Fiscal Policy

Fiscal policy is the set of decisions a government makes about how much it taxes, how much it spends and how much it borrows. Those choices pay for schools, roads, defence and pensions, move money between households, and change the overall level of demand in the economy. The word comes from the Latin fiscus, the treasury of ancient Rome.

Fiscal policy is usually discussed alongside monetary policy, which central banks run through interest rates and the money supply. In most countries elected governments and parliaments control fiscal policy through the annual government budget, while monetary policy is delegated to an independent central bank. The two interact closely: deficits are financed by selling government bonds into markets the central bank influences.

Think of a household that runs the finances of a large apartment building. It collects service charges from residents, pays for repairs, lighting and security, and sometimes takes a loan to replace the lift. If it raises charges, residents have less to spend elsewhere; if it hires more cleaners, local workers earn more. Its choices ripple through the whole street.

A government does the same on a national scale. When the economy is weak it can spend more or tax less so that people and firms keep buying; when the economy is running hot it can do the reverse. The catch is that every loan has to be serviced later, so today's choices shape the options of future governments.

Governments have three broad levers, and most budgets use all of them at once.

• Spending. Government spending covers purchases of goods and services (teachers' salaries, medicines, roads) and investment in infrastructure, which enter GDP directly.
• Transfers. Transfer payments such as pensions, unemployment benefits and child allowances move income from taxpayers to recipients without buying anything in return.
• Taxation. Income taxes, sales taxes and VAT, corporate and property taxes raise revenue and change incentives to work, save and invest.
• Borrowing. The gap between spending and revenue is the deficit, financed by government borrowing; accumulated deficits form the national debt.

A fiscal stance is called expansionary when it adds to demand (higher spending or lower taxes) and contractionary when it subtracts. The intellectual case for using it to fight downturns comes from Keynesian economics, which argues that in a slump private spending can fall short of what the economy could produce, leaving an output gap and idle workers. Each dollar of extra public spending may then raise total output by more than a dollar through the multiplier effect, whose size depends on the marginal propensity to consume.

Much stabilization happens without any new decision. Automatic stabilizers are parts of the tax and benefit system that respond to the cycle by themselves: tax receipts fall and benefit payments rise in a recession, cushioning household incomes, and the reverse happens in a boom. Discretionary measures, such as the US American Recovery and Reinvestment Act of 2009 or the large support packages of 2020, are passed deliberately and suffer from policy lags: by the time a law is debated, passed and spent, the economy may have moved on.

Economists also look at the primary balance, which strips interest payments out of the deficit, and at the cyclically adjusted balance, which removes the effect of the business cycle to show the underlying stance.

Because borrowing is politically easier than raising taxes, many countries bind themselves with fiscal rules. In the European Union, the reference values of a 3% of GDP deficit and 60% of GDP debt date from the Maastricht Treaty; a reformed framework, Regulation (EU) 2024/1263, entered into force on 30 April 2024 and steers countries through a multi-year path for net expenditure. The United Kingdom set up the Office for Budget Responsibility (OBR) in 2010 to produce independent forecasts, and the US Congressional Budget Office has scored legislation since 1975. Countries borrowing from the IMF, such as Pakistan under the Extended Fund Facility approved in September 2024, agree fiscal targets as a condition of the loan.

Fiscal policy is one of the most argued-over areas of economics.

• Crowding out. Critics argue that government borrowing can push up interest rates and displace private investment, a process known as crowding out.
• Household foresight. The theory of Ricardian equivalence holds that households may save a tax cut in anticipation of future taxes, weakening its effect on demand.
• Consolidation. Whether deficit reduction in a weak economy helps confidence or deepens the slump is the core of the debate on austerity.
• Monetary interaction. When interest rates are stuck near the zero lower bound, many economists see fiscal policy as more powerful; when a central bank is raising rates to fight inflation, fiscal expansion can work against it.
• Hidden tax rises. Leaving tax thresholds unchanged while prices and wages rise produces fiscal drag, raising revenue without a vote on new rates.

Supporters of active fiscal policy point to deep downturns such as the Great Depression and the 2008 financial crisis; sceptics, including many in the monetarist and supply-side traditions, stress lags, political bias towards deficits and the long-run cost of debt.

• International Monetary Fund: Fiscal Monitor
• Office for Budget Responsibility
• Congressional Budget Office