## Fiscal Policy: Taking and Giving Away ## Source details **Canonical URL:** [Fiscal Policy: Taking and Giving Away](https://www.imf.org/en/publications/fandd/issues/series/back-to-basics/fiscal-policy) ## Other formats - [Markdown version](/en/publications/fandd/issues/series/back-to-basics/fiscal-policy/index.md) - [Structured JSON version](/en/publications/fandd/issues/series/back-to-basics/fiscal-policy/index.json) - [Bundle manifest](/en/publications/fandd/issues/series/back-to-basics/fiscal-policy/bundle-manifest.json) ## 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.* --- _Source: https://www.imf.org/en/publications/fandd/issues/series/back-to-basics/fiscal-policy_