“Recession” is one of the scariest words in economics. The loss of jobs and income can have lasting impacts on people’s lives. How does the economy get back on track when it’s off course? In this episode of The Economic Lowdown podcast series, you’ll learn about how the government uses fiscal policy to influence the economy.
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“Recession” is one of the scariest words in economics. A recession is a significant decline in general economic activity extending over a period of time. During recessions, the unemployment rate usually rises and real income often declines. And when people lose jobs and income, many other unfortunate things can happen. So recessions can have lasting impacts on people’s lives.
How does the economy get back on track when it’s off course? The government can play a role by influencing the economy through its fiscal policy. Fiscal policy is how the government decides to tax and spend in response to economic conditions.
Taxes are fees the government charges on business and individual income, activities, property, and products. For example, the income tax is collected on income earned in any form, which includes salaries, wages, commissions, interest, and dividends.
Since taxes reduce income, and income influences spending, the government can influence the amount of spending in the economy by changing the tax rate.
By adjusting tax rates, the government can have some influence over the total level of spending by consumers.
Here’s the role government spending can play. The government spends money to provide public goods such as highways, bridges, defense, disaster relief, schooling, and so on. This type of spending is called discretionary spending because it is at the “discretion of” Congress and the president to decide how much to spend.
When the government spends money on goods and services, the spending creates economic activity. For example, when the government builds a bridge or an interstate highway, it provides income for the firms and workers who complete the job. In turn, those firms and workers spend their income on goods and services.
These are some fairly simple explanations of taxes and spending. Let’s take a closer look at recessions and inflation to see how taxes and government spending can create ripple effects in the economy. Remember, the end goal is to stabilize the economy.
When a recession occurs, the economy contracts and the unemployment rate likely increases. The level of spending by firms and consumers is simply not high enough to maintain full employment— there is a gap between the total level of spending in the economy and the level of spending that is needed to keep the economy fully employed.
In this case, the government might pursue expansionary fiscal policy to encourage the economy to expand, or grow. Here’s how taxes and government spending may be used to fill some of the spending gap.
First, taxes. The government could decrease tax rates. Decreasing tax rates allows people to keep more of their income. Policyholders hope people will spend some of this new, disposable income. And, if people spend more on goods and services, businesses are likely to increase production of goods and services. As production increases, businesses will likely order more raw materials and equipment and hire additional workers or ask current employees to work more hours. As new and current employees earn more income, policymakers hope those employees will spend some of it on goods and services, creating a ripple effect that will help the economy expand. More spending creates more production, which creates more spending and more production, and so on.
Second, government spending can create ripple effects in the economy as well. For example, the government could increase spending and build new interstate highways and bridges. Such spending is often referred to as a stimulus package. The goal of this extra spending is to have it end up in the pockets of households as wages and profits. As households spend the extra income, it would then create income for others. These waves of income are sometimes called the multiplier effect, as the initial spending has a large impact on the economy.
Expansionary fiscal policy tends to be very controversial because reducing tax rates and increasing spending will likely have adverse effect on the government’s budget. That is, the deficit and national debt could grow.
On the other hand, if spending is growing faster than expected, another issue can arise—inflation. Inflation is a general, sustained upward movement of prices for goods and services in an economy. Inflation is caused by “too much money chasing too few goods.” Because the total level of spending is the root of the problem, many policymakers suggest that fiscal policy can be used to combat inflation. In other words, they suggest that the government use its fiscal policy tools to reduce overall spending in the economy to relieve the upward pressure on prices. This is called contractionary fiscal policy.
To reduce the total level of spending, the government could increase tax rates. As more income is collected in taxes, less is available for spending, reducing inflationary pressures.
Less government spending would work in the same way. Less government spending on projects means less money in household pockets, fewer goods and services purchased, and so on. This too is meant to slow the upward pressure on prices.
That being said, most economists don’t think fiscal policy is the best approach for fighting inflation. Rather, because inflation is caused by “too much money chasing too few goods,” they believe a better approach is to reduce inflation by reducing the growth of the money supply by influencing interest rates. This is accomplished through monetary policy, which is handled by the Federal Reserve.
A major fiscal policy challenge is policy lags. If the economy takes an unexpected turn, it can take a long time to create new policy, and then a while longer for it to work, so there is a lag between taking action and creating change. For example, it can take many months to recognize that the economy has entered a recession. Then, the new legislation required to spur the economy would result in much debate and negotiation. It must pass through the U.S. House of Representatives and the Senate and then be signed by the president. By the time new policy is implemented, it’s possible economic conditions may have changed, gotten worse, or even improved. And new policy takes time to impact the economy. So once tax rates are changed, or spending projects are approved, it can take quite a while for households and firms to see the changes in income.
Our government, however, has built-in economic policies and programs called automatic stabilizers that buffer changes in the economy. When the economy changes—in either direction—these stabilizers automatically adjust taxes and spending without new legislation.
For example, the United States has a progressive income tax. High-income earners pay a larger fraction of their income in taxes than low-income earners do. In other words, as workers earn more income, they pay a higher tax rate. When the economy is booming and most people have jobs and investors and businesses are earning high profits, they pay a higher percentage of their incomes in taxes. And when an economy is fully employed, nearly every available worker is paying income taxes. The outcome of this automatic stabilizer is higher tax rates and more tax dollars collected; when the economy is booming, then, elements of contractionary policy automatically go into effect. Likewise, when the economy is in recession, people’s incomes often fall, which means they will automatically pay a lower tax rate. And since there are more people unemployed, there are fewer people paying the income tax. The outcome of this automatic stabilizer is a lower tax rate and fewer tax dollars collected; when the economy slows, then, elements of expansionary policy automatically go into effect.
There are also automatic stabilizers on the government spending side—for example, unemployment insurance. This program provides income for a limited time to workers who lose a job through no fault of their own. Because many people lose jobs during recessions, the government spends more money on this program during recessions. This is expansionary policy: It provides extra income to support people experiencing hardship. When the money is spent, it adds some support to a weakening economy. Likewise when the economy is booming, people find jobs easily. Government spending on unemployment insurance automatically decreases, which is contractionary policy.
Automatic stabilizers provide a cushion for the economy as it goes through ups and downs. And because these tax and spending programs don’t require Congress and the president to pass new legislation, the lags are much smaller.
Let’s review. Recessions and periods of high inflation are troublesome economic conditions. During recession, the total level of spending decreases. The government can fill the spending gap by using its power to tax and spend. If the government uses expansionary policy and reduces tax rates and increases its spending on goods and services, it will likely result in extra income and spending in the economy. Expansionary fiscal policy is controversial, however, because it is likely to increase the level of government debt. To combat inflation, the government could use contractionary fiscal policy. In this case, it might raise taxes and decrease government spending in an attempt reduce the total level of spending. Many economists suggests that monetary policy, enacted by the Federal Reserve, is more effective for reducing inflation. When Congress does take action, any new legislation to help the economy suffers from policy lags. For example, economic conditions could change while new policy is being made and implemented. Fortunately, the government has automatic stabilizers, such as the progressive income tax and unemployment insurance, which adjust automatically to changes in the economy.
The economy has both ups and downs. When it gets off course, the government may step in to try to help move it to a healthy path.