Fiscal policy

Fiscal policy

Fiscal policy is controlled and implemented by the U.S. Congress (House of Representatives and Senate) and the President. This form of economic policy focuses on how our government collects and spends money.

The majority of the government’s revenue is collected through taxation. You’re probably most familiar with income taxes, which the Internal Revenue Service (IRS) collected roughly $2.0 trillion of in 2021. That’s a lot of money, but the government spent even more than it collected (known as deficit spending). The amount of taxes collected and how individuals and businesses are assessed is determined through fiscal policy.

Keynesian (demand-side) theory

A modern form of fiscal policy called Keynesian (demand-side) theory was developed by British economist John Maynard Keynes in the Depression era. His theory stated that increased government spending drives the economy’s growth.

In a recession, the government should (according to Keynes) spend immense amounts of money, which drives demand for certain goods and services while increasing employment. For example, the American Recovery and Reinvestment Act of 2009 was enacted amid the Great Recession of 2008. The bill resulted in more than $800 billion spent on infrastructure, healthcare, education, and social programs amid the greatest economic collapse since the Great Depression. Well more than a decade later, many economists agree the legislation reduced unemployment and encouraged economic growth. If the private (non-government) sector is not hiring or spending enough money to keep the economy growing, the government certainly can (through deficit spending).

It also works the other way; the government should reduce spending to stabilize prices when inflation rises due to an “overheating” economy.

Keynes also argued tax rates could be used to influence the economy. In a recession, tax rates should fall to incentivize individuals and businesses to spend more money, encouraging economic growth. On the other hand, the government should raise taxes in an inflationary environment, leading to stabilizing prices.

Supply-side theory

In many ways, supply-side theory is the opposite of Keynesian theory. As the name suggests, supply-side theorists encourage a growing supply of goods and services across the economy through reduced taxation and 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 to demand-side (Keynesian) theory, the belief of what drives economic activity is the primary difference. Demand-side proponents believe demand for goods and services from the government is the catalyst. In contrast, supply-side proponents believe the supply of goods and services from the private (business) sector is.

Summary of fiscal vs. monetary policy

Both fiscal and monetary policy are utilized by our government to influence the economy. It’s important to know the differences, how they’re controlled, and the various ways the policies are implemented. Here’s a summary that should help:

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