FISCAL POLICY

Fiscal policy is one of the two instruments of macroeconomic policy. It comprises public spending and taxation, and any other government income or assistance to the private sector (such as tax breaks). It can be used to influence the level of demand in the economy, usually with a goal of getting unemployment as low as possible without triggering excessive inflation. At times it has been deployed to manage short-term demand through fine tuning, although since the end of the tabilize era it has more often been targeted on long-term goals, with monetary policy more often used for shorter-term adjustments.

For a government, there are two main issues in setting fiscal policy: what should be the overall stance of policy, and what form should its individual parts take?

Some economists and policymakers argue for a balanced budget. Others say that a persistent deficit (public spending exceeding revenue) is acceptable provided, in accordance with the golden rule, the deficit is used for investment (in infrastructure, say) rather than consumption. However, there may be a danger that public-sector investment will result in the crowding out of more productive private investment. Whatever the overall stance on average over an economic cycle, most economists agree that fiscal policy should be counter-cyclical, aiming to automatically tabilize demand by increasing public spending relative to revenue when the economy is struggling and increasing taxes relative to spending towards the top of the cycle. For instance, social (welfare) handouts from the state usually increase during tough times, and fiscal drag boosts government revenue when the economy is growing.

As for the bits and pieces making up fiscal policy, one debate is about how high public spending should be relative to GDP (gross domestic product). In the United States and many Asian countries, public spending is less than 30% of GDP; in European countries, such as Germany and Sweden, it has been as high as 40-50%. Some economic studies suggest that lower public spending relative to GDP results in higher rates of growth, though this conclusion is controversial. Certainly, over the years, much public spending has been highly inefficient.

Another issue is the form that taxation should take, especially the split between direct taxation and indirect taxation and between capital, income and expenditure tax.

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