Learn what fiscal policy is, how it affects the national economy and how it impacts small businesses.
- Governmental decisions to raise or decrease taxation and expenditure are known as fiscal policies.
- Together, monetary and fiscal policies are frequently employed to affect the economy.
- Taxes, hiring potential, and business expansion are all impacted by fiscal policy.
This article is for company owners who are curious in fiscal policy and how it affects the economy.
An essential component of American economy is fiscal policy. Fiscal policy is decided upon by both the executive and legislative arms of government, who utilize it to modify revenue and expenditure levels in order to affect the economy. Those choices might have a big effect on your small business.
Fiscal policy defined
The ideas of British economist John Maynard Keynes, on which fiscal policy is founded, assert that raising or lowering revenue (taxes) and expenditure (spending) levels affects inflation, employment, and the movement of money through the economy. In order to affect the direction of the economy, fiscal policy is frequently employed in conjunction with monetary policy, which is controlled by the Federal Reserve in the United States.
Given that the gross domestic product (GDP) is influenced by taxes, expenditures, inflation, and employment, fiscal policy is essential to effective economic management (GDP). The value of the commodities and services a country produces in a year is shown by this number. Learn how to estimate your company’s cost of goods sold (COGS).
Consider a fiscal expansion that results in higher demand, which then spurs an increase in output to gain an understanding of how fiscal policy may impact the economy. Prices will differ if this rise in demand happens in an environment with high employment. However, in an economy with low unemployment, increasing demand will result in more employment and output but not necessarily changes in prices. Depending on which of these scenarios is true, the GDP will fluctuate.
Fiscal policy factors and tools
The GDP is one of the metrics that are frequently used to assess an economy’s performance. Aggregate demand, or the total amount of goods and services produced by a country and bought at a particular price point, is another determinant. According to the aggregate demand curve, demand for products and services increases when prices are lower and declines when prices are higher.
These metrics are impacted by fiscal policy, which aims to sustainably boost GDP and aggregate demand. Three elements are altered to achieve this.
Business tax policy:
Taxes that companies pay to the government have an impact on their earnings and capital expenditures. Tax reductions boost overall demand and investment possibilities for businesses.
The governments own spending results in a rise in overall demand.
Taxes imposed on individuals:
Such as income taxes, have an impact on their personal income and spending power, which helps to stimulate the economy.
When an economy is experiencing significant unemployment and a decline in aggregate demand, fiscal policy usually has to be changed.
Taxes and expenditure are the two primary fiscal policy instruments. By dictating how much money the government must spend in specific sectors and how much money people should spend, taxes have an impact on the economy. For instance, the government may lower taxes to encourage consumer spending. Tax reductions give families more money, which the government hopes they will spend on goods and services, so boosting the economy as a whole.
Spending is a mechanism for fiscal policy that directs funding to particular industries that require an economic boost. As with taxes, the government expects that whomever receives those dollars will use their additional funds to purchase other products and services.
To prevent the economy from tilting to much in either direction, it’s critical to strike the appropriate balance. Before the Great Depression of the 1920s, the American government had a fairly laissez-faire attitude toward determining economic policy. After that, the government came to the conclusion that it needed to influence the course of the economy more. What Is Economics? is a connected article to this one.
Fiscal policy vs. monetary policy
Fiscal and monetary policies are used to alter the economy of the United States. While monetary policy controls the quantity of money that is accessible across the economy, fiscal policy is used to affect the overall demand in a nation. While the central banks’ monetary policy impacts our capacity to demand these services, the government may use fiscal policy to shape the amount of goods and services that people can or will desire.
While the federal executive and legislative departments determine federal fiscal policy, central banks, such as the Federal Reserve, determine monetary policy (state and local legislative and executive branches set state and local fiscal policy). While Congress and the White House decide on tax rates for businesses and people in order to advance fiscal policy objectives, the Federal Reserve may implement monetary policy in order to ensure price stability, full employment, and stable economic development.
Fiscal policy is therefore political by definition. It’s important to remember that Congress has declared that choices on monetary policy should be free from politics. The Federal Reserve is only required to put maximum employment and price stability first when formulating monetary policy. The Federal Reserve should never adopt or implement any policy that is politically driven.
Republican vs. Democrat policy differences
On fiscal policy, Republicans and Democrats hold contrasting opinions. Democrats normally think regulation is necessary, but Republicans typically think there should be less government engagement in the economy. Republicans tend to support corporate deregulation, reduced taxes, free markets, and restrictions on labour unions. Democrats, on the other hand, often advocate progressive taxation and make the case that greater government spending programmes may be implemented because of higher tax rates.
