Discretionary Fiscal Policy

Fiscal Policy is changing the government’s budget to influence aggregate demand. i.e., changing taxes and spending.

These are intentional government policies to increase or decrease government spending or taxation. For example, Keynesian economists might favour a deliberate increase in the size of the fiscal deficit when private sector demand and confidence is low during an economic recession.

Discretionary fiscal policy means the government make changes to tax rates and or levels of government spending. For example, cutting VAT in 2009 to provide boost to spending.

Expansionary fiscal policy is cutting taxes and/or increasing government spending. Lower taxes increase disposable income and in theory, should encourage people to spend.

Discretionary fiscal policy is different to automatic fiscal stabilisers. Automatic stabilisers occur where in a recession a government automatically spends more because there are more claiming unemployment benefits. However, the government may feel these automatic stabilisers are insufficient and so they decide to increase public work spending schemes too.

Types

There are two types of discretionary fiscal policy. The first is expansionary fiscal policy. It’s when the federal government increases spending or decreases taxes. When spending is increased, it creates jobs. It happens directly through public works programs or indirectly through contractors. Spending on public works construction is one of the four best ways to create jobs.

Job creation gives people more money to spend, boosting demand. According to Keynesian economic theory, that increases economic growth.

Supply-side economics says that a tax cut is the best way to stimulate the economy. Stronger economic growth will make up for the government revenue lost. That’s because it generates a larger tax base. But tax cuts only work if taxes were high in the first place. According to the underlying economic theory, the Laffer Curve, the highest tax rate must be above 50% for supply-side economics to work. Tax cuts are not the best way to create jobs.

Expansionary fiscal policy creates a budget deficit. This is one of its downsides. It’s because the government spends more than it receives in taxes. Often there’s no penalty until the debt-to-GDP ratio nears 100%. At that point, investors start to worry the government won’t repay its sovereign debt. They won’t be as eager to buy Treasurys or other sovereign debt. They will demand higher interest rates. This makes the debt even more expensive to pay back. It can create a downward spiral. For example, look at the Greek debt crisis.

Contractionary fiscal policy is when the government cuts spending or raises taxes. It slows economic growth. A spending cut means less money goes toward government contractors and employees. That then reduces job growth.

Discretionary fiscal policy should work as a counterweight to the business cycle. During the expansion phase, Govt. should cut spending and programs to cool down the economy. If done well, the reward is an ideal economic growth rate of around 2% to 3% a year.