Definitions and Basics

Fiscal Policy, from the Concise Encyclopedia of Economics

Fiscal policy is the use of government spending and taxation to influence the economy. When the government decides on the goods and services it purchases, the transfer payments it distributes, or the taxes it collects, it is engaging in fiscal policy. The primary economic impact of any change in the government budget is felt by particular groups–a tax cut for families with children, for example, raises their disposable income. Discussions of fiscal policy, however, generally focus on the effect of changes in the government budget on the overall economy. Although changes in taxes or spending that are “revenue neutral” may be construed as fiscal policy–and may affect the aggregate level of output by changing the incentives that firms or individuals face–the term “fiscal policy” is usually used to describe the effect on the aggregate economy of the overall levels of spending and taxation, and more particularly, the gap between them.

Fiscal policy is said to be tight or contractionary when revenue is higher than spending (i.e., the government budget is in surplus) and loose or expansionary when spending is higher than revenue (i.e., the budget is in deficit). Often, the focus is not on the level of the deficit, but on the change in the deficit. Thus, a reduction of the deficit from $200 billion to $100 billion is said to be contractionary fiscal policy, even though the budget is still in deficit….

Taxation, from the Concise Encyclopedia of Economics

In recent years, taxation has been one of the most prominent and controversial topics in economic policy. Taxation has been a principal issue in every presidential election since 1980–with a large tax cut as a winning issue in 1980, a pledge of “Read my lips: no new taxes” in the 1988 campaign, and a statement that “It’s your money” providing an enduring image of the 2000 campaign. Taxation was also the subject of major, and largely inconsistent, policy changes. It remains a source of ongoing debate….

At the federal level, total tax collections have hovered in a fairly narrow range around 19 percent of the gross domestic product (GDP) since the end of the Korean War, though the percentage was down sharply in 2003 (see Table 1)….

New Keynesian Economics, from the Concise Encyclopedia of Economics

Because new Keynesian economics is a school of thought regarding macroeconomic theory, its adherents do not necessarily share a single view about economic policy. At the broadest level, new Keynesian economics suggests–in contrast to some new classical theories–that recessions are departures from the normal efficient functioning of markets. The elements of new Keynesian economics–such as menu costs, staggered prices, coordination failures, and efficiency wages–represent substantial deviations from the assumptions of classical economics, which provides the intellectual basis for economists’ usual justification of laissez-faire. In new Keynesian theories recessions are caused by some economy-wide market failure. Thus, new Keynesian economics provides a rationale for government intervention in the economy, such as countercyclical monetary or fiscal policy….

Redistribution, from the Concise Encyclopedia of Economics

The federal government has increasingly assumed responsibility for reducing poverty in America. Its primary approach is to expand programs that transfer wealth, supposedly from the better off to the poor. In 1962, federal transfers to individuals (not counting payments for goods and services provided or interest for money loaned) amounted to 5.2 percent of gross domestic product, or 27 percent of federal spending (Stein and Foss 1995, p. 212). By 2000, federal transfers had increased to 10.9 percent of GDP, or approximately 60 percent of federal spending; GDP was $9.82 trillion and federal spending was $1.79 trillion. These transfers are commonly referred to as government redistribution programs, presumably from the wealthy to the poor….

Taxation, A Preface, from the Concise Encyclopedia of Economics

Economists specializing in public finance have long enumerated four objectives of tax policy: simplicity, efficiency, fairness, and revenue sufficiency. While these objectives are widely accepted, they often conflict, and different economists have different views of the appropriate balance among them….

Marginal Tax Rates, from the Concise Encyclopedia of Economics

The marginal tax rate is the rate on the last dollar of income earned. This is very different from the average tax rate, which is the total taxes paid as a percentage of total income earned….

Progressive Taxes, from the Concise Encyclopedia of Economics

If, as Oliver Wendell Holmes once said, taxes are the price we pay for civilized society, then the progressivity of taxes largely determines how that price varies among individuals. A progressive tax structure is one in which an individual or family’s tax liability as a fraction of income rises with income. If, for example, taxes for a family with an income of $20,000 are 20 percent of income and taxes for a family with an income of $200,000 are 30 percent of income, then the tax structure over that range of incomes is progressive. One tax structure is more progressive than another if its average tax rate rises more rapidly with income….

