What Is Fiscal Policy?
What Is Fiscal Policy?
Dr. Muhannad Talib Al-Hamdi
Both fiscal and monetary policy play a large role in managing the economy and each has direct and indirect impacts on personal and public finances. Fiscal policy includes tax decisions, state revenues and spending that are determined by the government, and affects the amount of taxes paid by individuals and companies and the possibility of creating job opportunities in government projects.
What is fiscal policy?
Fiscal policy refers to the use of government spending and tax policies to influence economic conditions, particularly macroeconomic conditions, including aggregate demand for goods and services, employment, inflation, and economic growth. In general, the goal of most government fiscal policies is to target the total level of spending, the components of total spending, or both in the economy. The two most common means of influencing fiscal policy are changes in government spending policies or in government tax policies and managing a country's resources.
If the government believes there is not enough business activity in the economy, it can increase the amount of money it spends, often referred to as stimulus spending. If there is not enough government revenue to pay for the spending increases, governments borrow money by issuing debt securities such as government bonds, and in the process, the debt accumulates. This is referred to as deficit spending .
By raising taxes, governments are withdrawing money from the economy and slowing down business activity. Usually, fiscal policy is used when the government seeks to stimulate the economy. It may lower taxes or offer tax breaks in an effort to encourage economic growth. Influencing economic outcomes through fiscal policy is one of the basic tenets of Keynesian economics .
Before the Great Depression, which lasted from October 29, 1929, to the start of the United States' involvement in World War II, the US government's approach to the economy was laissez-faire. After World War II, it was decided that government must play a proactive role in the economy to regulate unemployment, business cycles, inflation and the cost of money.
By using a mixture of monetary and fiscal policies (depending on the political orientations and philosophies of those in power at a given time, one policy may dominate another), governments can direct economic phenomena in some direction.
Understand Fiscal Policy
Fiscal policy relies largely on the ideas of the British economist John Maynard Keynes (1883-1946), who argued that economic recessions resulted from deficiencies in consumer spending and the commercial investment components of aggregate demand. Keynes believed that governments could work to stabilize the business cycle and regulate economic production by adjusting spending and taxation policies to make up for the shortfall in the private sector.
His theories were developed in response to the Great Depression, which challenged the assumptions of classical economics that economic fluctuations were self-correcting. Keynes' ideas were very influential and led to a new economic policy called the "New Deal" in the United States, which included massive government spending on public works projects and social welfare programs .
In the Keynesian economy, aggregate demand or spending drives the growth of the economy. Aggregate demand consists of consumer spending, business investment spending, government spending, and net exports. According to Keynesian economists, the private sector components of aggregate demand are highly variable and rely heavily on psychological factors as well as economic expectations to maintain sustainable growth in the economy .
Pessimism, fear, and uncertainty among consumers and businesses can lead to recessions and economic recessions, and excessive abundance in the good times can lead to a frenzy and inflationary economy.
However, according to Keynesian economists, taxes and government spending can be rationally managed and used to counter the excesses and shortcomings of private sector consumption and investment spending in order to stabilize the economy .
When private sector spending decreases, the government can spend more and / or impose less taxes in order to directly increase aggregate demand. When the private sector is more optimistic and spends more, and too quickly, on consumption and new investment projects, the government can spend less and / or impose more taxes in order to reduce aggregate demand .
This means that to help stabilize the economy, the government will face large budget deficits during economic recessions and must manage budget surpluses as the economy grows. These policies are known as expansionary or contractionary fiscal policies, respectively .
Expansive Fiscal Policies
If the economy is in recession, the government may decide to grant incentive tax breaks to increase aggregate demand and support economic growth. The logic behind this approach is that when people pay less taxes, they have more money to spend or invest, which leads to higher demand. This demand leads companies to hire more workers, which reduces unemployment.
This, in turn, raises wages and provides consumers with more income to spend and invest. It is a virtuous cycle, or a positive feedback loop . Instead of lowering taxes, the government might seek economic expansion by increasing spending (without corresponding tax increases). By building more highways, bridges, buildings and schools for example, this can lead to increased employment, increased demand and growth .
