Evaluating Fiscal Policy

Strengths of Fiscal Policy

Ability to Target Specific Sectors of the Economy

Unlike Monetary policy that influences the overall levels of aggregate demand, Fiscal Policy can target specific industries and sectors of the economy through either tax cuts for those sectors or direct government expenditure. Therefore, it is able to support industries that are most impacted by the economic situation. For example, during the Covid Pandemic, many governments around the world gave airlines bailouts or loans, in order to help them survive the impacts of reduced global travel and travel restrictions. Emirates airlines based in Dubai, received $2bn in order to survive the impacts of limited global travel.

Similarly, the "Build Back Better" plan introduced in 2021 in the US, provided large amounts of government expenditure on improving and investing in greener forms of energy as well as particular infrastructure programmes that could help the economy to recover from a recession as well as improve long term economic growth.

Government Spending to correct deep recessions

In a deep recession, consumer confidence and business confidence may be very low levels due to the higher levels of uncertainty. As a result, households and firms may not respond to lowering of interest rates by central banks and households may continue to save and not borrow as uncertainty around their future employment and ability to pay back. Similarly, despite the lower cost of borrowing, firms may be reluctant to borrow if the future is uncertain whether or not the firm will see a return on investment.

Fiscal Policy however can involve direct government expenditure into the economy, directly increasing the overall levels of aggregate demand. Therefore, whilst households and firms may not be responsive to lower interest rates or lower taxes, the government has the ability to directly spend in the economy, increasing aggregate demand and therefore real GDP. For example, Governments can increase employment in the public sector by increasing the current expenditure. This government expenditure will increase the rGDP as well as decreasing cyclical unemployment. These policies which are taken to correct a particular problem are called Discretionary fiscal policy.

Automatic Stabilisers

As we have discussed already, most governments have a progressive tax system for household incomes, and may provide transfer payments to vulnerable groups to help avoid poverty. These policies can automatically help reduce large fluctuations in economic activity, and reduce the size of expansions and recessions in the economy. As they automatically happen we call these Non-discretionary fiscal policy

During an expansion of the economy, as employment and incomes rise with an increase in economic activity (expansionary phase), households will begin pay a higher average tax rates. As such, incomes will not raise as quickly and therefore consumptions levels will not increase by as much.

On the other hand, during a recession as employment and incomes decrease with lower levels of economic activity, household incomes will pay a lower average tax rate, providing households with more income to continue consumption at a certain level. Similarly, for those made cyclically unemployed, they will begin to receive transfer payments, that will allow them to continue some levels of consumption. As such economic activity does decrease but by less than it would without a progressive tax system and transfer payments.

Weaknesses of Fiscal Policy

Political Pressures and Priorities

Unlike Monetary Policy, which for a lot of countries is controlled by independent central banks, Fiscal Policy is determined by the government of the day. Therefore, political ideologies may influence the policies and levels of government spending or taxation in the economy despite what might be economically viable.

For example, an economy may be suffering from high inflation and high unemployment (Stagflation). The government may wish to increase spending to reduce unemployment as it may be politically popular, however, this could lead to higher inflation.

Time Lags

Unlike Monetary Policy, where interest rates decrease is implemented over a short period of time, Fiscal Policies may take longer to implement. This may be as they require more time to clear political processes and parliaments or the time between approval and implementation of a policy. As a result, discretionary fiscal policies may take a long time to achieve the desired result.

Impact on overall levels of Debt

A government objective is to have sustainable levels of debt. This allows governments to be able to borrow at lower rates, provides confidence in the economy as tax rates will be stable and therefore stable employment and inflation. However unsustainable levels of debt can increase the costs of borrowing and opportunity costs for governments spending in terms of servicing debt vs investments in the economy.

Crowding Out

Crowding out is a classical economists argument that suggests the additional government spending (+G) will be offset by a fall in Consumption from households and Investment from firms (-C & -I). This crowding out can either be partial, as seen in the first diagram, the increase in real GDP from the government spending of Y1 -> Y2, is offset by an fall in real GDP of Y2 to Y3 due to the fall in consumption and investment. Or this can be complete crowding out from where the increase in realGDP of Y1 to Y2 due to increased government spending, is offset by the same fall in realGDP due to decreased Consumption and Investment.

