Small economic fluctuations are normal in any economy. However, if these are stronger, then the state is forced to ensure the economic stability of a country and to act. This is done through fiscal policy. Everything you need to know about the topic fiscal policyIn this article you will find out what it is, what measures exist, how they differ, what instruments exist and where fiscal policy reaches its limits.
What is fiscal policy? – Define
In general is fiscal policy a government control instrument to counteract economic fluctuations and ensure the country’s economic stability.
So shall priority Strength Economic fluctuations are avoided. This applies both to severe slumps in economic output and to high growth rates. Fiscal policy must be based on stability policy goals. These are:
John Maynard Keynes (1883–1946) is considered a pioneer of fiscal policy. According to Keynes, the state should influence aggregate demand in order to achieve the lowest possible unemployment rate. This is also known as countercyclical fiscal policy.
Anti-cyclical fiscal policy
Every market is subject to fluctuations. This is not bad in itself, but large fluctuations lead to an unstable economy. Therefore the state bears (treasury) a certain responsibility. In order to meet this obligation and avoid economic instability, the state ensures stability on the markets by means of anti-cyclical fiscal policy. However, this is only the case in extreme situations.
Anti-cyclical means against the current market trend.
An economic crisis shakes the markets. The state intervenes by supporting the economy with state aid (investments in social benefits). As soon as the crisis is over and the markets have recovered, the state will stop this aid and try to generate higher income through various instruments (increasing VAT). He needs this to cover the previous expenses and to be able to reduce national debt.
The anti-cyclical action of the state is reflected in the fact that investments are made when economic output is low and cuts are made when economic output is high.
The counterpart to countercyclical fiscal policy is the pro-cyclical fiscal policy. It is characterized by the fact that economic growth is driven by increasing government spending. However, pro-cyclical economic policy is only rarely applied and is viewed very critically by economists. The main criticisms here are:
- an increased rate of inflation
- excessive national debt
- fewer resources for crisis management
Classic budget policy
In addition to the anti-cyclical fiscal policy, many countries are pursuing the classic one budget policy (engl. for budget policy). This existed before Keynesianism. The goal of a narrow state was pursued until the socialist labor movement and the economic crisis of 1929. State expenditures are to be reduced to a minimum (minimum budget) and the state should behave neutrally with its tax policy in order to disturb the economic process and market forces as little as possible (postulate of neutrality). This structure goes back to the classic liberal economic assumptions of Adam Smith (1723-1790). The invisible hand of the market should regulate itself.
the budget policy – also known as budgetary policy – includes political measures to keep government debt as low as possible. This defines which state expenditures are financed by borrowing or by using equity.
After being put aside for a few decades, this way of doing business has been experiencing since the mid-1970s neoliberalism a renaissance. Milton Friedman (1912-2006) is considered the best-known representative of neoliberalism. Like Adam Smith, Milton Friedman relies on the invisible hand of the market. The state should intervene as little as possible in the economy and its markets, because the market can regulate itself.
Measures and instruments of fiscal policy
There is two actions of (countercyclical) fiscal policy. On the one hand at the expansionary fiscal policy government spending increases to strong negative economic fluctuations to counteract. On the other hand, at restrictive fiscal policy refinanced these expenses through higher revenues. In this way, the previously incurred debts are reduced.
Expansionary fiscal policy
In order to avoid strong negative economic fluctuations (recession) the state pursues an expansive fiscal policy. During a recession, demand from the economy as a whole is usually lower than supply. Through this expansionary fiscal policy the state tries to increase the spending and purchasing power of the population. This should stimulate the economy and create jobs. This means that more money is available for expenses again.
expansive fiscal policy denotes government intervention to intercept or prevent a recession. These fiscal policies include cutting taxes or increasing government spending.
In addition, tax cuts can provide financial relief for consumers, which in turn allows them to buy more. Companies also benefit from a reduction in taxes. If corporate taxes are reduced, they can e.g. B. offer their own products cheaper or invest in new technologies.
There are various expansive instruments of the state. The state can always choose between two basic strategies. For one, he can increase his own spending, or the income of the citizens. Instruments of expansive fiscal policy are:
- Investments in infrastructure e.g. B. Bridges, roads, public transport (expenditure increasing)
- Increase in social benefits e.g. B. higher unemployment benefit, higher child benefit (expenditure and income increasing)
- Borrowing/Debt (Increasing Spending)
- reducing taxes e.g. B. VAT, corporate tax, wage tax (revenue-increasing)
The government has a lot of leverage to increase its spending as well as increase the income of people and businesses. In order to refinance these expenses, the state must restrictive fiscal policy use.
Restrictive fiscal policy
In contrast to expansionary fiscal policy pursues the restrictive fiscal policy the goal of moderating growth and thus weakening boom phases. Politicians don’t do this to weaken the economy, but to national debt to to reduce. Because through the expansionary fiscal policy arise a lot debts and these must be settled over time. However, since companies and the population suffer in times of economic crisis, this is practiced in times of growth.
The goal of restrictive fiscal policy is to reduce government spending or increase revenue and thus form the counterpart to expansive fiscal policy.
The state has different options for this as well instruments available, which are in contrast to the expansive fiscal policy. Here the state can again choose between two basic strategies and link them together: either increase state revenue or reduce state expenditure.
- Reduction of social benefits, e.g. B. Reduction of child benefit and unemployment benefit (reducing expenses)
- Decrease in public investment in infrastructure projects (reducing spending)
- Increase in VAT (increasing revenue)
- Increase in corporate tax and/or payroll tax (increasing revenue)
Thus, the most common instruments of the Treasury (state) Tax increases and tax cuts. Cutting back or increasing investments is also common. These tools have a significant impact on state budget and orient themselves offer and demand.
In the figure below you can see what effects the intervention can have. Compare the red curve (intervention) with the blue curve (no intervention).
Figure 1: Anti-cyclical fiscal policy Source: Haushaltssteuerung.de
Supply-oriented and demand-oriented economic policy
In economic policy, a distinction is made between two different orientations: supply orientation and demand orientation. Again, both John Maynard Keynes and Adam Smith have been major influences on the way of thinking.
While Adam Smith advocates a supply-side economic policy, John Maynard Keynes is considered a representative of the demand-side economic policy.
supply-side economic policy
The supply-side economic policy mainly favors company. This can be done in particular by lowering taxes and removing entrepreneurial hurdles.
If politicians decide that certain environmental regulations no longer have to be complied with, companies can sell their products at lower prices. The obvious preference for the economy over the environment is criticized here.
Demand-oriented economic policy
The private households favored and thus stimulated demand among the population. The aim is to increase consumption.
When infrastructure programs or a scrappage premium are introduced, the demand for new vehicles increases. The problem with this is that the large-scale investments take on a lot of debt and the debt burden of the state increases. Also, these investments need to be refinanced, which in turn involves tax increases can go hand in hand.
Fiscal Policy Limits
The measures and instruments of fiscal policy are helpful in many cases. However, it also has its limits in some areas. In order for fiscal policy to be carried out successfully, the following factors must be taken into account:
- A large part of government spending is fixed for the long term and cannot be easily changed (parliamentary approval of changes to the government budget).
- The tax system can only be changed to a certain extent.
- Cuts in government spending and tax increases often cause resentment among interest groups.
- Fiscal policy measures usually only take effect with a delay.
- The effect of measures to influence investment and consumption depends on the behavior of those affected.