Fiscal policy is how governments adjust their spending levels and tax rates so they can influence the economy. It touches many parts of society, including businesses, households and infrastructure.
Explore how fiscal policy is developed in the United States, and discover some definitions of what this policy is as well as the different approaches that have been taken historically. We’ll also discuss where the country is now, and how you can get involved and make a difference.
What is fiscal policy?
As the idiom goes, nothing is certain in life except death and taxes. But while taxes are definitely an inevitability, the amount of taxes people pay and the methods used to impose those taxes are influenced by many different factors that are far beyond citizen control. To understand it better, one has to pay attention to fiscal policy. It's a concept that seems esoteric, but it really comes down to two simple things that everyone who has ever created a budget has had to contend with: spending and income.
All economies — no matter whether they are local, state or national — are influenced by these two things. Governments are funded by taxes, which are paid by the residents and companies that are located in a specific country. When governments spend money, they do so in the interest of the people who live in the country being governed.
Fiscal policy is how governments adjust their spending levels and tax rates so they can influence the economy. It touches many parts of society, including businesses, households and infrastructure.
In most governments, taxes and spending are controlled by legislative bodies, and in the United States, that legislative body is Congress. While Congress makes the ultimate decisions about who pays how much for taxes, and where tax revenues are spent, they are influenced by special interests, lobbyists and politics.
On this page, explore how fiscal policy is developed in the United States, and discover some definitions of what this policy is as well as the different approaches that have been taken historically. We’ll also discuss where the country is now, and how you can get involved and make a difference.
Expansionary fiscal policy
This policy can be either expansionary or contradictory — in other words, the government can choose to either expand or contract the available supply of money in the economy. When a government uses an expansionary policy, it increases the money supply in the economy by increasing spending or cutting taxes.
The goal of an expansionary policy is to stimulate an economy that isn’t growing by itself. The theory behind it is that if the government spends more, it will inject more money into the economy and hopefully stimulate additional spending by consumers. Similarly, if it cuts taxes, then consumers will put more money into the economy because they are not spending that money on taxes. But there are intricacies involved with both increased spending and tax cuts as well as varying economic theories about which types of spending and tax cuts are most effective for stimulating a stagnant or recessed economy.
Is the current U.S. fiscal policy expansionary or contradictory?
The U.S. government has been employing an expansionary policy since 2009. The expansionary policy was largely in response to the Great Recession, which began in December 2007 and lasted until June of 2009. While there have been differing opinions about which factors were most effective, economists have widely credited the fiscal stimulus caused by increased spending and tax cuts as the prime mitigating factor for the recession and the impetus for the increased economic growth the nation experienced over the following years.
U.S. fiscal policy timeline
Prior to the Great Depression in the 1930s, the U.S. government took a hands-off, laissez-faire approach to fiscal policy. The government did its share of taxing and spending during that time, but there was no calculated policy to influence the economy. That all changed with the Great Depression and the election of President Franklin D. Roosevelt.
President Roosevelt and the Great Depression
The Great Depression, which began with the crash of the U.S. stock market in 1929, was a worldwide economic depression, and its effects on the U.S. economy were devastating. By 1933, a whopping 25% of U.S. workers were unemployed, and the American public looked to its government to do something to help turn things around.
President Roosevelt was elected to lead the country at the height of the depression in 1933. He believed that the role of government in federal economic policy should be expanded and that the employment of an expansionary fiscal policy would help pull the country out of the depression. He implemented a series of projects, collectively called the New Deal, in the first 100 days of his administration. The New Deal was an expansionary policy that included the creation of several new federal agencies, a robust jobs program called the Works Progress Administration, the Tennessee Valley Authority and the Social Security Act, which became one of the largest entitlement programs in the country.
