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Governments use spending and taxing powers to promote stable and sustainable growth

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, when governments stepped in to support financial systems, jump-start growth, and mitigate the impact of the crisis on vulnerable groups. 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.” What did they mean by fiscal expansion? And, more generally, how can fiscal tools provide a boost to the world economy?

Historically, the prominence of fiscal policy as a policy tool has waxed and waned. Before 1930, an approach of limited government, or laissez-faire, prevailed. With the stock market crash and the Great Depression, policymakers pushed for governments to play a more proactive role in the economy. More recently, countries had scaled back the size and function of government—with markets taking on an enhanced role in the allocation of goods and services—but when the global financial crisis threatened worldwide recession, many countries returned to a more active fiscal policy. 

How does fiscal policy work?

When policymakers seek to influence the economy, they have two main tools at their disposal—monetary policy and fiscal policy. Central banks indirectly target activity by influencing the money supply through adjustments to interest rates, bank reserve requirements, and the purchase and sale of government securities and foreign exchange. Governments influence the economy by changing the level and types of taxes, the extent and composition of spending, and the degree and form of borrowing.

Governments directly and indirectly influence the way resources are used in the economy. A basic equation of national income accounting that measures the output of an economy—or gross domestic product (GDP)—according to expenditures helps show how this happens:

GDP = C + I + G + NX.

On the left side is GDP—the value of all final goods and services produced in the economy. On the right side are the sources of aggregate spending or demand—private consumption (C), private investment (I), purchases of goods and services by the government (G), and exports minus imports (net exports, NX). This equation makes it evident that governments affect economic activity (GDP), controlling G directly and influencing CI, and NXindirectly, through changes in taxes, transfers, and spending. Fiscal policy that increases aggregate demand directly through an increase in government spending is typically called expansionary or “loose.” By contrast, fiscal policy is often considered contractionary or “tight” if it reduces demand via lower spending.

Besides providing goods and services like public safety, highways, or primary education, fiscal policy objectives vary. In the short term, governments may focus on macroeconomic stabilization—for example, expanding spending or cutting taxes to stimulate an ailing economy, or slashing spending or raising taxes to combat rising inflation or to help reduce external vulnerabilities. In the longer term, the aim may be to foster sustainable growth or reduce poverty with actions on the supply side to improve infrastructure or education. Although these objectives are broadly shared across countries, their relative importance differs, depending on country circumstances. In the short term, priorities may reflect the business cycle or response to a natural disaster or a spike in global food or fuel prices. In the longer term, the drivers can be development levels, demographics, or natural resource endowments. The desire to reduce poverty might lead a low-income country to tilt spending toward primary health care, whereas in an advanced economy, pension reforms might target looming long-term costs related to an aging population. In an oil-producing country, policymakers might aim to better align fiscal policy with broader macroeconomic developments by moderating procyclical spending—both by limiting bursts of spending when oil prices rise and by refraining from painful cuts when they drop.

Response to the global crisis

The global crisis that had its roots in the 2007 meltdown in the U.S. mortgage market is a good case study in fiscal policy. The crisis hurt economies around the globe, with financial sector difficulties and flagging confidence hitting private consumption, investment, and international trade (all of which affect output, GDP). Governments responded by trying to boost activity through two channels: automatic stabilizers and fiscal stimulus—that is, new discretionary spending or tax cuts. Stabilizers go into effect as tax revenues and expenditure levels change and do not depend on specific actions by the government. They operate in relation to the business cycle. For instance, as output slows or falls, the amount of taxes collected declines because corporate profits and taxpayers’ incomes fall, particularly under progressive tax structures where higher-income earners fall into higher-tax-rate brackets. Unemployment benefits and other social spending are also designed to rise during a downturn. These cyclical changes make fiscal policy automatically expansionary during downturns and contractionary during upturns.

Automatic stabilizers are linked to the size of the government, and tend to be larger in advanced economies. Where stabilizers are larger, there may be less need for stimulus—tax cuts, subsidies, or public works programs—since both approaches help to soften the effects of a downturn. Indeed, during the recent crisis, countries with larger stabilizers tended to resort less to discretionary measures. In addition, although discretionary measures can be tailored to stabilization needs, automatic stabilizers are not subject to implementation lags as discretionary measures often are. (It can take time, for example, to design, get approval for, and implement new road projects.) Moreover, automatic stabilizers—and their effects—are automatically withdrawn as conditions improve.

Stimulus may be difficult to design and implement effectively and difficult to reverse when conditions pick up. In many low-income and emerging market countries, however, institutional limitations and narrow tax bases mean stabilizers are relatively weak. Even in countries with larger stabilizers, there may be a pressing need to compensate for the loss of economic activity and compelling reasons to target the government’s crisis response to those most directly in need.