This crowding out occurs due to the additional borrowing from governments to fund the additional spending. The increased demand for loanable funds by the governments on the open market, will increase the interest rate charged on the loanable funds (assuming the supply of money remains constant). As such, the higher interest rates discourage households and firms from borrowing to spend (households) or invest (firms) and encourages saving, and therefore this crowds out private spending by households and firms.

Case Study 1: Expansionary Fiscal Policy in Japan (2013 – Abenomics)

Introduction

Japan, plagued by decades of economic stagnation and deflation following its asset bubble collapse in the early 1990s, adopted an aggressive expansionary fiscal policy under the leadership of Prime Minister Shinzo Abe in 2013. This approach formed a key component of Abe’s broader economic strategy, commonly referred to as "Abenomics." The goal of this policy was to achieve sustainable economic growth, increase employment, and combat persistent deflation that had suppressed consumer spending and investment.

Policy Measures

The fiscal stimulus was one of the three "arrows" of Abenomics, alongside monetary easing and structural reforms. The Japanese government introduced a ¥10.3 trillion (approximately $116 billion) fiscal stimulus package in 2013. A significant portion of this funding was directed toward large-scale public infrastructure projects, including rebuilding areas affected by natural disasters, upgrading aging transport systems, and improving public facilities. This spending aimed to create jobs and boost aggregate demand. Additionally, the government provided subsidies and incentives to encourage private sector investment and allocated more resources to education and child care to support household spending. The policy also included consumer-focused initiatives, such as temporary tax credits and incentives to increase disposable income and stimulate consumption.

Outcomes

The expansionary fiscal policy produced mixed results. On the positive side, Japan experienced moderate economic growth, with GDP growth improving from 1.5% in 2012 to 2% in 2013. Unemployment also declined, reaching a low of 3.6% in 2014, indicating that the infrastructure projects and other measures helped create jobs. However, the impact on deflation was limited, as inflation rose only marginally and remained below the Bank of Japan’s 2% target. Critics argued that the fiscal stimulus exacerbated Japan’s already high public debt, which stood at over 230% of GDP by 2014, raising concerns about long-term fiscal sustainability. Moreover, the effects of the stimulus were constrained by weak global demand and structural issues in Japan’s economy, such as an aging population and stagnant productivity.

Conclusion

Japan’s use of expansionary fiscal policy as part of Abenomics illustrates both the potential and limitations of government spending in achieving macroeconomic objectives. While the measures succeeded in boosting short-term growth and reducing unemployment, they fell short of fully addressing deflation and structural economic challenges. This case highlights the importance of combining fiscal policy with complementary structural reforms to achieve long-term economic stability and growth.

Case Study 2: Contractionary Fiscal Policy in Greece (2010-2015 – Austerity Measures)

Introduction

After the 2008 global financial crisis, Greece faced a sovereign debt crisis characterized by unsustainable public debt levels and large budget deficits. To secure bailout packages from the European Union (EU) and the International Monetary Fund (IMF), Greece implemented stringent contractionary fiscal policies, also known as austerity measures, to reduce its deficit and stabilize the economy.

Policy Measures

The austerity measures focused on reducing government spending and increasing taxes:

Spending Cuts: Significant reductions in public sector wages, pensions, and government programs. For example, public sector salaries were cut by 20-30%, and pension payments were reduced by 40%.
Tax Increases: Introduction of higher value-added tax (VAT) rates, rising from 19% to 23%, and increases in income and property taxes.
Structural Reforms: Measures to reduce inefficiencies in public administration, streamline labor markets, and privatize state-owned enterprises.

Outcomes

While the contractionary fiscal policy succeeded in reducing Greece’s budget deficit, it had severe socio-economic consequences:

Fiscal Stabilization: The budget deficit fell from 15.1% of GDP in 2009 to 2.6% by 2014, and public debt growth slowed.
Economic Contraction: Real GDP shrank by 25% between 2009 and 2013, as austerity measures dampened consumption and investment.
Unemployment: The unemployment rate surged from 9.6% in 2009 to a peak of 27.5% in 2013, particularly affecting youth and public sector employees.
Public Discontent: Protests and social unrest became widespread, driven by declining living standards and reduced access to public services.

Although austerity policies addressed fiscal imbalances, they failed to achieve macroeconomic recovery in the short term. Critics argued that the policies deepened the recession, exacerbated unemployment, and disproportionately hurt low-income households.

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