Since the advent of endogenous growth theory, economic impacts of taxes and spending by government on output growth have been widely examined.
Lower taxes and spending stimulate economic expansion through greater consumer spending and after-tax income increases for workers, while deficits impede it by discouraging private-sector investment.
Taxes
Fiscal policy’s effects on economic growth have long been an area of intense debate, both theoretically and empirically. This debate gained new significance during the global financial crisis when governments intervened to support banks and launch growth.
Fiscal policy’s primary tool to increase output is increasing spending or cutting taxes, both of which increase demand by infusing more money directly or indirectly by lowering borrowing costs.
Short-run fiscal policy’s short-run effects are evident: expansionary policy raises output beyond its natural rate, while contractionary fiscal policy lowers it below current levels. The magnitude of these effects depends on the nature and composition of fiscal adjustments; for instance, expansionary ones typically use spending and transfer payments that have larger effects than taxes to generate adjustments.
Spending
Fiscal policy’s primary effect is altering aggregate demand for goods and services. A fiscal expansion can boost aggregate demand through two avenues. If government purchases increase without altering taxes or transfer payments, consumption directly rises; or by cutting taxes or increasing transfer payments households’ disposable income increases causing them to spend more on consumption.
Fiscal policy also alters aggregate demand. When governments run deficits, part of their expenses are covered through issuing bonds; as long as other factors remain constant, this increases interest rates and crowds out private investment, leading to less of output comprising private investment.
Increased government expenditures can stimulate economies when spent on infrastructure projects, creating job opportunities and improving consumer trust. It is crucial, however, to monitor their impact closely so as not to lead to inflation; one good strategy would be only implementing fiscal stimuli when necessary.
Deficits
During recessions, government spending increases to cushion the blow from reduced private investment and can even help increase growth by 0.75 percentage points or more in advanced economies. These “automatic stabilizers” provide essential support during an otherwise negative economic cycle.
Deficits can also boost domestic demand through other channels. For example, cutting taxes to encourage consumption will raise domestic demand – though its exact impact depends on timing and whether or not an economy has reached full employment.
Longstanding concerns regarding deficits have focused on their potential to lower future national income by decreasing savings rates – an effect known as crowding out. While much research has been conducted on this theory, evidence is mixed due to interest rate changes over time and between methods of study; deficits tend to be associated with lower rather than higher interest rates as predicted under crowding out theory. A more serious risk associated with expanding deficits is adding debt burdens onto future generations that reduce purchasing power in future years.
Incentives
Not only can fiscal policy impact aggregate demand and saving, but it can also alter incentives for production. For instance, cutting income taxes reduces people’s incentive to work while cutting capital borrowing rates increases investments and thus output (see supply-side economics).
An open economy makes federal spending even more important, since its effects can also have an effect on international trade and currency exchange rates. An increase in interest rates due to fiscal expansion attracts foreign funds and causes the dollar to appreciate, making imported goods cheaper in America while exports become more costly overseas; ultimately lowering merchandise trade balance and GDP.
These effects tend to be short-lived; in the long run, a country’s natural rate of output is determined by supply factors (labor, capital and technology), so attempts at keeping production above this natural rate through aggregate demand policies usually only result in inflation.