When a country's economy is struggling, its government may attempt to stimulate economic growth through expansionary fiscal policy. This is done by lowering tax rates and by increasing government spending. A government should consider a fiscal expansion only after reviewing the negative consequences of this policy. These issues include increased debt, the crowding out of private investment, and the possibility of an ineffective recovery.
It takes time for a government to realize its economy is having problems. A recession is not officially recognized until there have been at least two quarters of consecutive negative growth. It also can take the government a considerable amount of time to create, discuss and enact an expansionary fiscal policy. The problem of recognition lag is that by the time a government recognizes and acts on a recession, the recession has already self-corrected. The fiscal expansion then may overheat the economy and set the nation up for another market crash.
The theory of crowding out states that expansionary fiscal policy could lead to reduced investment in the private sector. Investors prefer government debt over corporate debt because it is considered safer. Government debt usually pays a lower interest rate than corporate debt. To fund a fiscal expansion, a government may need to raise more money through government bonds. It will raise the interest rates of government debt to attract more investors. This will reduce the demand for corporate debt and hurt the private sector's ability to grow.
Expansionary fiscal policy is used to provide a temporary boost to a lagging economy to increase consumption and investment to pre-recession levels. This fiscal expansion is often financed through borrowed funds that will need to be paid back. The theory of rational expectations states that consumers and businesses will realize that at some future date the government will raise taxes to repay the fiscal expansion's borrowed funds. The private sector will increase its savings level to prepare for a future tax increase. This will prevent the economy from growing and make the fiscal expansion useless.
Increased Deficit Levels
An expansionary fiscal policy financed by debt is designed to be temporary. Once a country's economy recovers, its government should increase taxes and reduce spending to pay off the expansion. This can be difficult to accomplish. Consumers may become accustomed to lower tax rates and higher government spending and vote against changing either. A risk of a temporary fiscal expansion is it becomes permanent due to political pressure. This higher level of spending could lead to a worsening deficit and a long-term debt issue.
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