The federal government uses fiscal policies -- taxing and spending -- to maintain full employment, stimulate economic growth and encourage investment in specific sectors of the economy. Anchored in Keynesian economic theory, fiscal policies have been used to promote economic activity since the 1940s. Fiscal policies are enacted by the congressional and executive branches.
If the economy is in recession or underperforming, the government can undertake expansionary fiscal policies to stimulate the economy. Lowering taxes allows Americans to keep more of their income to spend as they wish. This spending creates income for those who are selling products or services, through a process called the multiplier effect, the cycle is repeated again and again. Tax cuts or tax credits are frequently targeted at specific sectors of the economy -- a particular socioeconomic class or an industry, for example.
Much of government spending is nondiscretionary. Entitlement programs and defense spending are fairly rigid. But the government has significant leeway with discretionary spending. Whether spending if for infrastructure repair and construction, education or agriculture, the government can pump money into the economy, and the multiplier works for government spending just as it does for tax cuts. The money injected into the economy is re-spent many times.
The economy overheats when the demand for goods and services creates inflationary pressure, when high levels of resource use create bottlenecks in production and when credit availability tightens because businesses and consumers become maxed out. When this happens, the government employs contractionary policies to slow the economy. Raising taxes pulls money out of the economy, slowing down consumer spending and curtailing business investment. Likewise, curtailing discretionary spending slows the economy by reducing the amount of public works. Just as the multiplier effect can expand the economy, it works in the opposite direction with contractionary policies. Both expansionary and contractionary policies suffer from time lags. By the time the need for action is recognized, Congress debates and passes a bill and the president signs it into law, economic conditions may have changed.
Fiscal policies can help stabilize the economy without specific action by Congress or the president. When the economy slips into a slump or recession, incomes fall and so, too, do tax collections. At the same time, demand for government assistance, such as unemployment benefits and food stamps, rises. Conversely, in an improving economy, rising incomes push people into higher tax brackets and the demand for social services falls. In this manner, fiscal policies are enacted without specific government action.