World War II
While the New Deal did provide some relief and essentially reformed the U.S. economy, it did not pull the country out of the Great Depression as Roosevelt had hoped. But the further expansionary fiscal policies enacted by the government during World War II did. As the United States prepared to enter the global conflict, it increased spending by subsidizing arms manufacturers and the suppliers of raw materials used by the military. Then after the United States entered the war in 1941, it continued to spend. The increased spending on manufacturing created an increased demand for goods and services, and the vast number of people employed in manufacturing war materials lead to lower unemployment.
After the war ended in 1946, the government enacted the Employment Act of 1946 in an effort to keep the economy from plunging back into a depression. This law, which was signed into effect by President Harry S. Truman on February 20, 1946, was originally created to ensure that fiscal policy would be utilized to maximize employment as soldiers returned from war. While the act was revised many times over the following years, its primary effect was the creation of the Council of Economic Advisers, which had the job of advising the president on economic policy and helping to appoint members to the Joint Economic Committee. This committee, which still exists today as a standing committee of the U.S. Congress, reports on the current economic condition of the country and makes suggestions for how to improve it.
The 1970s stagflation and beyond
After World War II, the United States fluctuated between deficits and surpluses. Then during the 1970s, the country experienced what has come to be known as stagflation, slow growth with a rapid increase in prices. During that time, the country experienced high oil prices, inflation, unemployment and recession. Traditional expansionary fiscal policies did not have the effect of boosting the economy, so the government had to turn to a series of monetary policies that gave the Federal Reserve (the organization that today promotes the health of the U.S. economy and the stability of the U.S. financial system) a larger role in the creation and implementation of fiscal policy in the United States.
The federal deficit continued to increase as the government kept implementing expansionary fiscal policies in the 1970s, the 1980s and much of the 1990s. But between 1997 and 2001, revenues exceeded expenditures for the first time in many years. As a result, the country experienced a surplus and fiscal policies were largely contradictory. But in 2001, a series of events caused the U.S. economy to falter, requiring another round of expansionary fiscal policies to boost the economy. These events included the dot-com bubble burst, the attacks of September 11, 2001, and an increase in military spending aimed at the wars in Iraq and Afghanistan.
The United States experienced one of the deepest recessions since World War II between December 2007 and June 2009. That recession has since been eclipsed by the one we are currently experiencing as a result of the COVID-19 pandemic, but it had a severe effect on the U.S. economy, with a deep decline in GDP and severe unemployment. In order to keep the economy from falling into a depression in 2009, the U.S. government passed expansive fiscal legislation that included tax cuts and spending.
How does fiscal policy work?
Spending and taxes in the United States are largely controlled by Congress, although the Executive Branch does have a significant influence on the fiscal policies put into place in a particular administration. Let’s look at how spending and taxation work in the U.S. economy.
Congressional spending comes in two different types: discretionary and mandatory. Discretionary spending is authorized by Congress through annual appropriations that are included in the yearly budget. Many national programs and activities, including defense, education and transportation programs, are funded through appropriations. Discretionary spending is subject to rules and processes that Congress puts in place to ensure that funds are distributed as the appropriations have stipulated. This is the simplest way to increase spending because it does not require a special vote.
Mandatory or direct spending is spending on entitlement programs and direct payments to state and local governments as well as people and businesses. This type of spending is generally authorized by statute. The three biggest entitlement programs in the United States are Social Security, Medicare and Medicaid, but there are many other smaller programs that also rely on mandatory spending. Some of these programs stay in effect indefinitely, and others are tied to a specific time period, after which they expire. To increase mandatory spending by increasing benefits payments (also called transfer payments), it must be passed by a 60-vote majority in the Senate, which is more difficult.
Taxes in the United States are paid by every-day citizens through income and capital gains taxes and by corporations through corporate tax. The federal income tax, the largest source of income for the U.S. government, is divided into multiple tax rates and brackets that rise according to income. The government adjusts tax rates annually for inflation. The Corporate Income Tax is the third-largest source of revenue for the U.S. government, behind individual income tax and payroll tax. Tax rates are determined by the Internal Revenue Service.
