Updated December 29, 2022
Introduction to U.S. Economy: Fiscal Policy
What Is Fiscal Policy?
interest rates and investment, exchange rates and the trade
Fiscal policy is the means by which the government adjusts
balance, and the rate of inflation. First, assuming no action
its budget balance through spending and revenue changes to
from the Federal Reserve, expansionary fiscal policy is
influence broader economic conditions. According to
expected to result in rising interest rates, which puts
mainstream economics, the government can affect the level
downward pressure on investment spending in the
of economic activity—generally measured by gross
economy. Second, it can lead to a strengthening U.S. dollar,
domestic product (GDP)—in the short term by changing its
which results in a growing trade deficit. Third, it can lead to
levels of spending and tax revenue. This In Focus presents
accelerating inflation in the economy; although this was not
an introduction to fiscal policy. For a more in-depth look at
the case during the 2009-2020 expansion. All of these side
fiscal policy, its effect on the economy, and its use by the
effects from expansionary fiscal policy tend to put
government, refer to CRS Report R45723, Fiscal Policy:
downward pressure on economic activity, and therefore
Economic Effects, by Lida R. Weinstock.
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
Expansionary fiscal policy’s ultimate effect on the economy
counteract the business cycle by promoting growth through
depends on the relative magnitude of these opposing forces.
expansionary policy during a recession and preventing
In general, the increase in economic activity resulting from
“overheating” through contractionary policy during an
expansionary fiscal policy tends to be greatest during a
expansion. Procyclical policy does the opposite and is
recession, when the economy has more room to expand,
generally seen to be counterproductive, potentially
and the negative side effects are somewhat counteracted by
overheating the economy during expansions and further
the recession itself, monetary policy, or both.
dampening growth during recessions.
Contractionary Fiscal Policy
Expansionary Fiscal Policy
As the economy shifts from a recession and into an
Recessions can have negative consequences for both
expansion, broader economic conditions generally improve,
individuals and businesses. During a recession, aggregate
with falling unemployment and increasing wages and
demand (overall spending) in the economy falls, which
private spending.
generally results in slower wage growth, decreased
employment, lower business revenue, and lower business
With improving economic conditions, policymakers may
investment.
choose to begin withdrawing fiscal stimulus by decreasing
the size of the deficit or potentially by applying
As such, policymakers may want to intervene in the
contractionary fiscal policy and running a budget surplus.
economy when a recession occurs by implementing
Contractionary fiscal policy—a decrease in government
expansionary fiscal policy to mitigate the decline in
spending, an increase in tax revenue, or a combination of
aggregate demand. Expansionary fiscal policy—an increase
the two—is expected to temporarily slow economic
in government spending, a decrease in tax revenue, or a
activity.
combination of the two—is expected to temporarily spur
economic activity.
When the government raises individual income taxes, for
example, individuals have less disposable income and
Increased government spending can take the form of both
generally decrease their spending on goods and services in
purchases of goods and services by the government, which
response. The decrease in spending temporarily reduces
directly increase economic activity, and transfers to
aggregate demand for goods and services, slowing
individuals, which indirectly increase economic activity as
economic growth temporarily. Alternatively, when the
individuals spend those funds. Decreased tax revenue via
government reduces spending, it reduces aggregate demand
tax cuts also indirectly increases aggregate demand in the
in the economy, which again temporarily slows economic
economy. For example, an individual income tax cut
growth. As such, aggregate demand is expected to decrease
increases the amount of disposable income available to
in the short term when the government implements
individuals, enabling them to purchase more goods and
contractionary fiscal policy, regardless of the mix of fiscal
services. Standard economic theory suggests that in the
policy choices.
short term, fiscal stimulus can lessen a recession’s negative
impacts or hasten a recovery.
However, contractionary fiscal policy has the same caveats
as expansionary fiscal policy, except in reverse.