Despite the Federal Reserve’s stated intention to be politically neutral, budgetary policy can shift with each presidential administration or whenever the majority party in Congress changes. Because of these various strategies, firms may need to adapt to periodic changes in policy. The best school of thinking for your company will probably depend on your particular economic convictions.
Types of fiscal policy
There are two main types of fiscal policy: expansionary and contractionary.
Expansionary fiscal policy
The most frequent occasions to apply expansionary fiscal policy, which aims to boost the economy, are during recessions, periods of high unemployment, or other downturns in the business cycle. It involves either increasing government expenditure, reducing taxes, or doing both.
Putting more money in consumers’ hands so they can spend more to boost the economy is the aim of an expansionary fiscal policy. In terms of economics, expansionary fiscal policy aims to increase aggregate demand when private demand has dropped.
Contractionary fiscal policy
When inflation is rising too quickly, for example, contractionary fiscal policy is employed to cut down the economy’s expansion. Contractionary fiscal policy, which is the antithesis of expansionary fiscal policy, increases taxes while reducing spending. Consumers have less money to spend as a result of higher taxes, which slows economic development and stimulus.
Economic growth under contractionary fiscal policy is typically limited to 3% annually. If growth exceeds this pace, the economy might suffer from inflation, asset bubbles, higher unemployment, and even recessions.
Setting fiscal policy
The federal budget for each year sets the parameters for modern U.S. fiscal policy. The federal budget outlines the government’s anticipated expenditure for the fiscal year as well as how it intends to finance it, such as through new or current taxes. A joint effort between the president and Congress results in the budget.
The president will first present a budget to Congress that establishes the fiscal policy for the upcoming year by laying out how much money the government should spend on necessities like defence and healthcare, how much should be raised in tax revenues, and how much of a deficit or surplus is anticipated.
Following a review of the president’s budget proposal, Congress creates its own budget resolutions, which establish general spending and taxes levels. Legislators begin the appropriations procedure, which specifies how each dollar will be spent, after the resolutions have been adopted. Those appropriations legislation can’t be put into effect unless the president signs them.
You should evaluate potential financial risks for your small business based in part on anticipated changes to the government budget and fiscal policies.
How fiscal policy affects businesses
Both public and private businesses are directly impacted by the fiscal policies of an economy, whether it takes the form of expenditure or taxation. The following implications of fiscal policy on your small business are possible.
Government expenditure will present additional prospects for investment to businesses. When the government and other sources are injecting more money into the economy and taxes are low, this frequently happens during an expansionary fiscal policy. Companies may anticipate success and growth when pricing and demand are balanced.
When that balance is upset and demand — and prices — fall, a contractionary fiscal policy may become active to prevent inflation. Due to rising taxes, businesses typically slow their expansion and take steps to maintain profitability even as less money is moving through the economy.
The degree of taxation your business will incur may vary depending on where it is located, including local, state, and federal taxes. Think about how the tax policies of your state and local governments affect your business and how they interact with federal budgetary policy.
The quantity of taxes imposed on future generations is also influenced by fiscal policies. Government expenditure that increases deficits will eventually require more taxes to cover interest costs. On the other hand, when there is a surplus in the budget, taxes eventually need to be reduced.
Minimizing unemployment is one of fiscal policy’s main goals. The government may, for instance, cut taxes to put more money in the hands of citizens. Customers therefore have more money to spend, and businesses can see greater demand. Businesses may need to accomplish more production activities as a result of rising demand; in this case, they might respond by adding positions and staff members. A low unemployment rate may gradually rise with sound fiscal policies in place.
The best ways to tackle policy changes
Business owners should obtain financial guidance before acting hastily in reaction to even the smallest indications of economic shift. If your business doesn’t have a chief financial officer, you might want to think about employing a CPA or a financial management firm.
As a whole, small firms are resilient because they must be, according to Pad loop creator and entrepreneur Mike Catania. “Changes in fiscal policy expose us to what we detest the most: uncertainty,” says the author.
With the help of a professional, you can decide how much to spend, how much to charge for your goods and services, how much to pay for benefits, and other business decisions that might be influenced by fiscal policy.
The importance of tracking fiscal policy
Political parties may disagree on the best course of action for the prosperity of the country when it comes to fiscal policy, a complex area of economics. Fiscal policy is influenced by decisions made by the executive and legislative branches that have an impact on taxes and government expenditure. It’s crucial to follow economic trends since these decisions have an influence on even the tiniest firms, both positively and negatively.
Max Freedman and Kimberlee Leonard helped with the writing and reporting for this piece. For an earlier iteration of this article, source interviews were done.