June 18, 2019Updated August 3, 2020
Introduction to U.S. Economy: Fiscal Policy
What is Fiscal Policy?
Fiscal policy is the means by which the government adjusts
its budget balance through spending and revenue changes to
influence broader economic conditions. According to
mainstream economics, the government can impact the
level affect the level
of economic activity—generally measured by gross
domestic product (GDP)—in the short term by changing its
levels of spending and tax revenue. This In Focus presents
an introduction to fiscal policy. For a more in-depth look at
fiscal policy, its effect on the economy, and its use by the
government, refer to CRS Report R45723, Fiscal Policy:
Economic Effects, by Jeffrey M. Stupak.
Expansionary fiscal policy—an increase in government
spending, a decrease in tax revenue, or a combination of the
two—is expected to temporarily spur economic activity.
Conversely, contractionary fiscal policy—a decrease in
government spending, an increase in tax revenue, or a
combination of the two—is expected to temporarily slow
economic activity.
Expansionary Fiscal Policy
Recessions can have serious negative consequences for
both individuals and businesses. During a recession,
aggregate demand (overall spending) in the economy falls,
which generally results in slower wage growth, decreased
employment, lower business revenue, and lower business
investment. As such, policymakers may want to intervene
in the economy when a recession occurs by implementing
expansionary fiscal policy to mitigate the decline in
aggregate demand.
Expansionary fiscal policy can take the form of increased
government spending, decreased tax revenue, or a
combination of the two. Government spending takes the
form of both purchases of goods and services by the
government, which directly increase economic activity, and
transfers to individuals, which indirectly increase economic
activity as individuals spend those funds. Decreased tax
revenue via tax cuts indirectly increases aggregate demand
in the Marc Labonte.
interest rates and investment, exchange rates and the trade
balance, and the rate of inflation. First, assuming no action
from the Federal Reserve, expansionary fiscal policy is
expected to result in rising interest rates, which puts
downward pressure on investment spending in the
economy. Second, it can lead to a strengthening U.S. dollar,
which results in a growing trade deficit. Third, it can lead to
accelerating inflation in the economy; although this was not
the case during the 2009-2020 expansion. All of these side
effects from expansionary fiscal policy tend to put
downward pressure on economic activity, and therefore
work against the original stimulus generated through
expansionary fiscal policy.
Fiscal policy is often characterized by its countercyclical or
procyclical nature. Countercyclical policy attempts to
counteract the business cycle by promoting growth through
expansionary policy during a recession and preventing
“overheating” through contractionary policy during an
expansion. Procyclical policy does the opposite and is
generally seen to be counterproductive, potentially
overheating the economy during expansions and further
dampening growth during recessions.
Expansionary fiscal policy’s ultimate effect on the economy
depends on the relative magnitude of these opposing forces.
In general, the increase in economic activity resulting from
expansionary fiscal policy tends to be greatest during a
recession, when the economy has more room to expand,
and the negative side effects are somewhat counteracted by
the recession itself, monetary policy, or both.
Expansionary Fiscal Policy
Recessions can have negative consequences for both
individuals and businesses. During a recession, aggregate
demand (overall spending) in the economy falls , which
generally results in slower wage growth, decreased
employment, lower business revenue, and lower business
investment.
As such, policymakers may want to intervene in the
economy when a recession occurs by implementing
expansionary fiscal policy to mitigate the decline in
aggregate demand. Expansionary fiscal policy—an increase
in government spending, a decrease in tax revenue, or a
combination of the two—is expected to temporarily spur
economic activity.
Increased government spending can take the form of both
purchases of goods and services by the government, which
directly increase economic activity, and transfers to
individuals, which indirectly increase economic activity as
individuals spend those funds. Decreased tax revenue via
tax cuts also indirectly increases aggregate demand in the
economy. For example, an individual income tax cut
increases the amount of disposable income available to
individuals, enabling them to purchase more goods and
services. Standard economic theory suggests that in the
short term, fiscal stimulus can lessen a recession’s negative
impacts or hasten a recovery.