Fiscal vs. monetary policy
Monetary policy is the strategy, tools and communications that the Federal Reserve employ to keep employment high, stabilize prices and moderate interest rates. The Federal Reserve can use four different tools to help meet its goals:
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It can adjust the discount rate, the short-term loan interest rate that Reserve banks charge the commercial banks.
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It can adjust reserve requirements, the amount of money that Reserve banks must have in cash.
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It can manipulate open-market operations by influencing the buying and selling of government securities.
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It can change the interest on reserves, which is the amount of interest that is paid on excess reserves at Reserve banks.
Monetary policy is different from fiscal because it has to do with the actions of the central banks, and it is controlled by the Federal Reserve. Fiscal policy, on the other hand, has to do with taxing and spending, which is controlled by Congress.
Fiscal vs. economic policy
Economic policy is all of the systems that a government has in place for taxing, budgets, money supply and interest rates. It also encompasses employment, regulatory policies, trade policies and policies that affect economic growth.
Fiscal policy is just one portion of economic policy, referring solely to the taxation and spending portion that is controlled by Congress. The overall economic policy that guides the country is influenced by the fiscal part, but it is also influenced by monetary policy and international institutions like the International Monetary Fund and the World Bank.
Fiscal vs. stimulus
While fiscal policy often does have the effect of stimulating the economy, policy and stimulus are two different things.Stimulus is the use of either fiscal or monetary policy to stimulate the economy. Monetary stimulus affects the nation’s supply of money and is enacted by the Federal Reserve. A fiscal stimulus is enacted by Congress and involves increasing spending and decreasing taxes.
What are the effects of fiscal policy?
There is a direct effect on the economy. When spending is increased or taxes are decreased, more money is injected into the economy, which can help to stimulate growth. When spending decreases and taxes increase, it can slow growth in an economy that may be growing too fast and causing unnecessary inflation.
When a government increases discretionary spending, it appropriates more money towards national programs and activities during the budget approval process, which provides more jobs, more production, and more spending on raw goods, manufacturing and materials. Decreased taxes in the private and corporate sectors free up more income for individuals and businesses to spend on goods and services, which also stimulates the economy.
Decreased government spending slows down economic growth because the government is purchasing fewer raw materials and funding fewer large infrastructure plans and other projects that add to the economy. Decreased taxes reduce the amount of income people and corporations have to spend, which also slows economic growth.
Fiscal policy is often a tricky balancing act for policymakers, and it doesn't always have the desired effect. Sometimes a policy meant to stimulate the economy can slow it down over time or lead to undesirable side effects.
How does fiscal policy affect the U.S. economy?
While an expansionary policy can help boost a flagging economy and keep it from spinning into a depression in the short term, the long-term effects can be harmful. Over time, an expansionary policy can result in rising interest rates, which can stifle investment spending. It can also strengthen the U.S. dollar, which can create a trade deficit. In addition, it can lead to accelerating inflation.
In contrast, a contradictory policy can slow down an economy that might be growing out of control, and help control inflation. Over time, a contradictory policy can also help manage public debt. However, it can also add to the effects of a recession or a depression.
U.S. fiscal policy and COVID-19
The COVID-19 pandemic has pushed the global economy into the worst recession since World War II, with economists predicting that the global economy will shrink by 5.2% this year. Because of this, governments around the world have been doing their best to boost their individual economies with various stimulus packages.
The United States government has adopted an expansionary policy, with aggressive legislative actions designed to boost the economy and keep it from dropping into a deeper recession or a depression. These actions include direct consumer payments, forgivable loans to small businesses and increased benefits for the unemployed. All of these actions have had a substantial effect on the U.S. economy.
What can you do?
You can make a difference when it comes to fiscal policy. The most important thing you can do is get educated about what it means, and then communicate with your local, state and federal representatives. You can do this with Up to Us. Sign the pledge to let local representatives know that you are concerned about the nation’s fiscal future, or get involved by learning about how you can make a difference in your own community.
