Fiscal Policy: Taking and Giving Away

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Fiscal Policy: Taking and Giving Away

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Bibliographic details

• Authors: Mark Horton, ASMAA EL-GANAINY
• Published: June 28, 2019

Overview

• Fiscal policy is the use of government spending and taxation to influence the economy.
• Governments typically use fiscal policy to promote strong and sustainable growth and reduce poverty.
• The role and objectives of fiscal policy gained prominence during the recent global economic crisis; in the communiqué following their London summit in April 2009, leaders of the Group of 20 industrial and emerging market countries stated that they were undertaking “unprecedented and concerted fiscal expansion.”
• Historical context:
  • Before 1930, a laissez-faire approach prevailed.
  • The stock market crash and the Great Depression prompted more proactive government roles.
  • Prior to the global financial crisis, many countries had scaled back government size and function, but reverted to more active fiscal policy when the crisis threatened worldwide recession.

How fiscal policy works

• Two main policy tools to influence the economy: monetary policy (central banks) and fiscal policy (governments).
• National income identity used to show channels of influence:
  • GDP = C + I + G + NX
  • Governments control G directly and influence C, I, and NX indirectly through taxes, transfers, and spending.
• Definitions:
  • Expansionary (or “loose”) fiscal policy: increases aggregate demand via higher government spending.
  • Contractionary (or “tight”) fiscal policy: reduces aggregate demand via lower spending.
• Objectives differ by horizon and country circumstances:
  • Short-term: macroeconomic stabilization (stimulate during downturns; restrain during inflation or to reduce external vulnerabilities).
  • Long-term: foster sustainable growth or reduce poverty through supply-side actions (infrastructure, education).
  • Policy priorities reflect business cycle, natural disasters, spikes in global food or fuel prices, development levels, demographics, and natural resource endowments.
• Examples of differing priorities:
  • Low-income country may prioritize primary health care to reduce poverty.
  • Advanced economy may prioritize pension reforms for aging populations.
  • Oil-producing country may seek to moderate procyclical spending.

Response to the global crisis

• The 2007 U.S. mortgage market meltdown precipitated a global crisis that damaged private consumption, investment, and international trade.
• Governments responded through:
  • Automatic stabilizers: cyclical changes in tax revenues and social spending that activate without new government actions.
  • Stabilizers are linked to government size and tend to be larger in advanced economies.
  • Larger stabilizers reduce the need for discretionary stimulus and are not subject to implementation lags.
  • Fiscal stimulus: new discretionary spending or tax cuts.
  • Stimulus can be hard to design, implement, and later reverse; countries with weak stabilizers (low-income and many emerging markets) often relied more on discretionary measures despite institutional constraints.
• Practical considerations:
  • Countries with larger stabilizers tended to resort less to discretionary measures during the recent crisis.
  • Some governments emphasized “shovel-ready” projects—programs already vetted and ready to go.

Fiscal ability to respond

• A government’s response depends on its fiscal space: access to additional financing at reasonable cost or ability to reorder existing expenditures.
• Constraints that limit stimulus:
  • Creditors’ concerns about inflation, foreign exchange reserves, exchange rate pressure, or crowding out.
  • Doubts about governments’ ability to spend wisely or to reverse stimulus.
  • Underlying structural weaknesses: chronically low tax revenues, weak control over subnational finances or state-owned enterprises, rising health costs, aging populations.
  • High inflation or external current account deficits, where stimulus is likely to be ineffective or undesirable.
• In some countries, severe financing constraints forced spending cuts as revenues declined (automatic stabilizers functioning).

Design features that determine stimulus effectiveness

• Size, timing, composition, and duration matter.
• Size:
  • Policymakers aim to tailor stimulus to the estimated size of the output gap.
• Effectiveness (multiplier) depends on:
  • Leakage (savings and imports reduce multiplier).
  • Monetary conditions being accommodative.
  • Perceptions of fiscal sustainability after the stimulus.
  • Multipliers tend to be larger for spending measures than for tax cuts or transfers.
  • Multipliers tend to be lower for small, open economies.
  • Multipliers can be small or negative if expansion raises sustainability concerns, prompting private-sector offsetting behavior.
• Composition trade-offs:
  • Targeting the poor (high likelihood of full spending and strong economic effect).
  • Funding capital investments (job creation and longer-term growth).
  • Tax cuts (may encourage firms to hire or invest).
  • In practice, governments used a “balanced” approach with measures across these areas.
• Timing and duration:
  • Implementation lags can delay spending measures; measures may remain in place longer than needed.
  • If downturns are prolonged, lags are less pressing, and “shovel-ready” projects are valuable.
  • Stimulus measures should be timely, targeted, and temporary—quickly reversed once conditions improve.
• Enhancing stabilizers and frameworks:
  • More progressive tax systems can enhance automatic stabilizers.
  • Transfer payments can be linked to economic triggers (unemployment rates).
  • Fiscal rules can limit spending growth during booms, especially with natural resource revenues.
  • Sunset mechanisms for programs can prevent measures from outliving their purpose.
  • Medium-term frameworks with comprehensive coverage of revenues, expenditures, assets and liabilities, and risks improve policymaking over the business cycle.

Big deficits and rising public debt

• Fiscal deficits and public debt ratios expanded sharply in many countries due to crisis effects on GDP, tax revenues, and the cost of fiscal responses.
• Support and guarantees to financial and industrial sectors added to concerns about governments’ financial health.
• Many countries can run moderate deficits for extended periods if markets and partners remain convinced of solvency; however, deficits that grow too large and linger risk undermining confidence.
• IMF guidance in late 2008 and early 2009: establish a four-pronged fiscal policy strategy to help ensure solvency:
  • Stimulus should not have permanent effects on deficits.
  • Medium-term frameworks should include commitment to fiscal correction once conditions improve.
  • Structural reforms should be identified and implemented to enhance growth.
  • Countries facing medium- and long-term demographic pressures should commit to clear strategies for health care and pension reform.
• The strategy remains relevant as challenges persist, particularly in advanced economies in Europe and North America.

Key statements and authorship

• “Automatic stabilizers are linked to the size of the government, and tend to be larger in advanced economies.”
• “Stimulus measures should be timely, targeted, and temporary—quickly reversed once conditions improve.”
• MARK HORTON is the Assistant Director, IMF European Department.
• ASMAA EL-GANAINY is an Economist in the IMF’s Fiscal Affairs Department.

F&D Magazine — Fiscal Policy: Taking and Giving Away; MARK HORTON, ASMAA EL-GANAINY.