Fiscal policy is the use of government revenue (taxes) and expenditure (spending) to influence the economy, and meet the macroeconomic goals.
The government’s revenue and expenditure form its budget. If the revenue collection in the form of taxes equals its expenditure, it’s a balanced budget. If revenue exceeds expenditure, the government has a budget surplus. On the other hand, if expenditure exceeds revenue, it’s a budget deficit.
A government follows a neutral fiscal policy when the economy is in equilibrium. In such a case, the government’s expenditure is fully funded by the tax revenue. A government follows expansionary fiscal policy during times of recession. It may reduce taxes or increase expenditure in order to stimulate the economy – to increase demand, growth and employment. The government may follow contractionary fiscal policy to reduce fiscal deficit or pay down government debt. To do so, it may increase taxes or decrease expenditure, which will decrease demand, growth and employment.
Fiscal policy is based on Keynesian economics, which believes that the government can influence the macroeconomic productivity levels by changing the taxes and spending. Such influence can curb inflation, increase employment rate, and stabilize the value of money. Monetarists, however, believe that the effects of fiscal policy are only temporary, and they advocate use of monetary policy to control inflation.
Fiscal policy can be discretionary or nondiscretionary (automatic stabilizers). A discretionary fiscal policy refers to the deliberate changes in government spending and taxes in order to stabilize the economy; for example, the government decides to increase its capital expenditure on road infrastructure. On the other hand, automatic stabilizers are the automatic changes in the tax and spending levels because of the changes in economic conditions. They help stabilize business cycles. For example, when the economy is expanding, the tax revenue increases, and vice verse. There will also be lower government spending in the form of unemployment benefits. Economists have observed that automatic stabilizers can reduce the volatility of the economic cycle by up to 20%.