What Is Fiscal Neutrality?

Fiscal neutrality is used to describe the state when taxes and government spending are equal. In addition, the idea of a fiscally neutral policy is one that creates a condition in which demand is neither stimulated nor diminished by taxation and government spending. In other words, a policy that displays fiscal neutrality means there is no economic behavior that the government is trying to incentivize through it.

Key Takeaways

  • Fiscal neutrality describes the state in which taxes and government spending are equal.
  • In addition, a fiscally neutral policy is one employed by the government that does not incentivize certain economic behavior with tax benefits.
  • For example, a poll tax that all citizens are subject to is considered fiscally neutral because it does not impact the economic decisions made by an individual.

How Fiscal Neutrality Works

A balanced budget is an example of fiscal neutrality, where government spending is covered almost exactly by tax revenue – in other words, where tax revenue is equal to government spending.

A situation where spending exceeds the revenue generated from taxes is called a fiscal deficit and requires the government to borrow money to cover the shortfall. When tax revenues exceed spending, a fiscal surplus results, and the excess money can be invested for future use. A fiscally neutral budget is budget neutral--it's a balanced budget because the government doesn't have a surplus nor does it need to borrow a budget deficit.

Fiscally Neutral Policy

While fiscal neutrality can be used to describe a specific government budget, fiscal neutrality also refers to a school of thought and type of policy. In this sense, fiscal neutrality centers on the idea that a tax should not distort economic behavior. For example, income tax may influence the number of hours a worker is willing to work and potentially the amount of effort they want to put in to earn a higher salary. If income taxes are higher for those with higher salaries, a worker may be less incentivized to earn more, knowing that his net income will not increase by much.

This is an example of a tax that clearly alters or influences people’s behavior from a state that would have otherwise been different in the absence of a tax. On the other hand, a poll tax (which is a lump sum on each adult per year) is non-distortionary because it does not affect the economic choice of each adult--everyone will get taxed the same. Here, the tax does not affect one's behavior. This is also known as an efficient tax because it doesn’t distort economic behavior.

In general, a good tax considers features such as:

  • Fair redistribution of income
  • Influence on demand for demerit goods

A neutrally fiscal stance will explicitly factor the influence on aggregate demand. If the stance is truly neutral, the government is neither trying to boost aggregate demand (reflationary fiscal policy) or reduce aggregate demand (deflationary fiscal policy). In reality, effects of globalization and free-trade have largely made fiscal neutrality impossible. Invariably, fiscal policy will ultimately nudge demand in one way or another.