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 European Union, compared to 32 per cent in the United States .

It is open to policy-makers to augment the countercyclical effect of the automatic stabilisers with a discretionary fiscal stimulus. 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. . Discretionary fiscal policy figured prominantly in economic management in the post war 20th century until the 1980s. A consensus then developed in favour of using monetary policy for countercyclical purposes, and little use was made of countercyclical fiscal action until the crash of 2008, in the aftermath of which there was a general acceptance by the governments of the Group of Twenty industrialised countries of the need to use fiscal policy to augment monetary expansion.

An increase in a country's budget deficit is implicit in countercyclical fiscal action, and major national debt increases - due mainly to the operation of the automatic stabilisers - are expected to follow the ending of the recession of 2009.

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 - a situation that has been termed the debt trap. 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 exceeded double 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 fiscal sustainability. Moreover, an unstable situation can arise if investors lose confidence in the issuer of the debt and demand increased interest rates to compensate for what they perceive to be a risk that it may not be repaid (a condition that is termed sovereign default). Once started, that can lead to a herding panic similar to a run on a bank. For that reason, the maintenance of investor confidence is a condition for fiscal sustainability that can outweigh more objective considerations.

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 have influenced attitudes to debt and for the extent to which public expenditure has been constrained by arbitrary limits on borrowing. Some communities have sought the statutory prohibition of all budget deficits - especially in the United States, where it has often been associated with libertarianism - and others have sought to impose arbitrary limits upon the level of government borrowing. Members of the United States Congress have several times attempted to introduce "balanced budget amendments" that would have the effect of putting a stop to all borrowing - and similar, or less stringent, limits have been proposed elsewhere. Those proposals have usually been successfully resisted, but popular fears that debt might somehow get out of control have continued to exert a political influence.

Thus, arbitrary borrowing limits (such as the European Union's Stability and Growth Pact and the United Kingdom's Code for Fiscal Stability serve to promote political confidence in their providers as well as investor confidence in the integrity of their bonds. Among developing countries, in particular, the development of international capital mobility has made the maintenance of investor confidence a policy imperative despite their other drawbacks. Panics among investors and anticipations of default by speculators have been such a frequent cause of sovereign default among developing countries that it has prompted the imposition of otherwise damaging restrictions. Paul Krugman has defended the International Monetary Fund's apparently perverse interpretation of the Washington Consensus (in requiring the avoidance of deficits, even during recessions) 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. Further trends during the second decade of the 21st centuries are expected to be influenced on the one hand by the need to maintain the confidence of voters and investors, and on the other, to avoid economically damaging and politically unpopular public service cuts and tax increases.