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Syllabus? Evaluation of fiscal policy

  • Syllabus: Evaluate the effectiveness of fiscal policy through consideration of factors including:
  • the ability to target sectors of the economy,
  • the direct impact on aggregate demand,
  • the effectiveness of promoting economic activity in a recession,
  • time lags,
  • political constraints,
  • crowding out, and
  • the inability to deal with supply side causes of instability.
The effectiveness of fiscal policy, as a measure to influence aggregate demand and output, is open to much debate.

The argument over using fiscal policy revolves around whether:
  • it can be used as a fine tuning mechanism
  • it can be used to achieve the desired level of national income
  • it can be used to reduce unemployment without causing overheating and inflation
  • the 'right' levels of government spending and taxation be determined
  • changes in government spending and taxation can be offset by changes in other injections and leakages
  • time lags between changing policy and the effects are too long for the desirable results to be estimated or achieved
  • an increase in aggregate demand will necessarily lead to an increase in output income and employment
  • expansionary fiscal policy will have any undesirable effects, such as inflation, worsening the balance of payments situation or ' crowding out' private borrowing and investment

Major arguments in favour of fiscal policy

  • Increasing aggregate demand through changing government spending and taxation will increase output  employment and income, in the short run, working through an expenditure multiplier process.

Major arguments against fiscal policy

Fiscal policy - weaknesses

  • Time Lags- changes in direct taxes may take considerable time to implement and government spending is often inflexible in a downwards direction; e.g. for political or moral reasons, it is usually difficult to reduce government spending on pensions and benefits and once a capital project such as a motorway has been started, it is difficult, if not impossible, to stop it in mid-stream.
  • Conflicts between objectives - fiscal policy designed to achieve one goal may adversely impact on another. For example, reflationary fiscal policy designed to stimulate aggregate demand and reduce unemployment may worsen inflation (N.B. for HL students only, this is explained in greater detail in the extension section on the long run Phillips curve).
  • Supply-side economists believe that certain fiscal measures will have a disincentive effect. For example, an increase in income tax may adversely affect the supply of labour; an increase in profits tax may adversely affect the incentives of firms to invest and an increase in welfare benefits may adversely affect incentives to seek employment.