However, expansionaryExpansionary fiscal policy’s effectiveness may be
limited by its interaction with other economic processes,
including interest rates and investment, exchange rates and
the trade balance, and the rate of inflation. First,
expansionary fiscal policy is expected to result in rising
interest rates, which puts downward pressure on investment
spending in the economy. Second, it can lead to a
strengthening U.S. dollar, which results in a growing trade
deficit. Third, it can lead to accelerating inflation in the
economy, which tends to interfere with the efficient
operation of the economy. All of these side effects from
expansionary fiscal policy tend to put downward pressure
on economic activity, and therefore work against the
original stimulus generated through expansionary fiscal
policy.
Expansionary fiscal policy’s ultimate effect on the economy
depends on the relative magnitude of these opposing forces.
In general, the increase in economic activity resulting from
expansionary fiscal policy tends to be greatest during a
recession. This is because the positive effect of
expansionary policy tends to be largest during a recession
and the negative side effects tend to be smallest.
limited
by its interaction with other economic processes, including
Contractionary Fiscal Policy
As the economy shifts from a recession and into an
expansion, broader economic conditions will generally
improve, whereby unemployment falls andgenerally improve,
with falling unemployment and increasing wages and
private spending increase. .
With improving economic
conditions, policymakers may
choose to begin withdrawing
fiscal stimulus by decreasing
the size of the deficit or
potentially by applying
contractionary fiscal policy and
running a budget surplus.
The government can implement contractionary fiscal policy
by increasing taxes, decreasing spending, or a combination
of the two. running a budget surplus.
Contractionary fiscal policy—a decrease in government
spending, an increase in tax revenue, or a combination of
the two—is expected to temporarily slow economic
activity.
When the government raises individual income
taxes, for
example, individuals have less disposable income
and and
generally decrease their spending on goods and services
in in
response. The decrease in spending temporarily reduces
aggregate demand for goods and services, slowing
economic growth temporarily. Alternatively, when the
government reduces spending, it reduces aggregate demand
in the economy, which again temporarily slows economic
growth. As such, aggregate demand is expected to decrease
in the short term when the government implements
contractionary fiscal policy, regardless of the mix of fiscal
policy choices used to do so, aggregate demand is expected
to decrease in the near term.
However, contractionary fiscal policy is expected to interact
with similar economic processes as does expansionary
.
However, contractionary fiscal policy has the same caveats
as expansionary fiscal policy, except in reverse.
Contractionary fiscal policy
is expected to reduce interest
rates, leading to additional
investment, and weaken the U.S.
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Introduction to U.S. Economy: Fiscal Policy
dollar, leading to more
U.S. exports and fewer imports and
a slowing of inflation.
All of these side effects tend to spur
additional economic
activity, partly offsetting the decline in
economic activity
resulting from contractionary fiscal policy.
The ultimate impact on the economy of withdrawing fiscal
stimulus depends on the relative magnitude of its effects on
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Introduction to U.S. Economy: Fiscal Policy
aggregate demand, interest rates and investment, exchange
rates and the trade deficit, and inflation.
policy.
Long-Term Fiscal Policy Considerations
Persistently applying fiscal stimulus can negatively affect
the economy through three main avenues. First, persistent,
large budget deficits can result in a rising debt-to-GDP ratio
and lead to an unsustainable level of debt. A rising debt-toGDP ratio can be problematic if the perceived or real risk of
the government defaulting on that debt begins to rise. As
the perceived risk of default begins to increase, investors
will demand higher interest rates to compensate themselves.
Second, persistent fiscal stimulus—particularly during
economic expansions—can limit long-term economic
growth by crowding out private investment, as itwhich is an
important determinant of the economy’s long-term size.
Third, rising public debt will require a growing gradually increasing
portion of
the federal budget to be directed toward interest payments
payments on the debt, potentially crowding out spending on other
policy other policy
priorities.
