Fiscal policy refers to the taxation and spending policies of the federal government. The budget and appropriations bills are among the instruments of fiscal policy. The White House and the Congress are jointly responsible for setting fiscal policy. According to University of California professor Alan J. Auerbach, the three broad long-term fiscal policy objectives are economic performance, fiscal sustainability and intergenerational equity.
Fiscal policy sets federal taxation policy and spending plans. It sets the parameters for government revenue and spending. Deficits, which result when spending exceeds revenues, reduce budgetary flexibility. During difficult economic times, such as the recessions of 2001 and 2008, governments adopt expansionary fiscal policies to increase the demand for goods and services. Contractionary fiscal policy, which includes raising taxes and cutting spending, might be more appropriate in a strong economy. However, Brown University professor David N. Weil cautions that the lag effect -- the time it takes for Congress to implement legislation -- and poor economic forecasting make it difficult to precisely calibrate fiscal policy interventions.
Fiscal sustainability is a key fiscal policy objective. Lawmakers must demonstrate that they have a long-term plan to restore balance to budgetary deficits. According to Auerbach, this means that the present value of future surpluses must be equal to current deficits. Increasing deficits usually lead to higher interest rates, which could hamper economic growth. Political considerations often force the postponement of tough choices, such as letting tax cuts expire or meaningfully reducing expenditures.
Intergenerational equity means that one generation should not pass on its debts to the next. This means that future generations could have less spending flexibility on healthcare, schools and other programs. Auerbach suggests that economic analysis is not sufficient to model intergenerational equity because it requires judgments and tradeoffs about the welfare of individuals. Equity also refers to helping people today through automatic stabilizers. For example, unemployment insurance and job retraining programs help the unemployed meet their short-term cash flow needs while preparing for the jobs of today and tomorrow. The tax code also is a stabilizer because it is based on individual wages and business profits. Therefore, tax revenues are higher during economic expansion and lower during recessions, which means that individuals and businesses are not burdened during tough economic times but pay their fair share during the good times.
Considerations: Monetary Policy
The U.S. Federal Reserve sets monetary policy by adjusting short-term interest rates. It raises rates to fight inflation and lowers rates to stimulate job growth. When rates are at or near zero, as they were after the 2008 financial crisis, the Fed purchases financial securities to create liquidity. The Fed reviews fiscal policy to determine how the projected budget deficits and surpluses might affect economic activity, employment and inflation.