BASICS BAC K TO

What Is Fiscal Policy?

Mark Horton and Asmaa El-Ganainy

ISCAL policy is the use of government spending and G directly and inuencing C, I, and NX indirectly, through taxation to inuence the economy. Governments typi-changes in taxes, transfers, and spending. Fiscal policy that incally use scal policy to promote strong and sustain- creases aggregate demand directly through an increase in govable growth and reduce poverty. The role and objec- ernment spending is typically called expansionary or loose. tives of scal policy have gained prominence in the current By contrast, scal policy is often considered contractionary or crisis as governments have stepped in to support nancial systight if it reduces demand via lower spending. tems, jump-start growth, and mitigate the impact of the crisis Besides providing goods and services, fiscal policy objecon vulnerable groups. In the communiqu following their Lontives vary. In the short term, governments may focus on macdon summit in April, leaders of the Group of Twenty industrial roeconomic stabilizationfor example, stimulating an ailing and emerging market countries stated that they are undertakeconomy, combating rising inflation, or helping reduce extering unprecedented and concerted scal expansion. What do vulnerabilities. In the longer term, the aim may be to fosnal they mean by scal expansion? And, more generally, how can sustainable growth or reduce poverty with actions on the ter scal tools provide a boost to the world economy? supply side to improve infrastructure or education. Although Historically, the prominence of fiscal policy as a policy toolthese objectives are broadly shared across countries, their relahas waxed and waned. Before 1930, an approach of limited tive importance differs depending on country circumstances. government, or laissez-faire, prevailed. With the stock mar- In the short term, priorities may reflect the business cycle or ket crash and the Great Depression, policymakers pushed for response to a natural disasterin the longer term, the drivgovernments to play a more proactive role. More recently, ers can be development levels, demographics, or resource countries scaled back the size and function of government, endowments. The desire to reduce poverty might lead a lowwith markets taking on an enhanced role in the allocation income country to tilt spending toward primary health care, of goods and services. Now, with the financial crisis in full whereas in an advanced economy, pension reforms might tarswing, a more active fiscal policy is back in favor. get looming long-term costs related to an aging population. In an oil-producing country, fiscal policy might aim to moderate procyclical spendingmoderating both bursts when oil prices rise and painful cuts when they drop.

How does fiscal policy work?

When policymakers seek to inuence the economy, they have two main tools at their disposalmonetary policy and scal policy. Central banks indirectly target activity by inuencingResponse to the crisis the money supply through adjustments to interest rates, bank The crisis has had a negative impact on economies around the reserve requirements, and the sale of government securities and foreign exchange; governments inuence the economy globe, with nancial sector difculties and agging condence by hitting private consumption, investment, and international changing the level and types of taxes, the extent and compositrade (recall the national income accounting equation). Govtion of spending, and the degree and form of borrowing. ernments have responded by aiming to boost activity through Governments directly and indirectly influence the way resources are used in the economy. The basic equation of two channels: automatic stabilizers and scal stimulusthat national income accounting helps show how this happens: is, new discretionary spending or tax cuts. Stabilizers go into effect as tax revenues and expenditure levels change and do GDP = C + I + G + NX. On the left side is gross domestic product (GDP)the value not depend on specic actions but operate in relation to the busiof all nal goods and services produced in the economy (see Back to Basics, F&D, December 2008). On the right side ness cycle. For instance, as output slows or falls, the amount are the sources of aggregate spending or demandprivate of taxes collected declines because corporate prots and taxconsumption (C), private investment (I), purchases of goods payers incomes fall. Unemployment benets and other social and services by the government (G), and exports minus im- spending are also designed to rise during a downturn. These ports (net exports, NX). This equation makes it evident that cyclical changes make scal policy automatically expansionary during downturns and contractionary during upturns. governments affect economic activity (GDP), controlling Automatic stabilizers are linked to the size of the government, and tend to be larger in advanced economies. Where

