Fiscal Neutrality

What Is Fiscal Neutrality?

Fiscal neutrality refers to a principle or goal of public finance that fiscal decisions (taxing, spending, or borrowing) of a government can or should avoid distorting economic decisions by businesses, workers, and consumers. A policy change can be considered to be neutral to the economy in either a macro- or microeconomic sense (or both).

In a macroeconomic sense, the idea of a fiscally neutral policy is one in which demand is neither stimulated nor diminished by taxation and government spending. In a microeconomic sense, a policy that displays fiscal neutrality does not incentivize (encourage or discourage) any type of transaction or economic behavior relative to others. Fiscal neutrality may also refer strictly to the budgetary impact of a policy change in that it neither increases nor decreases a projected budget deficit or surplus. 

Key Takeaways

  • Fiscal neutrality is when a government taxing, spending, or borrowing decision has or is intended to have no net effect on the economy.
  • Policy changes can be considered neutral in either their macroeconomic or microeconomic impact, or both. 
  • Fiscal neutrality may also refer strictly to the budgetary impact of a certain policy change. 

How Fiscal Neutrality Works

Because the term fiscal neutrality can be applied in several different senses, it is important to understand the context and purpose for which it is being used in order to understand its meaning. 

Budgetary Neutrality

Strict budgetary neutrality is when a policy change does not result in any net change in a government entity’s total budgetary balance. Any new spending introduced by a policy change that is fiscally neutral in this sense is expected to be entirely offset by additional revenues generated; the net effect of the policy change is neutral with respect to the balance of the government’s budget. 

For example, a policy to provide tax credits for the purchase of new automobiles, along with an increase in the tax on gasoline, might be fiscally neutral if the tax increase is sufficient to pay for the cost of the tax credits.  

This may be considered a desirable feature and may increase the chance of a policy change’s acceptance and passage into law. Legislative pay-as-you-go rules could encourage or even mandate that some or all new policy measures be fiscally neutral in this sense.  

Macroeconomic Neutrality

In the realm of macroeconomic fiscal policy, government deficit spending, or budget surpluses, are encouraged as a means to increase or decrease aggregate demand in the economy in order to stabilize macroeconomic growth and avoid recessions. 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 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. Fiscal neutrality in this sense means that the government’s overall fiscal policy is neutral with respect to aggregate demand in the economy. Because the government doesn't have a surplus nor a budget deficit, according to Keynesian economics this type of fiscal policy will neither expand nor contract aggregate demand. 

Continuing the example of an auto tax credit coupled with an increase in gasoline taxes, it is clear that such a policy is also fiscally neutral in a macroeconomic sense provided the increased demand for new autos is offset by the decreased demand for gasoline thus creating no net change in aggregate demand. 

Microeconomic Neutrality

In a microeconomic sense, fiscal neutrality centers on the idea that government policy can influence individual economic behavior. A neutral fiscal policy in sense is one that leaves individuals to decide to work, consume, save, invest, or engage in other economic actions unaltered. 

This type of fiscal neutrality focuses on designing mechanisms of taxation because it is never possible for government spending not to influence microeconomic behavior. When a government spends money to purchase real goods and services, it necessarily influences the prices of those goods and services and removes them from availability on the market or other users and uses thus altering the behavior of other market participants.  

Once again continuing the example from above (an auto tax credit and offsetting gasoline tax), such a policy is definitely not fiscally neutral in a microeconomic sense, because it influences consumers to change their economic behavior by buying more new autos and paying higher prices for gasoline.