Fiscal policy

Fiscal policy encompasses public expenditure, taxation and borrowing. Its essential function is the provision of public goods and services. It is also used to influence social conduct and the distribution of wealth, and to promote the growth and stability of economic activity.

Introduction: the fiscal stance

The considerations affecting public expenditure decisions and taxation decisions are discussed in separate articles on those subjects but, for several reasons, those decisions are normally taken jointly. One reason is that the same objective can often be sought either by changes of expenditure or by changes of taxation: another is that they are jointly constrained by the need to maintain fiscal sustainability (which is defined by the OECD as the condition in which the "borrower is expected to be able to continue servicing its debt without an unrealistically large future correction to the balance of income and expenditure").

The term "fiscal stance" has been applied both to the "fiscal balance", which is the choice that has to be made between financing expenditure by taxation and financing it by borrowing - and to the choice that has to be made among interacting social and economic fiscal policy measures. From an economic standpoint, the distinction between social and economic measures is to some extent arbitrary because both are concerned with the allocation of resources for the benefit of the community, and it is only necessary to distinguish the actual expenditures of resources, and their redistribution among members of a community. In financial terms, however, a distinction has to be drawn between policies that are intended to be self-financing, and those whose justification depends upon their social benefits. It is customary to draw a distinction between discretionary changes in the fiscal balance and those that occur automatically in response to fluctuations in the level of economic activity. It is also customary to distinguish discretionary "countercyclical" policy measures that are designed to limit such fluctuations, from other discretionary policy measures, and to refer to those other measures as "structural".

The variations of fiscal stance that occur over time and between countries are reflections of the fact that it is the outcome, not of a single unlimited choice, but of successive incremental choices made within different financial and political constraints.

Policy choices

Structural policies

The criterion of fiscal policy choice by a representative government may be presumed to be the expectation of net benefit to the community (although, under a democracy, a dilemma can arise if the majority of voters demand a choice that they mistakenly believe to be beneficial). It is implicit in that criterion that fiscal policy may be employed only if it can be expected to provide a greater net benefit than could be expected from the operation of the market. The obligation to meet that criterion - either by cost-benefit analysis or by informed judgement - applies even to the politically essential items of law and defence. Except in wartime, however expenditure on those items seldom exceeds 10 percent of national income (see table), and the bulk of expenditure has been devoted to other social welfare objectives. Perceptions of the benefits from such expenditure have been influenced by a range of conflicting concepts of social justice, and there are large international differences in policy, especially in the treatment of income inequality. Social welfare objectives account for most of the expenditure on health, housing, education and social security which in many industrialised countries, cost over 20 per cent of national income , and most of which involve a significant element of redistribution.

Some of the fiscal policy measures that have been attributed to social welfare objectives may also be expected to contribute to supply-side objectives. Studies have shown that several components of social capital and human capital , including education and the maintenance of law, make significant indirect contributions to economic growth. The evidence concerning the effect of reducing inequality is mixed, but suggests, on balance, that it tends to increase growth . Policy measures concerned directly with supply-side objectives account for a relatively small proportion of national income.

Countercyclical policies

According to Keynesian theory, fiscal policy choices concerning the burden of personal and corporate income tax have a major influence upon economic stability because the revenue from such taxes falls when the economy encounters a shock, and that provides a countercyclical fiscal stimulus. The larger is the burden of those taxes and the higher are their marginal tax rates, the greater will be their countercyclical influence - implying a conflict between stability and growth (in view of the economic effects of taxation). A further, and often smaller, contribution to stability arises from the provision of income support such as unemployment benefit, the expenditure on which rises during a downturn, adding further to the stimulus. Those two effects are termed automatic stabilisers, and it has been estimated that they can absorb 38 per cent of a proportional income shock in the EU, compared to 32 per cent in the US.

A study by economists at the International Monetary Fund has shown that a fiscal stimulus package equivalent to 1 percent of country's GDP is associated on average with GDP increases of about 0.1 to 0.2 percent. In advanced economies, the longer-term effects are also positive and even possibly higher. But the longer-term effects are typically negative in emerging economies. .

Attitudes to the additional use of discretionary fiscal measures 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 constraints

Financial constraints

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 the banking 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.

The level of public debt among OECD countries is expected to rise substantially following the recession of 2009 (see table) - mainly because of the operation of automatic stabilisers.

Political constraints

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. 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 (such as the European Union's Stability and Growth Pact and the United Kingdom's Code for Fiscal Stability 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.

Policy trends

There have been substantial increases in the burden of taxation as a share of GDP in the OECD countries since the 1970s, and in composition of taxation, 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.