12.5. Fiscal Policy
Fiscal policy is the responsibility of the president and Congress because they control taxing and spending. Suppose that the economy is in a recession. As you have learned, this means GDP is falling and unemployment increasing. Therefore, if the government could do something to increase real GDP, the effects of the recession could be reduced.
GDP, you will recall, is equal to the total spent by consumers, businesses, and governments plus net exports. If spending by one or more of these groups were to increase while the others remained the same, GDP would increase.
What fiscal policy tools can the president and Congress use to stimulate the growth of GDP? They could lower taxes while continuing to spend the same amount, or they could increase spending while keeping taxes about the same.
When taxes are cut, individuals and businesses have more income to spend. As business and consumer spending (and therefore the GDP) begin to increase, the economy will enter an expansion phase. Similarly, if the president and Congress increase government spending, GDP would increase.
Fiscal tools also can be used to slow the economy. Suppose, for example, that in an economic "boom," prices increase at an alarming rate. To end inflation, the president and Congress decide to use their fiscal powers. They could increase taxes, reduce government spending, or both. If they increased taxes, consumers and businesses would have less to spend. This would reduce the total demand for goods and services and the rate of inflation.
Fiscal policy has critics. Many economists feel that when properly applied, fiscal policies provide effective weapons for fighting recession and inflation. Others believe that fiscal policies have several serious flaws:
• When government reduces taxes to fight a recession, it often creates a budget deficit. Its revenues will be less than its expenditures, and the national debt will increase. When taxes are reduced, the government can still spend because it can borrow. However, if the government chooses to borrow from the public to offset a tax reduction, the money it borrows cannot be spent by the lenders. In addition, it may crowd out private borrowers by reducing the supply of available funds. This can also cause an increase in interest rates, making it more difficult for individuals and businesses to borrow. Both consumers and businesses will have less to spend. For that reason, say the critics, a tax reduction offset by borrowing is of no help in fighting a recession.
• The federal government can also finance its debts by printing money. When it does this the money supply increases and so does consumer spending and business spending. Unfortunately, such increases in the money supply tend to fuel inflation by pushing up prices. For that reason many economists are opposed to this strategy.
• The political problems associated with fiscal policies often make them unworkable. Fiscal policy can call for a tax increase or reduction in government spending during periods of inflation, but neither the president nor Congress likes to increase taxes, least of all during an election year. Who, for example, would want to run on a campaign slogan that says, "Vote for me and I will guarantee an increase in your taxes"?
Similarly, efforts to reduce spending are frequently opposed by those who benefit from the programs that Congress wishes to cut. Consequently, members of the Congress are often reluctant to risk defeat at election time by giving their support to spending cuts.
The large budget deficits of the Reagan-Bush years have caused other problems. A great deal of public attention has focused on the size of the deficits and the harm they may have caused. This has made it difficult to reduce taxes or increase government spending because either policy would add to the deficit. But cutting taxes and increasing spending only represent one half of the nation's fiscal tools. As one economist put it, "It's as if Congress was being asked to play its fiscal cards with less than a full deck."
• Even supporters of fiscal action admit that their success depends heavily on their timing and the accuracy of the data available. Fiscal policies must be timed so that they are applied at the right moment. This requires the close cooperation of both the president and Congress. All too often, however, it takes so long for the necessary bills to be passed into law that it is too late to solve the problem. In any case, critics argue that no one knows enough about timing to make fiscal policy work, and poorly timed fiscal moves can sometimes do more harm than good.