Effectiveness of Fiscal Policy

In earlier sections, we learnt what a fiscal policy is all about, and how it works. In this section, we shall evaluate the effectiveness of fiscal policy. Ultimately, there are pros and cons of contractionary fiscal policy and expansionary fiscal policy.

Effectiveness of fiscal policy

fiscal policy strengths and weaknesses - pros and cons - benefits and limitations

Strengths of Fiscal Policy

#1 Good track record

  1. Expansionary fiscal policy is effective in pulling an economy out of recession. There are good track records for that.
  2. We can also use contractionary fiscal policy to control and rein in an overheated economy. This, however, is not often used due to political constraints.

#2 Short effect lag

  • It has a short effect lag as stimulus spending will have an immediate effect on the economy. This is because  government spending is a direct component of aggregate demand.

#3 Industry targeting

  • Government can identify and target its spending at specific industry clusters/sectors and areas of the economy. For instance, areas such as education, healthcare, infrastructure, and R&D can yield long term ‘supply-side’ benefits.
  • On a separate but related note, government can also direct its funds/subsidies/taxes at specific large corporates and rescue them during crisis. This can help to avoid massive job losses.

Weaknesses of Fiscal Policy

Governments can use fiscal policy to shift the country’s Aggregate Demand away from deep recession and high inflation. This is so that the economy can reach a relative stable state for economic activities to thrive. However, they do have certain limitations.

#1 Political tool

  • Fiscal policy can potentially become a political tool to gain votes.
  • For instance, we can see that government often increases its spending near election periods to attract votes. This can facilitate the incumbent political party to stay in their position.

#2 Crowding out effect

  •  A rise in government expenditure can lead to a crowding out effect if the government has borrowed funds to finance the budget deficit. This can drive up interest rates, leading to crowding out of private sector investment.

#3 Net export effect

  • In addition to the crowding out of private sector investment in the domestic market, it can also lead to the “net export effect”. This is especially so if the country is an open economy.  
  • Essentially, the increase in interest rate will draw in offshore funds looking at high interest investment opportunities. These funds will need to be converted to domestic currency in order to purchase high interest yielding assets. This will drive up exchange rates, and that will in turn make net exports more expensive.

#4 Debt burden

  • The government will eventually need to repay the loans, if they have earlier borrowed to finance the budget deficit. 
  • This loan repayment can be problematic if the interest payable is high.
  • Hence there is an opportunity cost, as funds can be better used for other purposes.

#5 Time lag (detection and decision lag)

  • Although fiscal policy works relatively fast in terms of influencing aggregate demand, however the time lag to recognize the problem, to engineer a solution, and to get consensus for it typically takes time. So much so that it may be out of sync with reality. This means that the policy intervention may be too slow to target the economic problems accurately. 
  • In extreme cases, it can even exacerbate the problem. For instance, if the economy’s high inflation problem can already be correcting itself, when the contractionary fiscal policy is introduced. As a result, the contractionary fiscal policy can push the economy below its desired full employment rate.
  • Furthermore, due to a relatively long administrative lag, it is more prone to economic shocks that can happen along the way. In turn, this makes the economic assessment of the fiscal policy more difficult. 

#6 Cost inflation

  •  If the government raise taxes to dampen the rise in the general price level, it can lead to cost inflation.
  • A rise in corporate tax, for example, is usually passed on to the consumers in the form of higher prices. In turn, this can lead to higher wage claims to deal with the increasing prices if workers have significant negotiating powers.
  • Conversely, if workers do not have bargaining powers, it can erode their real wages overtime and hurt their welfare. 

#7 Exacerbating inequality

  • It is difficult to manage welfare and redistributive justice. It can even conflict with welfare and social programs. 
  • For example, a cut in government spending can hurt the poor more than the higher income segment of society.  

#8 Lower incentive to work

  • High taxes can rob people of the incentive to work.