Skip links

Fiscal Policies Tools and Examples

Fiscal policies are measures carried out by the government to stabilize the economy by altering the level of its spending or by altering the types and levels of taxes. These policies can influence the economy by increasing the money available to the citizens or reducing the money available to them to achieve economic stability.

What are fiscal policies?

Fiscal policies are actions taken by the government to stabilize the economy by changing its taxation and spendings above the usual levels that are often gotten from taxes. When the government spends more money on projects above the amount gotten from taxes, it is said to be applying expansionary fiscal policy; but when it spends less than what is gotten from taxes, it is applying contractionary fiscal policy. When the government spendings are fully funded by taxes, then it is said to have a neutral fiscal policy.
Economists use the term fiscal policy to refer to changes in the taxing and spending policies of the government.

Fiscal Policy Tools

The fiscal policy tools are the specific actions taken by a government to influence the economy. Examples of fiscal policy tools include changing the level and types of taxes, borrowing to fund projects, selling of government bonds and securities, etc.

What are the tools of fiscal policy?

There are 2 major fiscal policy tools used by the government which are altering the level and type of taxation and the extent and composition of government spending. Each type of tool is explained below.

Level and type of taxation

The government could influence the economy by reducing income tax for some groups of people such as the middle class or reducing the tax collected on some specific products. When taxes are reduced, more money is available to spend which increases aggregate demand.

The extent and composition of spending by the government

The government may increase or decrease its spending to stabilize or improve the economy. The economy is said to be improved when the poverty levels are low, unemployment rates are low, and the GDP is high.

Increased spending

The government usually improves the economy by increasing spending, and this can happen in various ways. It could construct highways that create more jobs for people in the construction industries. This provides access to roads as well as providing jobs. It makes it possible to transport goods and services easily and boost the economic activity of the linked communities or states.

The government can also spend money creating dams that also provide jobs in the construction industry as well as providing water that could be used for agriculture or in households.

Creating more public works programs to help alleviate poverty such as the social investment programs (an example is N-Power program) of the Nigerian government. This is an expansionary fiscal policy tool.

Government subsidies for petrol or fertilizer are all forms of fiscal tools used by the government to help improve the economy.

Increased spending by the government leads to increase aggregate demand because the people now have jobs that provide income that is used for private consumption and funding of personal lifestyles.

Decreased spendings

On the other hand, when there is inflation, assuming because of excess supply of money; then the government reduces spendings and this could be in the form of delay in getting promotions in government jobs, reduced or no constructions unless necessary, placing an embargo on employment to reduce the money that would have been used for training, recruitment, and payments of wages and salaries.

Another form of control in spendings by the government might be to save money even when the economy is growing. This often occurs in countries that are dependent on oil. When fuel prices rise, the economy of such countries grows, but when the fuel prices fall, the economy suffers. To prevent these fluctuations from affecting the welfare of the citizens when the oil prices fall, the government prefers to save in the form of external reserves than spending during an economic boom. This is a contractionary fiscal policy tool in this instance even though there was no reduction in spending.

What is affected by fiscal tools?

The fiscal tools used by the government affect various activities of the country such as private consumption, private investment, purchases of goods and services, and net exports.

Activities affected by fiscal policies:

  1. Private consumption
  2. Private investment
  3. Purchases of goods and services by the government
  4. Net exports

Together, the activities listed above are referred to as “aggregate demand” and they affect the productivity in a country. Therefore, fiscal policy refers to the idea that aggregate demand is affected by changes in government spending and taxation. The aggregate demand, in turn, affects the total goods produced in the country as firms produce more in order to meet demand. The GDP, therefore, can be influenced by fiscal policies and the main aim of the government using the fiscal policy tools is to improve or stabilize the GDP.

The 3 Types of fiscal policies

  1. Contractionary or tight
  2. Expansionary or loose
  3. Neutral

Contractionary fiscal policy (tight)

Contractionary fiscal policy is so named because it is aimed at the contraction of excessive aggregate demand. This is a type of fiscal policy that causes the contraction of the spending power of citizens in a country. It is also called “Restrictive or tight fiscal policy“. The aim is to reduce the money available in a country to control high inflation (especially the demand pull inflation). The government does this by spending less and increasing the tax rates or even extending taxation to products that were not initially taxed. When this happens, people spend less money, investments reduce, and net export reduces, hence the aggregate demand reduces also. Reduced government spending and increase taxation cause a left shift of the aggregate demand curve. Therefore, an appropriate fiscal policy for severe demand pull inflation is contractionary fiscal policy.

This is an unpopular fiscal policy that is rarely used by the government because of the political effects it has on their reelection. Voters love government spendings and reduced taxes instead of increased taxes and reduced spendings. To avoid using the contractionary fiscal policy, the government rather uses the contractionary monetary policy where the interest rates are increased by the central bank together with other monetary policies to reduce the supply of money in circulation to curtail high inflation.

Examples of contractionary fiscal policy tools

  1. Placing an embargo on employment or public works programs
  2. Removal of subsidies
  3. Increased tax rates and extending taxes to previously untaxed products
  4. Reduce constructions to only necessary projects

What does contractionary fiscal policy do to economic growth?

