What Is Fiscal Policy?

Fiscal policy defined

Fiscal policy is based on the theories of British economist John Maynard Keynes, which hold that increasing or decreasing revenue (taxes) and expenditure (spending) levels influence inflation, employment and the flow of money through the economic system. Fiscal policy is often used in combination with monetary policy, which, in the United States, is set by the Federal Reserve to influence the direction of the economy.

Fiscal policy is paramount to successful economic management since taxes, spending, inflation and employment all factor into gross domestic product (GDP). This figure details the value of goods and services produced by a nation within a year. [Learn how to calculate the cost of goods sold (COGS) for your business.]

To understand how fiscal policy can affect the economy, consider a fiscal expansion that leads to rising demand, which in turn increases production. If this demand increase occurs in a high-employment economy, prices will vary. However, in a low-employment economy, this demand will lead to more employment and production but not necessarily price variation. The change in GDP depends on which of these situations applies.

Fiscal policy factors and tools

Economic factors

The success of the economy is commonly measured by a few factors, including GDP. Another factor is aggregate demand, which is the sum of goods and services produced by a nation purchased at a certain price point. The aggregate demand curve dictates that at lower price levels, more goods and services are demanded, while there is less demand at higher price points.

Fiscal policy affects these measurements, with the goal of increasing GDP and aggregate demand in a sustainable manner. This happens by changing three factors.

1. Business tax policy: Taxes that businesses pay to the government affects its profits and investment spending. Lowering taxes increases both aggregate demand and business investment opportunities.
2. Government spending: Aggregate demand is increased by the government’s own spending.
3. Individual taxes: Taxes on individuals – such as income tax – affect their personal income and how much they can spend, injecting more money back into the economy.

Fiscal policy typically needs to be altered when an economy is running low on aggregate demand and unemployment levels are high.

Policy tools

The two main tools of fiscal policy are taxes and spending. Taxes influence the economy by determining how much money the government has to spend in certain areas and how much money individuals should spend. For example, if the government is trying to spur consumer spending, it can decrease taxes. A cut in taxes provides families with extra cash, which the government hopes will in turn be spent on goods and services, thus spurring the economy as a whole.

Spending is used as a tool for fiscal policy to drive government money to specific sectors needing an economic boost. Whoever receives those dollars will have extra money to spend – and, as with taxes, the government hopes that money will be spent on other goods and services.

It’s important to find the right balance and ensure the economy doesn’t lean too far either way. Prior to the Great Depression in the 1920s, the U.S. government took a very hands-off approach when it came to setting economic policy. Afterward, the government decided it needed to play a larger role in determining the direction of the economy. [Read related article: What Is Economics?]

Fiscal policy vs. monetary policy

The United States relies on two types of policies to shape the economy: fiscal and monetary. Fiscal policy is used to influence the aggregate demand in a country, whereas monetary policy is used to control the amount of money available throughout the economy. The government may implement fiscal policy to shape the number of products and services that people can or will demand, whereas the central banks’ monetary policy affects our ability to demand these services.

The central banks – like the Federal Reserve – set monetary policy, whereas the federal legislative and executive branches set federal fiscal policy (state and local legislative and executive branches set state and local fiscal policy). The Federal Reserve may take monetary policy action to achieve price stability, full employment and stable economic growth, whereas Congress and the White House determine tax rates for corporations and individuals to work toward fiscal policy goals.

By definition, fiscal policy is thus political. That’s why it’s worth noting Congress has stated that monetary policy decisions should be apolitical. The only requirements that the Federal Reserve must follow when crafting monetary policy is always to prioritize maximum employment and price stability. At no point in its policy creation or execution should the Federal Reserve take any politically motivated actions.

Republican vs. Democrat policy differences

Republicans and Democrats have differing views on fiscal policy. Where Republicans usually feel there should be limited government involvement in the economy, Democrats typically believe regulation is needed. Republicans tend to favor lower taxes, free-market capitalism, corporate deregulation and limits on labor unions. In contrast, Democrats usually support progressive taxation and argue that higher tax rates allow for more programs to be introduced by the government that encourage spending and positive economic conditions.

Even though the Federal Reserve is intended to be apolitical, fiscal policy can vary with each presidential administration or when the party in power changes in Congress. These different approaches can mean businesses have to adjust to policy changes every few years. Which school of thought is better for your business will likely come down to your own personal, economic beliefs.

