Fiscal policy

Fiscal policy encompasses public expenditure, taxation and borrowing. Its essential function is the provision of public goods and services, and it can also be used to influence social conduct, the distribution of wealth and the level of economic activity.

Policy options

Fiscal policy is necessarily concerned with the provision and financing of those public goods and services that have to be collectively funded because they cannot be provided by the market; and it may also be concerned with the provision of other goods and services for which collective funding is deemed to offer advantages over provision by the market. It is not normally concerned with procurement decisions such as the decision whether to obtain goods or services from the public sector or from the private sector. Fiscal policy decisions may be expected to affect the interpersonal distribution of human welfare, and may be tailored to that purpose. They may also be expected to influence social and personal behaviour, and may be tailored to the purpose of promoting the growth of social capital and the purpose of encouraging personal behaviour that is deemed to be beneficial and of discouraging such behaviour that is deemed to be harmful. Fiscal policy may also be expected to affect economic activity, and its decisions may be concerned with the promotion of economic efficiency, economic growth or economic stabili

Some policy objectives are achievable either by public expenditure or by taxation. For example tax breaks may serve the same purpose as government-funding or subsidies. It is also possible to use taxation instead of legislation to discourage socially harmful conduct such as smoking.

Policy objectives and constraints

The policy mix

The objectives of fiscal policy are an amalgam of the objectives of its social, political and economic policies; including policies concerning defence, law and order, health and education. A major consideration in deciding each year's public expenditure total and its allocation among those objectives is the importance attributed to welfare-promoting measures which account for the majority of public expenditure and for which there is no expectation of financial return. Ideological attitudes to welfare-promoting measures have ranged from socialism which is the advocacy of public control of all forms of socially-important expenditure to libertarianism which is opposed to any public expenditure that is not necessary for the maintenance of law and order or national defence.

The fiscal balance

Political constraints

Ideology may also influence choices concerning the proportion of public expenditure to be paid for by taxation. Some communities have developed an ideological attachment to the statutory limitation or prohibition of budget deficits - especially in the United States, where it has often been associated with libertarianism. National legislatures have sometimes sought to impose arbitrary limits upon government borrowing. Members of the United States Congress have attempted to introduce "balanced budget amendments" that would have the effect of putting a stop to all borrowing, and similar or less stringent have limits have been proposed elsewhere. Those proposals have usually been successfully resisted, but some governments have adopted self-imposed limits in order to promote investor confidence in the integrity of their bonds. Among developing countries, the development of international capital mobility has made the maintenance of investor confidence a policy imperative because panics among investors and anticipations of default by speculators have been a common cause of sovereign default - as explained by Paul Krugman . Paul Krugman explains the International Monetary Fund's apparently perverse interpretation of the Washington Consensus as requiring the avoidance of deficits, even in periods of recession as a confidence-building tactic.

The debt trap

Fiscal policy is necessarily constrained by the consideration that if a budget deficit were to be repeated year after year, a point would eventually be reached at which more money would be required for repayment of the accumulated national debt than could conceivably be raised by taxation. The need to avoid such an outcome does not, however, place an absolute limit upon the budget deficit in any particular year. In fact there have been instances when a country's budget deficits had continued until its national debt had substantially exceeded the value of its annual output - but had then been repaid from budget surpluses over a further series of years. However, the the larger is the accumulated debt and the greater the interest rate that has to be paid on it, the larger will be the budget surpluses required for its repayment. It is demonstrated on the tutorials subpage of this article that the average level of surplus required, when expressed as fraction of the national debt that has been accumulated, has to amount to a percentage of GDP at least equal to the difference between the interest rate payable and the GDP growth rate. An unstable situation can arise, however, if investors in the debt repeatedly demand increased interest rates to compensate for what they perceive to be a risk that it may never be repaid - and for that reason, the maintenance of investor confidence is a further condition for fiscal sustainability.

Stabilisation

Attitudes to the use of fiscal policy to stabilise the economy have changed as a result of experience during the early post-war years. Discretionary fiscal policy was widely used for that purpose until the 1980s , but a consensus has subsequently developed in favour of restricting its use to the promotion of recovery from cataclysmic shocks such as wars and systemic financial crises.

Policy trends

There have been substantial increases in taxation as a share of GDP in the OECD countries since the 1970s, with substantial reductions in the shares of consumption taxes and personal income tax in tax revenues, being offset by increases in the shares of corporate income tax and social security contributions. Corporate income tax rates and the higher rates of personal income tax have generally been reduced.