Fiscal policy is implemented by governments through taxes and spending.

Governments levy direct and indirect taxes. Tax rates can be changed according to the economic situation. The distribution of the accumulated funds takes place through transfer payments (welfare payments, pensions, unemployment benefits), current government spending (health and education) and capital expenditures (infrastructure projects).

The redistribution of public resources between different social groups and economic sectors allows for more precise control over the business cycle. This concept was developed by the economist J. Keynes in response to the Great Depression. He stressed the need for fiscal solutions when the economy is in an extreme state – at risk of recession or danger of overheating.

When the goal is to prop up the economy, the government will pursue an expanding fiscal policy. It will cut taxes and commit to certain sectoral spending (e.g., infrastructure projects). In doing so, it will create/protect jobs and increase the funds available to businesses and households. These funds are expected to lead to an increase in aggregate demand, thereby stimulating growth.

When the economy overheats (high growth and inflation), governments will try to cool it through higher taxes and limited government spending. This constitutes contractionary fiscal policy. Higher taxes will curb consumption and business activity, thereby cooling the economy and reducing inflation.

When the economic environment is stable and healthy, fiscal policy will be neutral – spending and revenues should be relatively balanced and tax changes rare. For many countries, times of sustainable growth provide an opportunity to accumulate fiscal surpluses. However, this is not always the case. For example, the United States has run budget deficits in each of the last 20 years, a period of alternating economic ups and downs.

Financing chronic deficits is a serious challenge. It happens mostly through issuing government debt. The steady increase in debt, in turn, risks bankruptcy for the country concerned.

Fiscal policy is often implemented in sync with monetary policy. This was, for example, the response of governments and central banks around the world during the Covid-19 pandemic. Central banks lowered interest rates sharply and engaged in massive monetary stimulus, while governments introduced tax and other relief. Sometimes, however, fiscal and monetary policies are at odds and the ultimate effects on the economy are uncertain.

There is no shortage of criticism of fiscal policy. One of the main arguments is purely political – governments redistribute wealth among different socio-economic groups according to their political goals. For example, a left-wing government is expected to engage in significant public spending financed through higher taxes on the more well-off part of the population.

Fiscal policy is applied more often when the economy is slowing and less often when the economy is overheating. This is because tax increases and spending cuts are politically unpopular measures. Some critics see this as precisely the flaw in fiscal policy – support measures for a slowing economy become a given. Over time, this leads to inflation, bubbles in particular asset classes and an overheating economy that, however, finds it difficult to make restrictive decisions.

Another criticism concerns the time required to identify the need for fiscal changes (recognition lag) and the time required to take appropriate decisions (implementation lag). The desired effects may come when they are no longer needed (impact lag).  

Sometimes too much state activity in free markets can lead to distortions and discourage businesses from investing.

Despite their imperfections, fiscal solutions are a modern and widely used tool for business cycle management. They bring some improvement over traditional notions of a self-regulating economy. In recent decades, fiscal policy has been a key tool for support in periods of recessions.

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