Fiscal policy refers to the actions taken by governments to help direct their economies. This is done through a variety of measures, including taxation. There isn't just one central body responsible for fiscal policy. In fact, both the President and the U.S. Congress have a hand in it, which means it is directed by both the executive and legislative branches of the U.S:
- In the executive branch, the two most influential offices in this regard belong to the President and the Secretary of the Treasury, although contemporary presidents often rely on a council of economic advisers as well.
- In the legislative branch, the U.S. Congress passes laws and appropriates spending for any fiscal policy measures. This process involves participation, deliberation, and approval from both the House of Representatives and the Senate.
The so-called Taxing and Spending Clause of the U.S. Constitution, Article I, Section 8, Clause 1, authorizes Congress to levy taxes. However, the Constitution really only specifies two legitimate purposes for taxation: To pay the debts of the federal government and to provide for the common defense.
Even though an argument could be made that the clause's provisions exclude the use of taxes for fiscal policy purposes, such as a tax-cut bill to expand the economy, basic macroeconomics suggests that any level of taxation has an impact on aggregate demand.
- In the United States, fiscal policy is directed by both the executive and legislative branches of the government.
- In the executive branch, the President and the Secretary of the Treasury, often with economic advisers' counsel, direct fiscal policies.
- In the legislative branch, the U.S. Congress passes laws and appropriates spending for any fiscal policy measures.
- The judicial branch of the government can impact fiscal policy by legitimizing, amending, or declaring unconstitutional certain measures taken by the executive or legislative branches.
- Contractionary fiscal policy increases taxation and reduces government spending when the economy overheats while expansionary fiscal policy does the opposite during periods of slowdown.
What Is Fiscal Policy?
Fiscal policy is an economic strategy that uses a government's taxing and spending powers to impact a nation's economy. Contemporary fiscal policy is largely founded on the economic theories of John Maynard Keynes who rose to prominence during the 1930s. He developed many of his ideas in response to the Great Depression and proposed that governments could stabilize the business cycle and regulate economic output by adjusting spending and tax policies. Per Keynesian economic theory, both government spending and tax cuts should boost:
- Aggregate demand
- The level of consumption and investment in the economy
- Help reduce unemployment
It is commonly used in conjunction with monetary policy to help keep the economy in check. Monetary policy is set by a central bank and focuses on interest rates and the money supply to either slow down or propel economic growth.
As noted above, the legislative and executive branches play a major role in shaping fiscal policy. But the judicial branch—the Supreme Court and even lesser courts—can also impact fiscal policy by legitimizing, amending, or declaring unconstitutional certain measures taken by the executive or legislative branches to affect the national economy.
The power to spend to encourage certain outcomes has been generally interpreted as constitutional ever since the South Dakota v. Dole ruling by the U.S. Supreme Court in 1987. In this case, the court upheld the constitutionality of a federal statute that withheld federal highway funds from states whose legal drinking age did not conform to federal policy (a minimum drinking age of 21).
Contractionary vs. Expansionary Fiscal Policy
The type of fiscal policies enacted by the executive and legislative branches depends on the course of the economy. They may take a contractionary or expansionary approach based on what outcome they wish to achieve.
- Contractionary Fiscal Policy: These actions are used when the economy is booming and needs to be slowed down so things don't get out of control. When this happens, there's a very good likelihood of market bubbles, overconfidence, and other economic hurdles that can lead to overheating. Fiscal policies are used to curb all this growth through increased taxation and a reduction in government spending. Although it does keep inflation in check, contractionary fiscal policy does raise the unemployment rate.
- Expansionary Fiscal Policy: This type of fiscal policy is used when things get too slow, commonly during a recession, and the government wants to fuel growth. Government spending increases and tax rates drop. Unemployment falls as jobs open up and more people jump back into the workforce. This policy helps put more money into people's pockets so they can spend more.
Inflation can create major problems for the economy, which is why governments and economists closely monitor it. They each use fiscal and monetary policies to fuel growth or to stop the economy from overheating.
How Fiscal Policy Is Set
As we already mentioned in the previous section, expansionary fiscal policy in the U.S. has been pursued through a combination of spending public funds on politically attractive ends, such as infrastructure, job training, or anti-poverty programs. It also involves lowering taxes on all or some taxpayers.
Fiscal policies in the U.S. are normally tied into each year's federal budget, which is proposed by the president and approved by Congress. This budget highlights details of what is to be expected in the upcoming fiscal year, which begins on October 1. Here are the main priorities of the budget:
- To provide Congress with a signal of the president's fiscal policy for the year, including spending, and how much revenue that's expected to be collected from taxpayers. It also indicates whether the government intends to run under a deficit or a surplus and by how much.
- To signal priorities in the president's federal programs, including how much spending is expected on health, education, and defense.
- To make tax policy and spending recommendations to Congress.
But there have been times when no budget has been proposed, which makes it more difficult for market participants to react and adjust to coming fiscal policy proposals.
Once the budget is approved, Congress then develops budget resolutions. These are used to set parameters for spending and tax policy. After resolutions are made, Congress begins the process of appropriating funds from the budget toward specific targets. These appropriations bills must be signed by the President before they can be enacted.
What Role Does the President Play in Fiscal Policy?
The president has a major role in the country's fiscal policy. As part of the executive branch, the president lays out plans during the annual budget proposal. This proposal indicates the amount of tax revenue the government intends to collect and how much government spending is anticipated per portfolio, such as education, defense, and health.
Is Congress Involved in Fiscal Policy?
Congress has a big role to play in fiscal policy. It is one of the bodies that help shape the country's spending and tax policies along with the executive branch. This branch of the government is responsible for developing budget resolutions once the president's annual budget is approved.
What Causes the President and Congress to Enact Expansionary Fiscal Policy?
Expansionary fiscal policy involves an increase in government spending and a drop in the collection of taxes, perhaps through lowered tax rates. Governments use expansionary fiscal policies in order when they want to fuel growth after a recession. Prices rise and unemployment drops. During this period, people have more money in their pockets and can spend more freely.
The Bottom Line
Authorities have a few tools at their disposal when it comes to helping control the direction of the economy. Monetary policy is enacted by central banks like the U.S. Federal Reserve while fiscal policy is the responsibility of the government—namely the executive and legislative branches. It commonly involves the use of government spending and taxation. The president submits an annual budget, which Congress uses to develop budget resolutions.