An expansionary fiscal policy is usually characterized by deficit spending as government expenditures exceed revenues from taxes and other sources. In practice, deficit spending tends to result in a combination of tax cuts and spending increases .
Downsides Of Financial Expansion
Mounting deficits are among the problems facing expansionary fiscal policy, with critics arguing that an influx of government funds could affect growth and ultimately create the need for destructive austerity. Many economists simply question the effectiveness of expansionary fiscal policies, and say government spending crowds out private sector investments and pushes them out of the market.
Basically, fiscal policy targets aggregate demand. Businesses also benefit from increased revenues. However, if the economy is close to its full production capacity, an expansionary fiscal policy is a risk that could fuel inflation. This inflation is eating into the profit margins of some firms in competitive industries that may not be able to easily transfer costs to customers; It also eats away the money of people with fixed income.
The expansionary policy is dangerously popular, some economists say. It is politically difficult to reverse the fiscal stimulus. Whether or not they achieve the desired macroeconomic impacts, voters love lower taxes and increased public spending. Because of the political incentives that policymakers face, there is a persistent tendency to engage in somewhat persistent deficit spending that can be partly justified as "good for the economy ".
Ultimately, fiscal expansion can get out of control, rising wages lead to inflation, and asset bubbles begin to form. High inflation and the risk of large-scale default when debt bubbles burst can severely damage the economy and this risk in turn pushes governments (or their central banks) to reverse course and attempt to "deflate" the economy .
Contractionary Fiscal Policies
In the face of rising inflation and other symptoms of expansionary fiscal policy, the government can pursue a contractionary fiscal policy, perhaps even to the point of inducing a short recession in order to restore balance to the economic cycle. The government does this by increasing taxes, cutting public spending, and cutting public sector wages or jobs .
If the expansionary fiscal policy involves a deficit, then contractionary fiscal policy is characterized by a budget surplus. This policy is rarely used, as it is not very popular politically. Thus, public policy makers face significant asymmetry in their incentives to engage in expansionary or contractionary fiscal policy. Instead, the preferred tool to curb unsustainable growth is usually deflationary monetary policy, or raising interest rates and restricting the money supply and credit in order to curb inflation .
When inflation is very strong, the economy may need to slow down. In such a situation, the government can use fiscal policy to raise taxes to absorb money from the economy. Fiscal policy can also dictate lower government spending and thus reduce money in circulation.
Of course, in the long run the potential negative effects of such a policy could be a slowing economy and higher levels of unemployment. However, the process continues as the government uses its fiscal policy to regulate spending and tax levels, with the goal of regulating business cycles .
Who Does Fiscal Policy Affect?
Unfortunately, the effects of any fiscal policy are not the same for everyone. Depending on political orientations and fiscal policy-makers' goals, a tax cut could only affect the middle class, which is usually the largest economic group. In times of economic decline and high taxes, this same class may have to pay more taxes than the wealthier upper class .
Likewise, when a government decides to adjust its spending, its policy may only affect a certain group of people. The decision to build a new bridge, for example, would provide more jobs and income for hundreds of construction workers. On the other hand, the decision to spend money on building a new space shuttle benefits only a small, specialized group of experts, which will do little to increase overall operating levels .
When the government spends money or changes tax policy, it should choose where to spend or change the tax. In doing so, government fiscal policy can target specific societies, industries, investments, or commodities either in favor of increasing production or discouraging it. Sometimes the government's actions are based on considerations that are not entirely economic. For this reason, fiscal policy is often the subject of heated debate among economists and government policymakers.
One of the biggest hurdles facing policymakers is determining the extent of government involvement in the economy. In fact, there have been various degrees of interference by the government over the years. But for the most part, it is accepted that a degree of government involvement is necessary to maintain an active economy, on which the economic well-being of the population depends .
Fiscal Policy in Iraq: What is the Challenge?