Types of fiscal policy

There are two main types of fiscal policy: expansionary and contractionary.

Expansionary fiscal policy

Expansionary fiscal policy, designed to stimulate the economy, is most often used during a recession, times of high unemployment or other low periods of the business cycle. It entails the government spending more money, lowering taxes or both.

The goal of expansionary fiscal policy is to put more money in the hands of consumers so they spend more to stimulate the economy. Explained in economic language, the goal of expansionary fiscal policy is to bolster aggregate demand in cases when private demand has decreased.

Contractionary fiscal policy

Contractionary fiscal policy is used to slow economic growth, such as when inflation is growing too rapidly. The opposite of expansionary fiscal policy, contractionary fiscal policy raises taxes to cut spending. As consumers pay more taxes, they have less money to spend, and economic stimulation and growth slow.

Under contractionary fiscal policies, the economy usually grows by no more than 3% per year. Above this growth rate, negative economic consequences – such as inflation, asset bubbles, increased unemployment and even recessions – may occur.

Setting fiscal policy

Today’s U.S. fiscal policies are tied to each year’s federal budget. The federal budget spells out the government’s spending plans for the fiscal year and how it plans to pay for that spending, such as through new or existing taxes. The budget is developed through a collaborative effort between the president and Congress.

The president will first submit a budget to Congress that sets the tone for the coming year’s fiscal policy by outlining how much money the government should spend on public needs, such as defense and healthcare; how much the government should collect in tax revenues; and how much of a deficit or surplus is projected.

Congress then reviews the president’s budget request and develops its own budget resolutions, which set broad levels for spending and taxation. Once the resolutions are approved, legislators start the appropriations process, which spells out where each dollar will be spent. The president must sign those appropriations bills before they can be enacted.

When setting a budget for your small business, you should estimate possible financial risks based partly on expected changes to the federal budget and fiscal policy.

How fiscal policy affects businesses

Public and private companies experience direct effects of an economy’s fiscal policy – whether in the form of spending or taxation. Fiscal policy can have the following effects on your small business.

1. Investment opportunities

Businesses will see more investment opportunities related to government spending. This commonly occurs during an expansionary fiscal policy, when more money is flowing into the economy from the government and from other sources since taxation is also low. When a balance between price and demand is met, then companies can expect to thrive and grow.

2. Slower growth

A contractionary fiscal policy may kick in to prevent inflation when that balance is broken and demand – and prices – fall. Businesses typically rein in their growth due to rising taxes and take measures to stay in the black with less money flowing through the economy.

3. Taxation changes

Depending on your company’s location, your business will face several levels of taxation: including local, state and federal. Consider how your state and local government taxes your company and how it interweaves with federal fiscal policy.

Fiscal policy also impacts the amount of taxation on future generations. Government spending that leads to greater deficits means that taxation will eventually have to increase to pay interest. Inversely, when the government runs on a surplus, taxes must eventually be lowered.

4. Unemployment rates

A major objective of fiscal policy is to minimize unemployment. For example, the government can lower taxes to put more money back in consumers’ pockets. As such, consumers have more money to spend and companies may face increased demand. With increased demand may come additional production tasks for companies to complete, and businesses can respond by creating more jobs and hiring more employees. With proper fiscal policy in place, a low unemployment rate may gradually increase.

The best ways to tackle policy changes

Before making rash decisions in response to the slightest signs of economic change, business owners should seek financial advice. If your company doesn’t employ a chief financial officer, consider hiring a CPA or a financial management company.

“As a group, small businesses are resilient because we have to be,” said Mike Catania, entrepreneur and founder of Padloop. “Changes in fiscal policy, particularly at the federal level, expose us to what we dislike the most: uncertainty.”

With an expert’s guidance, you can make appropriate decisions on spending, pricing for your products and services, benefits packages and other company aspects that may be impacted by fiscal policy. 

The importance of tracking fiscal policy

Fiscal policy is a complicated aspect of economics where political parties may disagree on the best path forward for the success of the nation. The presidential and legislative branches contribute to fiscal policy, making determinations that affect taxes and government spending. These decisions have impacts that trickle down – in good ways and bad – to the smallest of businesses, so it’s critical to stay on top of economic developments.

Kimberlee Leonard and Max Freedman contributed to the writing and reporting in this article. Source interviews were conducted for a previous version of this article.