Fiscal Policy

The government can also use its own spending and taxing activities to achieve specific objectives. This is called fiscal policy. By increasing or decreasing its spending or taxing programs, the federal government may reduce or increase demand for goods and services. If the government reduces its own spending, it buys less from businesses, reducing sales and earnings, and people have less money to spend. Similarly, if the government raises taxes, people have less money to spend. Moreover, spending and taxing policies work together to increase or decrease aggregate demand. For example, if the government taxes to a greater extent than it spends, it causes a net reduction in the flow of income to people and businesses. Because this reduces aggregate demand for goods and services, it is a method for fighting inflation.

Fiscal policy uses budget deficits or surpluses to promote economic stability and growth. In the United States, some fiscal policy tools work automatically -- without action being taken by the president or Congress. The progressive income tax, for example, is generally considered to promote stability automatically. It tends to reduce the government's collection of revenue when personal and business incomes are declining, and thus helps offset the cutbacks in spending that accompany declining incomes. During business expansions, however, federal tax collection tends to rise fairly quickly and thus reduce inflationary pressures. During postwar business declines, Congress has sometimes legislated emergency spending measures, such as temporary increases in public works expenditures, as additional means of offsetting cutbacks in private spending and preventing unemployment.

Yet there are also problems associated with the use of fiscal policy. Many object to a reduction in government spending because this could mean a reduction in funds used to help provide education, health care and other services. Higher taxes are unpopular with both individuals and businesses. In addition, the use of fiscal policy to cause a sharp reduction in demand is somewhat controversial because it tends not only to reduce inflation but also to increase unemployment.