Overview of the United States Fiscal Policy:

How it is Managed, Directed, Controlled, and Formulated

Abstract

The United States government has several tools to regulate the fiscal policy in order to keep the economy from swinging too quickly into growth or recession. The fiscal policy was not formally in place until the Great Depression when economists strategized how to get the economy back into a growth phase. In the textbook Economics Today, it is explained how John Maynard Keynes advocated that a deficit was beneficial to helping the economy recover and grow (Miller, 2018). Keynesian analysis became the starting point to creating a federal fiscal policy. While the U.S. government doesn’t fully adhere to Keynes’ ideas in current times, his theories did lay the groundwork for how the fiscal policy is maintained today. Economic analyst Kimberly Amadeo explains how the government has put permanent safeguards into the fiscal policy to assist in maintaining a balanced economy such as unemployment benefits, graduated income tax brackets, and income transfer payments (Amadeo, March 2021). She also explains how government representatives vote on the implementation of non-permanent measures, such as tax rates and annual government spending, to keep the economy from swinging too far into either extreme (Amadeo, March 2021). The policies that are put in place all take time to review to make sure they are positively impacting the economy (Miller, 2018). The ultimate goal of the fiscal policy is to maintain a state of equilibrium within the U.S. economy and to prevent too much inflation or too large of a recession.

            Keywords: fiscal policy, government, United States, economy

Overview of the United States Fiscal Policy:

How it is Managed, Directed, Controlled, and Formulated

Literature Review

The United States fiscal policy is a way for the government to manage the nation’s economy by speeding up or slowing down taxation and monetary expenditures. The policy is managed, directed, controlled, and formulated by the federal government. It was formulated in the 1930s by an English economist named John Maynard Keynes based on his ideas of economic policies that are now called traditional Keynesian analysis. During the Great Depression, Keynes believed that the cause of the prolonged high unemployment rate was from a lack of aggregate demand in the economy. He felt the government had to intervene and help the economy increase aggregate demand by developing and implementing a fiscal policy. With a fiscal policy put into place, there was an increase in aggregate demand which then brought an increase in the prices of goods and services in the economy. Keynes’ economic theories helped pull the United States out of the Great Depression. Though Keynesian economics are not used as a primary source of government policies in today’s economy, they do still influence financial decisions.

Keynes noted the relationship between gross domestic product and aggregate demand. Since GDP and AD use the same input calculations, they rise and fall in the same manner. The calculation for GDP and AD is: C + I + G + X, private consumption (C), private investment (I), government expenditures of goods and services (G), and net exports minus net imports (X). The government can adjust its spending and taxation based on the economy being in a state of inflation or deflation (Miller, 2018, page 272).

The U.S. government uses the fiscal policy to manage economic conditions that can influence recessionary gaps and inflationary gaps. High employment, low employment, price stability, and economic growth are all relative targets of the U.S. government’s reasoning to change expenditures and taxes in the economy. These changes ultimately impact the government budget deficit as well as the national debt, in time changing AD and GDP. In an article titled Who sets fiscal policy – the President or Congress? (Ross, January 2021), the author states that the U.S. fiscal policy is directed by both the executive and legislative branches of the government. The President, the President’s economic advisors, the Secretary of Treasury, and the U.S. Congress control and approve any spending and laws related to fiscal policy measures. If there are any legislative measures in the proposed fiscal policy that may be unconstitutional, the Supreme Court (or even lesser courts) will debate upon them and decide upon their legality so that the fiscal policy can play a positive role in the nation’s economy.

In an article titled What is Fiscal Policy? (Amadeo, March 2021) by Kimberly Amadeo, a 20 year veteran of economic analysis and business strategy, she wrote that there are two approaches that can be used when trying to control economic swings. The first is automatic stabilizers and the second is discretionary fiscal policies. Automatic stabilizers consist of the income tax system, unemployment compensation, and income transfer payments. These are permanent structures in the economic system that don’t require a vote by legislatures for use and are readily available for individuals to take advantage of. For example, in the tax system, if you work less you are paid less, which in turn can put you in a lower tax bracket. The graduated income tax system means someone is taxed at a rate that corresponds to their income, so taxes are adjusted according to earnings. Economists consider that falling into a lower tax bracket is a tax cut that will help stimulate the economy during a recession. When business activity drops and people lose jobs or have a reduction in hours worked, most people are eligible for unemployment benefits. The unemployment checks that those people receive are still a positive number within their disposable income, even though it is less money than they were getting paid while they were working. Unemployment benefits are an automatic stabilizer because they are always available for people to obtain— a legislative body doesn’t need to vote on someone’s ability to access the payments. The third automatic stabilizer is income transfer payments. These are programs such as Supplemental Security Income, Temporary Assistance for Needy Families, and other public assistance programs. People are eligible to receive payments under these organizations based on income level. While these payments may be less than they earned while working and come at a significant drop in disposable income, it still helps to stabilize the economy by providing people with necessities for living. From an article titled Fiscal Policy: Taking and Giving Away, (Horton, El-Ganainy, January 2020) the authors say, “Automatic stabilizers are linked to the size of the government and tend to be larger in advanced countries.”

