Fiscal policy

Government holds two great levers over the economy. Fiscal policy is the one it pulls through its budget, by spending and by taxing.

Fiscal policy is the use of government spending and taxation to influence the economy. By changing how much it spends and how much it takes in tax, a government can stimulate demand when the economy is weak or restrain it when it threatens to overheat.

Expansion and restraint

When the economy is depressed, expansionary fiscal policy, more spending, lower taxes, or both, injects demand, putting money into people's hands and directly buying goods and services, to support output and employment. When the economy is overheating, contractionary fiscal policy, less spending or higher taxes, withdraws demand to cool inflation. The budget thus becomes a tool for managing the level of activity, not merely a ledger of public accounts.

Automatic and discretionary

Fiscal policy works partly on autopilot. Automatic stabilisers, such as unemployment benefits that rise in downturns and taxes that fall when incomes drop, cushion the cycle without any new decision being taken. Beyond these, discretionary fiscal policy involves deliberate changes, a stimulus package, a tax cut, an austerity programme. The automatic stabilisers are quietly powerful and well-timed; discretionary measures are stronger but slower, since they must pass through the politics of decision and the lag of implementation.

The constraints and the debate

Fiscal policy is constrained by the need to finance it. Spending more than is raised means borrowing, adding to public debt, which cannot rise without limit. Debates rage over how much governments should use fiscal policy to manage the cycle, whether stimulus crowds out private activity, and when high debt becomes dangerous. These arguments, between those who favour active fiscal management and those who fear its costs and distortions, are among the most consequential in economic policy.

Fiscal policy is the government's most direct instrument for shaping demand, and the one most entangled with politics, since every tax and every spending line has constituencies and consequences. Alongside monetary policy, it is one of the two great tools by which modern states try to steer their economies.