In the News and Examples

Fiscal Sustainability, from the Concise Encyclopedia of Economics

The population of wealthy countries is getting much older. Between 2005 and 2035, the number of elderly in wealthy countries will more than double, but the number of workers will barely change. This historically unprecedented demographic change portends enormous fiscal stresses because of the high and growing cost of meeting government pension and health-care commitments to the elderly. Indeed, these projected payments are so high that collecting them may not be feasible, either economically or politically. The costs associated with the coming generational storm will bankrupt the governments of most wealthy countries unless major and painful adjustments are made now….

One way to put the U.S. fiscal gap in perspective is to ask how much of a tax hike would be required to make the present value of the new taxes equal the gap. The answer is that U.S. federal personal and corporate income taxes would have to be doubled, immediately and permanently! Alternatively, the gap could be closed by immediately and permanently cutting by two-thirds the elderly’s Medicare health benefits as well as their Social Security pension benefits!… [N.B.–written prior to government’s $700 billion bailout (Emergency Economic Stabilization Act of 2008) of Oct. 3, 2008.–Econlib Editor]

Bernstein on Inequality, podcast on EconTalk. Oct. 6, 2008

William Bernstein, author of A Splendid Exchange, talks with EconTalk host Russ Roberts about inequality. Bernstein is worried about it; Roberts is not. Bernstein argues that inequality is damaging to the health of low-status people and hurts the health of the economy. Roberts challenges Bernstein’s empirical evidence. It’s a lively conversation on the economics of status, productivity and the progressivity of taxes.

Health Insurance, from the Concise Encyclopedia of Economics

The system began to unravel in the 1970s and 1980s. Large employers began to manage their own health care plans, started paying hospitals based on set charges rather than on costs, and negotiated price discounts. Through the Medicare program, the federal government began paying hospitals fixed prices for surgical procedures (the Prospective Payment System). Health maintenance organizations (HMOs) emerged as competitors to traditional fee-for-service insurance….

Social Security, from the Concise Encyclopedia of Economics

Social Security, or, to be precise, Old Age, Survivors and Disability Insurance (OASDI), is the U.S. government program that pays benefits to workers after retirement, to spouses and children of deceased workers, and to workers who become disabled before they retire….

A Little History: Primary Sources and References

Taylor on Rules, Discretion, and First Principles, podcast on EconTalk. April 30, 2012.

John Taylor of Stanford University’s Hoover Institution talks with EconTalk host Russ Roberts about his new book, First Principles: Five Keys to Restoring America’s Prosperity. Taylor argues that when economic policy adhere to the right basic principles such as keeping rules rather than using discretion, then the economy thrives. Ignoring these principles, Taylor argues, leads to bad economic outcomes such as recessions, inflation, or high unemployment. Taylor illustrates these ideas with a whirlwind tour of the last half century of American economic policy and history….

Supply-Side Economics, from theConcise Encyclopedia of Economics

“Supply-side economics” is also used to describe how changes in marginal tax rates influence economic activity. Supply-side economists believe that high marginal tax rates strongly discourage income, output, and the efficiency of resource use. In recent years, this latter use of the term has become the more common of the two and is thus the focus of this article….

The marginal tax rate is crucial because it affects the incentive to earn. The marginal tax rate reveals how much of one’s additional income must be turned over to the tax collector as well as how much is retained by the individual. For example, when the marginal rate is 40 percent, forty of every one hundred dollars of additional earnings must be paid in taxes, and the individual is permitted to keep only sixty dollars of his or her additional income. As marginal tax rates increase, people get to keep less of what they earn.

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Related Topics

Roles of Government
Aggregate Demand
Government Budget Deficits and Government Debt
Government Failures, Rent Seeking, and Public Choice
Income Distribution