The U.S. government’s budget deficit and national debt are linked to fiscal policy and automatic stabilizers that play a part in the positive or negative impact of the United States economy. When the government spends an excess amount on goods, services, and income transfer payments so that expenditures surpass their tax revenues, this is known as a budget deficit. To have funds for the deficit, the government needs to borrow money. But borrowing money leads to more national debt, which the government must pay back with interest, and leads to less borrowing in the future. The national debt that the government incurs brings the economy to a state of lower output of real GDP by reducing private investments which is known as the “crowding out effect.” Fewer private investments means less growth in the economy. While automatic stabilizers can be a positive asset for the economy, the government has to be careful not to spend or cut too much as it may eventually cause harmful long-term effects with too much debt and not enough investments.

In What is Fiscal Policy? (Amadeo, March 2021) the author says the government’s second approach to controlling economic swings is discretionary fiscal policy. The government has two types of discretionary fiscal policies, expansionary and contractionary, which are used for different conditions of the economic cycle. Expansionary policy happens when the government spends more, cuts taxes, or does both. Contractionary policy is when the government spends less and increases tax rates. These fiscal policies can have a positive or negative economic impact, depending on how and when the government deploys the policy during the economy’s current state of growth or decline. Unlike automatic stabilizers, discretionary fiscal policy requires that the legislative body votes to change taxation rates and government expenditures. This is where we as individuals have the opportunity to voice our opinions on how the government spends money based on who we vote for. While the governmental branches have the final say in the policies implemented, the views and political leanings of the general public can influence which spending and taxation policies are put into place.

With each piece of the fiscal policy that is implemented or changed, there are lengths of time that pass before the effects are visible and acted upon. The book Economics Today (Miller, 2018, page 289) states, “Not only is it difficult to measure economic variables, but it also takes time to collect and assimilate such data.” These segments of time for noticing detrimental economic effects and updating needed changes are known as time lags. There are three phases of time lags. The “recognition” time lag is the period of time that passes before the government realizes there is an economic problem occurring. After the realization of the problem, there is time between the realization and the application to fix the problem, which is known as the “action” time lag. Once the new or updated policy is in effect, it still takes time for the economy to be impacted by it. This time between the application and impact is known as the “effect” time lag. If gone unnoticed or uncorrected for too long, the ripple effects of these time lags may make problems progressively worse in a recession or boom, especially since the time lags can last for 1-3 years. The longer a time lag is left to fester, the more time is wasted and there is less opportunity to fix an inflating or deflating economy.

Another way the government can impact the economy by using the fiscal policy is by reducing taxes on individuals and businesses. This frees up money in the private sector, keeping the economy from going too far into a recession. Even though taxes have been reduced, the government still needs money to cover its budget, so it borrows funds. However, whatever they borrow today will need to be paid back in the future, along with interest. This is paid back through the eventual raising of taxes sometime in the future once the economy stabilizes. We can usually expect an increase in aggregate demand when the government lowers or cuts the nation’s taxes. When taxpayers realize that they will be paying back interest on the taxes that have been cut in the present, they may begin to save more money, leading to aggregate demand returning back to its original rate. This gives no real positive effect on the economy as the government had hoped with their decision to cut taxes. This effect is known as the Ricardian Equivalence Theorem, after a nineteenth-century economist David Ricardo (Miller, 2018, page 286).

A type of tax cut from the federal government known as a “fiscal stimulus” means the government gives individual checks back to taxpayers. This is done in an attempt by the government to increase spending and stimulate the economy. These stimulus checks have been known to have minimal changes on aggregate consumption in times of economic uncertainty because people tend to save or invest the money as a personal safety net. Just like with the Ricardian Equivalence Theorem, the aggregate demand shows an initial increase when taxes are redistributed but then returns to its original rate when taxpayers decide to save the money or use it to make payments on outstanding debts.

The history of the fiscal policy dates back to the Great Depression era, and even before. It did not exist in formal terms, but the government still borrowed money when it needed to. Economic historian J. Bradford De Long writes that the War of 1812 was paid off by the 1830s, debt from the Mexican War had been paid off by the 1850s, and the Civil War and the Spanish-American War debt was paid off before World War I (Bordo, 1998, page 67). The economy went into the Great Depression because both President Hoover and President Roosevelt thought the government should have a surplus of money. It was discovered that government surpluses were bad for the economy, so it was concluded that deficits do help in times of recession.

During and at the end of the Great Depression is the start of what we know as the formation of Keynesian analysis and it being applied to the U.S. economy. Keynes provided an excellent start to the fiscal policy in the United States by implementing the ideas for growing aggregate demand, spending money, and having more people work, thus generating more aggregate output and more income that creates a higher GDP which is beneficial to the U.S. economy.

References

Amadeo, K. (2020, August 19). What Is Fiscal Policy? The Balance. https://www.thebalance.com/what-is-fiscal-policy-types-objectives-and-tools-3305844.

Bordo, M. D., Goldin, C. D., & White, E. N. (1998). In The defining moment: the Great Depression and the American economy in the twentieth century (pp. 67–86). essay, University of Chicago Press.

Horton, M., & El-Ganainy, A. (2020). Finance & Development. Finance & Development | F&D. https://www.imf.org/external/pubs/ft/fandd/basics/fiscpol.htm.

Miller, R. L. (2018). In Economics Today (19th ed., pp. 272–289). essay, Pearson.

Ross, S. (2021, January 24). Who sets fiscal policy-the President or Congress? Investopedia. https://www.investopedia.com/ask/answers/012715/who-sets-fiscal-policy-president-or-congress.asp#:~:text=key%20takeaways-,In%20the%20United%20States%2C%20fiscal%20policy%20is%20directed%20by%20both,%27%20counsel%2C%20direct%20fiscal%20policies.