The long-term goal of fiscal policy in most oil-producing countries is to take advantage of depleted oil wealth to promote sustainable economic development. This involves making strategic choices about the share of oil revenues to be diverted to other forms of assets (real or financial) or to be depreciated, taking into account long-term financial sustainability and considerations of intergenerational equity.
The options should reflect the economic and social priorities of the government, its ability to spend efficiently, as well as the rate of return and risk associated with each asset type.
Iraq has one of the most immersive revenue bases in the world and is therefore more vulnerable than most countries to oil price movements. In 2018, oil revenues accounted for about 92% of total budget revenues. Rising oil production has amplified this dependence.
For example, at current production levels, every dollar of change in oil prices leads to a change in total revenues of 1.1% of non-oil GDP ($ 1.5 billion), compared to 0.6% in other oil exporting countries in the Middle East and North Africa. On the other hand, the non-oil tax base is tight and eroded by poor tax compliance. In 2018, tax revenues represented less than 5% of non-oil GDP .
The volatility and unpredictability of oil prices in recent years have posed major challenges for fiscal policymakers. Oil price shocks are often large and persistent, with booms and busts that involve price movements of up to 40-80% for up to a decade.
Oil price volatility increased sharply, particularly during the commodity price shock of 2014-2015, and showed renewed volatility since the fourth quarter of 2018. Hence, forecasting commodity prices has proven very difficult in recent years. An additional factor of volatility in Iraq is the difference with international prices, which have fluctuated significantly since 2004, reflecting security-related changes in shipping costs, mixes of light and heavy crude, and delivery risks .
Iraqi policy frameworks and institutions are ill-equipped to deal with these challenges. A directed fiscal policy is a short-term policy and is conducted largely in the context of the annual budget, while financial planning in the medium to long term supported by a policy to build adequate buffers was lacking.
Revenue projections generally reflect oil prices prevailing at the time of budget preparation, while spending allocations typically follow a bottom-up approach, leading to rising trends without sufficient consideration to alter government or fiscal priorities.
Moreover, weaknesses in the legal framework allowed for spending outside the budget process to be approved, and inadequate compliance monitoring and cash management processes undermined the integrity of the annual budget, which became a poor indicator of fiscal results. Together, these factors have led to a largely pro-cyclical fiscal policy and an unbalanced spending structure, which negatively affected growth and development.
Government spending has been closely linked to changes in oil prices. The correlation between government spending growth and oil prices was 70% during the period 2003-2018. The negative impact of spending volatility on long-term growth is well documented, and is exacerbated by asymmetric fiscal policy responses to changes in oil prices.
Current spending, particularly the cost of wages, was increased during booms, while sudden cuts in capital spending and accumulating arrears were the first line of defense when oil prices fell. This disparity skewed the spending structure towards current spending, as non-oil capital expenditures accounted for only 4% of total spending in 2018, and resulted in severe spending rigidity and limited reserves.
As a result, Iraq has witnessed greater economic volatility than comparative countries, and lower investment rates, which have translated over time into reduced human and material capital accumulation.
Iraq’s short to medium term goal is to meet urgent post-conflict demands and address infrastructure gaps while maintaining macroeconomic stability. The investment space is constrained by the volatility of international oil prices and the lack of fiscal buffers, while modest debt sustainability and incomplete access to capital markets limit the scope for financing spending through borrowing.
Therefore, fiscal policy should aim to create space within the budget, through strict control of current spending and increase in taxes and revenues, to expand the required infrastructure and social spending, manage fluctuations in oil revenues and avoid the pro-cyclical fiscal policy by building adequate financial reserves (which can be used To protect capital spending during recessions) .
Developing a medium-term approach to budgeting should help reduce pro-cyclicality and ensure that oil revenues are spent in a sustainable manner. Medium-term financial planning helps prevent volatile annual revenues from translating into spending fluctuations that could destabilize the economy and reduce the quality of spending .
* Professor of Economics and Political Science, Kansas State University, USA.