In economics, fiscal policy is the use of government expenditure and revenue collection to influence the economy.[1]
Fiscal policy can be contrasted with the other main type of economic policy, monetary policy, which attempts to stabilize the economy by controlling interest rates and the supply of money. The two main instruments of fiscal policy are government expenditure and taxation. Changes in the level and composition of taxation and government spending can impact on the following variables in the economy:
- Aggregate demand and the level of economic activity;
- The pattern of resource allocation;
- The distribution of income.
Fiscal policy refers to the overall effect of the budget outcome on economic activity. The three possible stances of fiscal policy are neutral, expansionary, and contractionary:
- A neutral stance of fiscal policy implies a balanced budget where G = T (Government spending = Tax revenue). Government spending is fully funded by tax revenue and overall the budget outcome has a neutral effect on the level of economic activity.
- An expansionary stance of fiscal policy involves a net increase in government spending (G > T) through rises in government spending, a fall in taxation revenue, or a combination of the two. This will lead to a larger budget deficit or a smaller budget surplus than the government previously had, or a deficit if the government previously had a balanced budget. Expansionary fiscal policy is usually associated with a budget deficit.
- A contractionary fiscal policy (G < T) occurs when net government spending is reduced either through higher taxation revenue, reduced government spending, or a combination of the two. This would lead to a lower budget deficit or a larger surplus than the government previously had, or a surplus if the government previously had a balanced budget. Contractionary fiscal policy is usually associated with a surplus.
The idea of using fiscal policy to combat recessions was introduced by John Maynard Keynes in the 1930s, partly as a response to the Great Depression.
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