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stabilizers are larger, there may be less need for stimuexpected to be prolonged (as in the current crisis), concerns lustax cuts, subsidies, or public works programssince over lags may be less pressing. For all these reasons, stimulus both approaches help to soften the effects of a downturn. measures should be timely, targeted, and temporaryquickly Indeed, in the current crisis, countries with larger stabiliz- reversed once conditions improve. ers have tended to resort less to discretionary measures. In Similarly, the responsiveness and scope of stabilizaddition, although discretionary measures can be tailored ers can be enhanced; for instance, by a more progressive to stabilization needs, automatic stabilizers are not subject tax systemtaxing high-income households at a higher to implementation lags (for example, design, approval, and rate than lower-income households. Transfer payments implementation of new road projects), and their impacts arecan also be explicitly linked to economic conditions (for automatically withdrawn as conditions improve. Stimulus instance, unemployment rates or other labor market trigmay be difficult to design and implement effectively and diffigers). In some countries, fiscal rules aim to limit the growth cult to reverse when conditions pick up. In many low-incomeof spending during boom times, when revenue growth and emerging market countries, however, institutional limi- particularly from natural resourcesis high. Elsewhere, tations and narrow tax bases mean stabilizers are relatively formal review or expiration (sunset) mechanisms for weak. Even in countries with larger stabilizers, there may beprograms help ensure that new initiatives do not outlive a pressing need to compensate for the loss of economic activ-their initial purpose. Finally, medium-term frameworks ity and compelling reasons to target the governments crisiswith comprehensive coverage and assessment of revenues, response to those most directly in need. expenditures, assets and liabilities, and risks help improve The exact response ultimately depends on the fiscal spacepolicymaking over the business cycle. a government has available for new spending initiatives or tax cutsthat is, its access to additional financing at a reasonable cost or its ability to reprioritize its existing expenditures. Some governments have not been in a position to respond with stimulus, because their potential creditors believe addiBig deficits and rising public debt tional spending and borrowing would put too much pressure on inflation, foreign exchange reserves, or the exchange Fiscal decits and public debt ratios have expanded sharply rateor take too many resources from the local private sector many countries with the scal response of the crisis. Supin (also known as crowding out), delaying recovery. For other port and guarantees to nancial and industrial sectors have governments, more severe financing constraints have necesadded to concerns. Many countries can afford to run modersitated spending cuts as revenues decline (stabilizers func- ate scal decits for extended periods, with domestic and intioning). In countries with high inflation or external current ternational nancial markets and international and bilateral account deficits, fiscal stimulus is likely to be ineffective, and partners convinced of their ability to meet present and future even undesirable. obligations. Decits that grow too large and linger too long may, however, undermine that condence. Aware of these risks in the present crisis, the IMF is calling on governments to establish a four-pronged scal policy strategy to help ensure solvency: stimulus should not have permanent effects on decits; medium-term frameworks should include commitment to scal correction once conditions improve; structural reforms should be identied and implemented to enhance growth; and countries facing medium- and long-term demoFine-tuning the response graphic pressures should rmly commit to clear strategies for The size, timing, composition, and duration of stimulus mat- health care and pension reform. ter. Policymakers generally aim to tailor the size of stimulus measures to their estimates of the size of the output gapthe difference between expected output and what output would be if the economy were functioning at full capacity. A measure of the effectiveness of the stimulusor, more precisely, its translation in terms of output (also known as the multi- Mark Horton is a Division Chief and Asmaa El-Ganainy is an plier)is also needed. Multipliers tend to be larger if there isEconomist in the IMFs Fiscal Affairs Department. less leakage (for example, only a small part of the stimulus is saved or spent on imports), monetary conditions are accommodative (interest rates do not rise as a consequence of theSuggestions for further reading: Daniel, James, Jeffrey Davis, Manal Fouad, and Caroline Van scal expansion), and the countrys scal position after the Rijckeghem, 2006, Fiscal Adjustment for Stability and Growth, IMF stimulus is viewed as sustainable. Multipliers can be small or Pamphlet 55 (Washington: International Monetary Fund). even negative if the expansion raises concerns about future Heller, Peter S., 2005, Understanding Fiscal Space, IMF Policy sustainability, in which case the private sector would likely Discussion Paper 05/4 (Washington: International Monetary Fund). counteract government intervention by increasing savings or International Monetary Fund, 2008, Fiscal Policy as a Countercyclical even moving money offshore, rather than investing or con- Tool, World Economic Outlook, Chapter 5 (Washington, October). suming. Multipliers also tend to be higher for spending mea- International Monetary Fund, 2009, The State of Public Finances: Outlook and Medium-Term Policies After the 2008 Crisis (Washington); sures than for tax cuts or transfers and for larger countries (in available at www.imf.org/external/np/pp/eng/2009/030609.pdf both cases, because of fewer leakages). As for timing, it oftenSpilimbergo, Antonio, Steve Symansky, Olivier Blanchard, and Carlo takes time to implement spending measures, and once in place Cottarelli, 2008, Fiscal Policy for the Crisis, IMF Staff Position Note they may no longer be needed. However, if the downturn is 08/01 (Washington: International Monetary Fund).

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