Monetary Policy
Fiscal policy is not the only policy lever available if the
government wishes to influence broader economic
conditions. The Federal Reserve implements monetary
policy by influencing interest rates throughout the
economy. The Federal Reserve can spur economic activity
by lowering interest rates and slow economic activity by
doing the opposite. Monetary policy can also be used in
conjunction with fiscal policy to limit the undesirable
aspects of expansionary or contractionary fiscal policy. For
example, expansionary fiscal policy tends to have the
undesirable effect of increasing interest rates; however, the
Federal Reserve could combat this by pushing interest rates
down through monetary policy. Monetary policy is set
independently of fiscal policy, so it is also possible for the
Federal Reserve to pursue monetary policy that neutralizes
fiscal policy’s effects. For a more detailed discussion regarding
regarding monetary policy, refer to CRS Report RL30354, Monetary
Monetary Policy and the Federal Reserve: Current Policy and
and Conditions, by Marc Labonte.
Fiscal Policy Stance
As shown in Figure 1, the federal government has
generally been running a budget deficit for much of the past
50 years—save for two short periods in the 1960s and
1990s. This suggests that the federal government has been
applying some level of fiscal stimulus to the economy for
much of the previous several decades, although the level of
amount
of stimulus has increased and decreased over time.
Examining the overall budget deficit to judge the level of
fiscal stimulus can be misleading, as the levels of federal
spending and revenue differ over time due to changes in the
state of the economy, rather thanin addition to deliberate choices made
each year by Congress. During economic expansions, tax
revenue tends to increase and spending tends to decrease
automatically, as rising incomes and employment result in
greater individual and corporate income tax revenues.
Federal spending on income support programs, such as food
stamps and unemployment insurance, tends to fall during
economic expansions as fewer people need financial
assistance and file unemployment claims. The combination
of rising tax revenue and falling federal spending tends to
improve the government’s budget deficit. The opposite is
true during recessions, when federal spending rises and
revenue shrinks. These cyclical fluctuations in revenue and
spending are often referred to as automatic stabilizers.
Therefore, when examining fiscal policy, it is often
beneficial to estimate the budget deficit excluding these
automatic stabilizers, referred to as the structural deficit, to
get a sense of the affirmative fiscal policy decisions made
each year by Congress.
Figure 1. Federal Budget Deficit/Surplus
Source: Federal Reserve Bank of St. Louis and U.S. Office of
Management and Budget, https://fred.stlouisfed.org/series/
FYFSGDA188S.
Note: GreyCongressional Budget
Office.
Note: Gray bars denote recessions as determined by the National
Bureau of Economic Research.
As shown in Figure 1, budget deficits tend to increase
during and shortly after recessions (denoted by grey bars)
as policymakers attempt to buoy the economy by applying
fiscal stimulus. This can be seen explicitly by viewing the
structural deficit or surplus, as this only shows affirmative
changes in fiscal policy made by Congress. The budget
The budget deficit then tends to shrink as
the economy enters into
recovery and fiscal stimulus is less
necessary to support
economic growth. However, in recent
years, the federal
budget has bucked this trend. After the
structural deficit
peaked in 2009 at roughly 7.5% of GDP, it
began to decline
through 2014, falling to about 2.0% of
GDP. Beginning in
2016, despite relatively strong
economic conditions, the
structural deficit has started to rise
again, nearing 45.0% of
GDP in 2018.
Jeffrey M. Stupak GDP in 2019.
Fiscal Policy and COVID-19
Coronavirus Disease 2019 (COVID-19) has caused a deep
recession in the U.S. economy, and several stimulus bills
have been enacted in response. Fiscal stimulus has included
direct cash transfers to consumers, forgivable loans to small
businesses, and increased unemployment benefits, among
others. The projected deficit increase as a percent of GDP
for FY2020 is 10.6%, which, if accurate, would be the
largest deficit since World War II.
(Note: This In Focus was originally authored by Jeffrey
Stupak, former CRS Analyst in Macroeconomic Policy.)
Lida R. Weinstock, Analyst in Macroeconomic Policy
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IF11253
Introduction to U.S. Economy: Fiscal Policy
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