Expansionary fiscal policy’s effectiveness may be limited
Contractionary fiscal policy is expected to reduce interest
by its interaction with other economic processes, including
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
stamps and unemployment insurance, tends to fall during
a slowing of inflation. All of these side effects tend to spur
economic expansions as fewer people need financial
additional economic activity, partly offsetting the decline in
assistance and file unemployment claims. The combination
economic activity resulting from contractionary fiscal
of rising tax revenue and falling federal spending tends to
policy.
improve the government’s budget deficit. The opposite is
true during recessions, when federal spending rises and
Long-Term Fiscal Policy Considerations
revenue shrinks. These cyclical fluctuations in revenue and
Persistently applying fiscal stimulus can negatively affect
spending are often referred to as automatic stabilizers.
the economy through three main avenues. First, persistent,
Therefore, when examining fiscal policy, it is often
large budget deficits can result in a rising debt-to-GDP ratio
beneficial to estimate the budget deficit excluding these
and lead to an unsustainable level of debt. A rising debt-to-
automatic stabilizers, referred to as the structural deficit, to
GDP ratio can be problematic if the perceived or real risk of
get a sense of the affirmative fiscal policy decisions made
the government defaulting on that debt begins to rise. As
each year by Congress.
the perceived risk of default begins to increase, investors
will demand higher interest rates to compensate themselves.
Figure 1. Federal Budget Deficit/Surplus
Second, persistent fiscal stimulus—particularly during
FY1965-FY2021
economic expansions—can limit long-term economic
growth by crowding out private investment, which is an
important determinant of the economy’s long-term size.
Third, rising public debt will require a gradually increasing
portion of the federal budget to be directed toward interest
payments on the debt, potentially crowding out 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
Source: Federal Reserve Bank of St. Louis and Congressional Budget
doing the opposite. Monetary policy can also be used in
Office.
conjunction with fiscal policy to limit the undesirable
Notes: Gray bars denote recessions as determined by the National
aspects of expansionary or contractionary fiscal policy. For
Bureau of Economic Research. CBO calculates automatic stabilizers
example, expansionary fiscal policy tends to have the
as a percent of potential GDP.
undesirable effect of increasing interest rates; however, the
Federal Reserve could combat this by pushing interest rates
As shown in Figure 1, budget deficits tend to increase
down through monetary policy. Monetary policy is set
during and shortly after recessions (denoted by grey bars)
independently of fiscal policy, so it is also possible for the
as policymakers attempt to buoy the economy by applying
Federal Reserve to pursue monetary policy that neutralizes
fiscal stimulus. The budget deficit then tends to shrink as
fiscal policy’s effects. For a more detailed discussion
the economy enters into recovery and fiscal stimulus is less
regarding monetary policy, refer to CRS Report RL30354,
necessary to support economic growth. However, in recent
Monetary Policy and the Federal Reserve: Current Policy
years, the federal budget has bucked this trend. After the
and Conditions, by Marc Labonte.
structural deficit peaked in 2009 at roughly 7.5% of GDP, it
Fiscal Policy Stance
began to decline through 2014, falling to about 2.0% of
GDP. Beginning in 2016, despite relatively strong
As shown in Figure 1, the federal government has
economic conditions, the structural deficit started to rise
generally been running a budget deficit for much of the past
again, nearing 5.0% of GDP in 2019.
50 years—save for two short periods in the 1960s and
1990s. This suggests that the federal government has been
COVID-19 and the Budget Deficit
applying some level of fiscal stimulus to the economy for
As a result of unprecedented stimulus enacted during
much of the previous several decades, although the amount
COVID-19, in FY2020, the deficit totaled $3.1 trillion,
of stimulus has increased and decreased over time.
equal to 14.9% of GDP—the highest share of GDP since
the end of World War II. The deficit has decreased since as
Examining the overall budget deficit to judge the level of
the economy recovered, but it remains high relative to
fiscal stimulus can be misleading, as the levels of federal
historical terms.
spending and revenue differ over time due to changes in the
state of the economy, in addition to deliberate choices made
(Note: This In Focus was originally authored by Jeffrey
each year by Congress. During economic expansions, tax
Stupak, former CRS Analyst in Macroeconomic Policy.)
revenue tends to increase and spending tends to decrease
automatically, as rising incomes and employment result in
greater individual and corporate income tax revenues.
Lida R. Weinstock, Analyst Macroeconomic Policy
Federal spending on income support programs, such as food
IF11253
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Introduction to U.S. Economy: Fiscal Policy


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