending. Fiscal policy determines both how much tax revenue is collected and how individuals and businesses are taxed.
Keynesian (demand-side) theory
A modern approach to fiscal policy called Keynesian (demand-side) theory was developed by British economist John Maynard Keynes during the Great Depression era. The core idea is that increased government spending can drive economic growth.
In a recession, Keynes argued that the government should spend large amounts of money. This spending increases demand for goods and services and can raise employment. For example, the American Recovery and Reinvestment Act of 2009 was enacted during the Great Recession of 2008. The bill led to more than $800 billion in spending on infrastructure, healthcare, education, and social programs during the most severe economic collapse since the Great Depression. More than a decade later, many economists agree the legislation reduced unemployment and encouraged economic growth. When the private (non-government) sector isn’t hiring or spending enough to support growth, the government can increase spending, including through deficit spending.
Keynesian policy also works in the opposite direction. When inflation rises because the economy is “overheating,” the government can reduce spending to help stabilize prices.
Keynes also argued that tax rates can be used to influence economic activity:
In a recession, tax rates should fall to encourage individuals and businesses to spend more, supporting growth. In an inflationary environment, the government should raise taxes to help stabilize prices.
Supply-side theory
In many ways, supply-side theory takes the opposite approach from Keynesian theory. As the name suggests, supply-side theorists focus on increasing the supply of goods and services across the economy, often through reduced taxation and reduced government spending. A recent example is the Tax Cuts and Jobs Act of 2017, which resulted in significant cuts to individual income, corporate, estate, and portfolio (investment) income tax rates.
When comparing supply-side and demand-side (Keynesian) theory, the key difference is what each view treats as the main driver of economic activity:
Demand-side proponents emphasize demand for goods and services, including demand created by government spending. Supply-side proponents emphasize production and investment by the private (business) sector.
Summary of fiscal vs. monetary policy
Both fiscal and monetary policy are used by the U.S. government to influence the economy. You’ll want to know how they differ, who controls them, and the main tools each one uses.
Fiscal policy
Controlled by Congress and the President
Keynesian (demand-side) theory
Increased gov’t spending benefits the economy
Supply-side theory
Decreased gov’t spending benefits the economy
Monetary policy
Controlled by the Federal Reserve
In a recession
Increase (loosen) money supply
Bring interest rates down
In an inflationary environment
Decrease (tighten) money supply
Bring interest rates up
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