Fiscal ability to respond

The exact response ultimately depends on the fiscal space a government has available for new spending initiatives or tax cuts—that is, its access to additional financing at a reasonable cost or its ability to reorder its existing expenditures. Some governments were not in a position to respond with stimulus, because their potential creditors believed additional spending and borrowing would put too much pressure on inflation, foreign exchange reserves, or the exchange rate—or delay recovery by taking too many resources from the local private sector (also known as crowding out). Creditors may also have doubted some governments’ ability to spend wisely, to reverse stimulus once put in place, or to address long-standing concerns with underlying structural weaknesses in public finances (such as chronically low tax revenues due to a poor tax structure or evasion, weak control over the finances of local governments or state-owned enterprises, or rising health costs and aging populations). For other governments, more severe financing constraints have necessitated spending cuts as revenues decline (stabilizers functioning). In countries with high inflation or external current account deficits, fiscal stimulus is likely to be ineffective, and even undesirable.

The size, timing, composition, and duration of stimulus matter. Policymakers generally aim to tailor the size of stimulus measures to their estimates of the size of the output gap—the difference between expected output and what output would be if the economy were functioning at full capacity. A measure of the effectiveness of the stimulus—or, more precisely, how it affects the growth of output (also known as the multiplier)—is also needed. Multipliers tend to be larger if there is less leakage (for example, only a small part of the stimulus is saved or spent on imports), monetary conditions are accommodative (interest rates do not rise as a consequence of the fiscal expansion and thereby counter its effects), and the country’s fiscal position after the stimulus is viewed as sustainable. Multipliers can be small or even negative if the expansion raises concerns about sustainability in the period immediately ahead or in the longer term, in which case the private sector would likely counteract government intervention by increasing savings or even moving money offshore, rather than investing or consuming. Multipliers also tend to be higher for spending measures than for tax cuts or transfers and lower for small, open economies (in both cases, because of the extent of leakages). As for composition, governments face a trade-off in deciding between targeting stimulus to the poor, where the likelihood of full spending and a strong economic effect is higher; funding capital investments, which may create jobs and help bolster longer-term growth; or providing tax cuts that may encourage firms to take on more workers or buy new capital equipment. In practice, governments have taken a “balanced” approach with measures in all of these areas.

As for timing, it often takes awhile to implement spending measures (program or project design, procurement, execution), and once in place, the measures may be in effect longer than needed. However, if the downturn is expected to be prolonged (as was the recent crisis), concerns over lags may be less pressing: some governments stressed the implementation of “shovel-ready” projects that were already vetted and ready to go. For all these reasons, stimulus measures should be timely, targeted, and temporary—quickly reversed once conditions improve.

Similarly, the responsiveness and scope of stabilizers can be enhanced—for instance, by a more progressive tax system that taxes high-income households at a higher rate than lower-income households. Transfer payments can also be explicitly linked to economic conditions (for instance, unemployment rates or other labor market triggers). In some countries, fiscal rules aim to limit the growth of spending during boom times, when revenue growth—particularly from natural resources—is high and constraints seem less binding. Elsewhere, formal review or expiration (“sunset”) mechanisms for programs help to ensure that new initiatives do not outlive their initial purpose. Finally, medium-term frameworks with comprehensive coverage and assessment of revenues, expenditures, assets and liabilities, and risks help improve policymaking over the business cycle.

Big deficits and rising public debt

Fiscal deficits and public debt ratios (the ratio of debt to GDP) have expanded sharply in many countries because of the effects of the crisis on GDP and tax revenues as well as the cost of the fiscal response to the crisis. Support and guarantees to financial and industrial sectors have added to concerns about the financial health of governments. Many countries can afford to run moderate fiscal deficits for extended periods, with domestic and international financial markets and international and bilateral partners convinced of their ability to meet present and future obligations. Deficits that grow too large and linger too long may, however, undermine that confidence. Aware of these risks in the present crisis, the IMF in late 2008 and early 2009 called on governments to 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; and countries facing medium- and long-term demographic pressures should firmly commit to clear strategies for health care and pension reform. Even as the worse effects of the crisis recede, fiscal challenges remain significant, particularly in advanced economies in Europe and North America and this strategy remains as valid as ever.

Mark Horton

MARK HORTON is the Assistant Director, IMF European Department.

ASMAA EL-GANAINY is an Economist in the IMF’s Fiscal Affairs Department.

Opinions expressed in articles and other materials are those of the authors; they do not necessarily reflect IMF policy.