Fiscal Policy

Abstract

Fiscal policy comes in many forms. Direct interventions in the economy might set hard limits on volumes or prices, including wages, or manipulate behaviours with taxes and subsidies. Unintended side effects and deadweight loss also need to be considered. Fiscal policy might be deployed to stabilise demand in the economy, perhaps with discretionary stimulus beyond the automatic stabilisers. Electoral tolerance or the state’s balance sheet might constrain the response. Financial markets are the ultimate arbiter of sustainability, although international support might then be made conditionally available to smooth the adjustment.

Appendices

Main Messages

• When times are hard, the electorate is prone to demand something be done about it. Direct intervention by capping prices, rationing , wage controls, taxes or subsidies can all seem like natural appeasements.

• Interventions, including price caps and minimum wages, carry costs that can leave output and employment lower than otherwise. There are distributive effects, but there is typically an overall deadweight loss .

• Taxes and subsidies are sometimes calibrated to internalise social costs within the related companies, where it will influence the targeted level of output and prices. However, most taxes exist just to raise money for all the government’s wish list of expenditure.

• Automatic fiscal stabilisers arise from the tax and benefit systems. By making most taxation on flows of activity rather than the stock of wealth, an economic slowdown reduces tax demands. Slower growth also raises unemployment, causing benefits to kick in. Both help smooth spending.

• Discretionary stimulus is sometimes necessary. As people are not perfectly forward-looking, they do not anticipate future tax rises and restrict current spending (i.e. Ricardian equivalence doesn’t hold in practice). Nonetheless, there is an opportunity cost from what the private sector would have done, so fiscal stimulus should still seek a real productive return.

• The electorate values personal and economic freedoms, but there is a variable amount that they are willing to give up. Political sustainability of interventions might extend with propaganda that shifts the blame, potentially as justification for more interventions.

• Good politics often involves triangulating to the centre ground between a party’s core vote and what the opposition proposes. Scenarios for how political vacuums might develop and influence policy drifts can be informative.

• Ability to finance spending is the ultimate arbiter of sustainability and that tends to be enforced by financial markets (i.e. “bond vigilantes”), albeit far less frequently than it is forecast.

• There is a state-dependent optimal speed of consolidation that is slower than market demands might necessitate, albeit still faster than some statist-biased defenders maintain. International support with conditionality on consolidation and structural reforms can smooth the adjustment.

Further Reading

• Bastiat, Frédéric. 1850. The Law.

• Mankiw, N. Gregory. 2015. Macroeconomics.

• Rothbard, Murry. 1962. Man, Economy, and State, with Power and Market.

• Mirrlees, James. 2011. Reforming the Tax System for the 21st Century: The Mirrlees Review. Institute for Fiscal Studies.