When there is excess aggregate demand, the appropriate fiscal policy would be for the government to increase tax and reduce spending in order to control the inflation associated with excessive aggregate demand.

Expansionary fiscal policy (loose)

This is a type of fiscal policy that involves the government spending more than it gets from tax or other sources of revenue; the goal of expansionary fiscal policy is to increase the aggregate demand by improving the spending power of citizens in a country. The aim is to make more money to be available in a country to stimulate growth and employment. The government does this by spending more and reducing the tax rates or even giving tax exemption on some products that were initially taxed.

Examples of expansionary fiscal policy tools

  1. Creating public works programs by the government
  2. Paying of subsidies on various products such as fuel, fertilizers, health care, education. etc.
  3. Reduced taxes
  4. Tax exemption to companies and some products
  5. Major construction projects

Neutral Fiscal Policy

A neutral fiscal policy means the government does not increase nor decrease its spending nor does it increase or decrease any tax rate. What this means is that there is no significant alteration in the habit of the government to cause a change in the economic activity of the country. Whenever the government is carrying out the projects in a budget, the proposed amount may fall short of the actual funds needed to fund the projects, this is known as a budget deficit. In order to fund the projects, the government needs to borrow money. In a neutral fiscal policy, there is no change in the amount of money that the government usually borrows to fund a deficit budget. This should not be confused with borrowing to stimulate economic growth (which is often much) compared with that for funding part of a budget. Hence, in a neutral fiscal policy, there is no change to the amount of the usual government spending habits and no economic impact.

How does fiscal policy affect the economy?

Government spendings can affect the economy positively and negatively as well.

The positive effects on the economy

When this happens, people have more money to spend and invest which increases the demand for goods and services; the increased demand drives companies, businesses, and firms to try to meet up to the demand by employing more people to produce more goods and services. This has a positive effect on the economy because it creates employment; and when more companies require employees, it does not only create jobs but also increases the wages and salaries because every enterprise tries to win the employees to itself. In the end, there is increased aggregate demand, more jobs, higher wages and salaries as well as economic growth. Increased government spending and reduced taxation cause the aggregate demand curve to shift to the right.

The negative effects on the economy

Increased government spendings above the funds gotten from revenue sources have some disadvantages as well. The government has to borrow to spend more as a fiscal tool; when this happens, it can actually drive the interest rates up and therefore discourages the private sector from getting loans and investing in projects that would have improved the economy. This is known as the crowding out effect. To better understand the crowd out effect, assume many companies want to borrow some money from a local bank and the government also need even more money to spend to improve the economy; when the money in the local bank is not enough, the bank would increase the interest rate because the demand is high. This simple increase in the interest rate discourages the private firms because it reduces the profit that would have been made and if the profit margin is small, the private firms would let go of their projects, which in turn further depresses the economy.

Another disadvantage of expansionary fiscal policy is that it is difficult to reverse it because any politician who reduces spendings and increases taxes may likely not be elected again. This causes a reluctance by the government to reverse this policy even to the detriment of the economy. When not checked in time, the debt may be so high that a default would occur and high inflation also because of the excessive money in circulation caused by excessive spendings.

Fiscal policy fundings

  1. Increased Taxation
  2. Seigniorage, the benefit from printing money
  3. Borrowing from the population or other sources outside of the country
  4. Reserves
  5. Sale of some assets such as lands, companies, etc
  6. Selling equity to the population

For the government to spend more than it gets from taxes, it must source funds from various sources which are listed above.

Who controls fiscal policy?

The executive arm of government is in charge of handling fiscal policies. Other arms of government such as the legislative also handle fiscal policies in some countries such as the United States of America, where the legislative arm is in charge of authorizing taxes and determining the amount of spending appropriated for any fiscal policy. In some countries such as Nigeria, a minister of finance may suggest to the federal executive council (FEC), which is headed by the president on the need to increase or decrease tax; the same can be suggested by other ministers of which when accepted by the council, the appropriate fiscal policy can be effected.

The government determines what should be addressed through fiscal policy whereas the central bank determines the monetary policies. In the USA, the legislative arm also determines how the problems regarding taxes and its laws are addressed as well as allocates the limit to the spending on fiscal policies. The process involves several deliberations prior to approval by the House of Representatives and the Senate.

When are fiscal policies said to be effective?

I  know you would be wondering since applying one measure such as increasing government spending may lead to inflation when the economy bounces back while a reduction in spending together with increased taxes may lead to poverty, then when can the fiscal policy be effective?

The target for use of fiscal policies is to keep the inflation rate at 2 to 3% and also to keep the GDP growth rate at 2 to 3% as well as reduce the unemployment rate to a level that is near the natural unemployment rate of 4 to 5%.

What does fiscal policy most closely focus on?

Fiscal policy closely focuses on government spending than taxation because the political will to increase taxes is rare.

Who decides what problems should be addressed through fiscal policy?

The government determines what should be addressed through fiscal policy whereas the central bank determines the monetary policies. In the USA, the legislative arm also determines how the problems regarding taxes and its laws are addressed as well as allocates the limit to the spending on fiscal policies. The process involves several deliberations prior to approval by the House of Representatives and the Senate.