The term “fiscal policy” refers to a government’s tax and spending plans. It regulates taxation and spending in the public sector, eventually impacting the overall economy.
While fiscal policy can be implemented successfully to lower budget deficits, battle unemployment, and boost domestic consumption, its implementation typically takes some time. Moreover, it can result in conflicts between different objectives.
For at least a century now, economists have been discussing the benefits and drawbacks of fiscal policy. Below are some of the primary pros and cons of fiscal policy.
Pros of Fiscal Policy
The government can employ an expansionary fiscal policy to limit unemployment when it is high. Likewise, when the government uses budgetary tools to boost spending or reduce taxes, it implements an expansionary fiscal policy.
For instance, tax reductions may increase people’s expendable income, which increases demand for products and services. This leads to the private sector increasing production to keep up with the rising demand, leading to more job openings.
Boosts Economic Growth
A nation can boost its economy by employing various fiscal policy strategies in its financial plan. For example, firms and individuals will be more motivated to spend and drive the economy forward when the government lowers tax rates.
For instance, the US government passed the Economic Stimulus Act of 2008 to help the US economy recover from the Great Recession 2008. This act offered a variety of fiscal measures, including tax incentives to stimulate business investment and increase economic growth.
Lowering Budget Deficit
When expenses surpass income, a country has a budget deficit. A budget deficit may result in increased debt, greater interest costs, and minimal reinvestment, reducing income.
The country can adopt contractionary fiscal policy measures as one of the negative economic outcomes of a budget deficit is an increase in public debt. In a contractionary fiscal policy, the government will have to decrease public spending while raising tax rates to boost revenue and ultimately reduce the budget deficit. These actions can, in some cases, convert a budget deficit to a surplus. However, it depends on how significantly the measures will increase revenue or cut expenses.
Reducing Income and Wealth Imbalances
To attain equity or social justice, a country can use fiscal policy to lessen income gaps among the various segments of the population. Rich people must pay more in direct taxes, like income tax, than those in lower income brackets.
Additionally, indirect taxes are more prevalent for semi-luxury and luxury goods, primarily used by the upper-middle and upper class. To better the lives of the poor people in society, the government can use a large percentage of the tax money it receives to undertake programs to combat poverty.
Efficient Resource Mobilization
By employing various fiscal policy measures, countries can efficiently mobilize their financial resources, which ultimately leads to better economic development and growth. This can be done in the following three ways.
- Private Savings: The government can collect money from families and the private sector by using efficient fiscal tools like tax benefits. Resources can be raised by the government borrowing through issuing Treasury bills, Government Bonds, other debt obligations, loans from domestic and international partners, and deficit financing.
- Public Reserves: By lowering government spending and raising the surpluses of public sector businesses, the resources can be mobilized via public reserves.
- Taxes: Since taxation is one of the most significant sources of resource mobilization in some countries, the government can attempt to mobilize resources through efficient fiscal policies via direct and indirect taxes.
Foreign Exchange Gains
When a nation’s central government offers incentives to producers of goods for local consumption, such as exemptions from customs duties and reduced excise taxes, it encourages foreign investors to boost their investments.
Cons of Fiscal Policy
Conflict of Interests
A conflict of interest could happen when a government employs a mix of contractionary and expansionary fiscal policies. Fiscal policies that reduce income disparities or manage inflation may harm capital formation and economic growth rates.
For instance, the national government could issue bonds to the general people to raise additional funds to boost spending and promote economic growth.
Individuals and businesses often purchase government bonds due to their numerous advantages to buyers. However, according to the Michigan Institute of Technology, the private sector will have little money to invest. As a result, the economy could slow down with less investment activity.
Lack of Flexibility
The execution of fiscal policy typically lags because certain proposed actions might need to go through legislative procedures. For example, cutting back on government expenditure on pensions and benefits is usually challenging. In addition, it is hard, if not impossible, to halt a capital project like a highway in the middle of construction.
While governments can readily raise spending, there are certain challenges when trying to cut back during times of rapid economic development. This might be because:
- Contracts currently in place to limit investment initiatives
- When spending in government sectors declines, public service unions exert pressure
- Spending on vital government services like defense, health care, and education is difficult to cut.
Spending on the budget can be used as a political tactic to get support. Fiscal investment may be swayed and redirected away from regions of need and toward undetermined seats. The government frequently employs fiscal spending as a political weapon during elections to increase voter turnout.
Additionally, a sizeable portion of public spending in developing nations is likely to be lost on unwanted, pointless, and flashy activities to sway the public onion or stolen by dishonest officials.
The timing of budgetary measures is a topic of significant debate nowadays. This is because the expected effects cannot be achieved unless the variations in taxes and public spending are well timed.
Both houses of the legislature must debate proposed budgetary changes. Budget measures can frequently take days or weeks to pass in both chambers of parliament. As a result, budgetary measures could potentially be rejected or changed, which would significantly influence budget projections.
There is typically some lag period between the time when a specific action is required and the time that a fiscal measure is felt. The length of this period influences how effective a certain fiscal action can be. This period includes three different lags: administrative, operational, and recognition.
The government’s compensatory fiscal policies may deter private investment since private business owners must compete with public firms for labor, raw materials, and capital. Hence, long-term fiscal spending may replace short-term private spending.
Persistent government budget deficits might reduce private expenditure by raising interest rates and increasing demand for borrowing. In addition to lowering net exports, the increased interest rates may cause the country’s currency to rise.
Additionally, when a recession starts, the government becomes more actively involved in economic activity, which only reinforces private business owners’ gloomy predictions. A decrease in private spending could go hand in hand with an increase in state spending. As a result, the financial measures can balance each other out.
The ineptitude of Fiscal Measures
The increase in public spending and the reduction in taxation are always crucial components of an anti-depression fiscal strategy. Naturally, the question of whether a certain change in public expenditure or taxation will produce the desired results or not emerges.
The system won’t proceed in the desired direction if the withdrawals from the financial system are greater or smaller than necessary. As a result, the economy’s instability is exaggerated.
What are some advantages of fiscal policy?
Some advantages of fiscal policy are that, if implemented correctly, it can reduce unemployment, budget deficit, and the wealth imbalance between the rich and poor class. Additionally, it also helps boost economic growth.
What are the negative effects of fiscal policy?
Some negative effects of fiscal policy are that private business owners must compete with public firms for labor, raw materials, and capital. This may lead to a decrease in private investments.
What are the 4 problems with fiscal policy?
- Government spending in excess of tax revenue.
- Conflict of interest arising due to different fiscal strategies.
- Lack of ability to quickly implement fiscal policy due to institutional operations.
- The length of time it takes for a fiscal policy to take effect after being enacted.
What are the 5 limitations of fiscal policy?
The 5 limitations of fiscal policy include the lack of flexibility, a lack of public coordination, tax fraud, a small tax base, and a timing lag brought on by administrative processes.