Fiscal policy represents the actions of Congress to promote economic growth and stability. Since the Great Depression the federal government has used fiscal policy to achieve these goals. Fiscal policy is often divided into two strands: discretionary fiscal policy and nondiscretionary fiscal policy. The two main tools of fiscal policy are taxation and government spending.

Fiscal Policy Tools

Discretionary fiscal policy refers to the conscious actions by Congress to achieve economic growth and stability, mainly through changes in tax policy and government spending. These actions typically require Congress to pass new legislation. There are two types of discretionary fiscal policy: expansionary and restrictive. An expansionary fiscal policy uses tax cuts and additional government spending to inject money into the economy and thereby increase aggregate demand. Economists refer to these money injections as priming the pump so that the economy can move forward. Higher aggregate demand gives producers the incentive to produce more goods and hire more workers. Expansionary fiscal policy is used to fight recessions and depressions. A restrictive fiscal policy, on the other hand, requires tax hikes and lower government spending to decrease aggregate demand. Restrictive policies withdraw money from the economy to slow inflation or curb the exuberant growth that may accompany an economic expansion.

The use of discretionary fiscal policies to restore the economic health of the U.S. economy gained momentum during the Great Depression of the 1930s. British economist John Maynard Keynes popularized the use of discretionary fiscal policy in his landmark book The General Theory of Employment, Interest, and Money (1936). Since that time Keynesians and non-Keynesian policy makers have used taxes and government spending to promote the goals of growth, full employment, and price stability. For example, Congress and the president supported more than $1 trillion in additional discretionary spending to jump-start the sputtering U.S. economy during the Great Recession (2007– 2009). This burst of discretionary spending, called stimulus spending, occurred during the presidencies of George W. Bush and Barack Obama. During the same time period the government extended certain tax breaks and offered a tax rebate to put more money into the hands of individuals and firms.

Nondiscretionary fiscal policy refers to the built-in or automatic stabilizers that exist within the tax system and federal spending programs—especially government transfer payments. Automatic stabilizers tend to inject money into the economy when the economy dips into recessions. These cash injections increase aggregate demand, and motivate businesses to increase production and hiring. Automatic stabilizers also withdraw money from the economy when prosperity returns. The two main automatic stabilizers in the U.S. economy are the progressive income tax and public transfer payments.

The progressive income tax is a tax on people's income, mainly income from wages. During recessions, when some workers lose their jobs or are underemployed, wage income declines. As a result, these workers automatically pay less in taxes to the government. During expansions, on the other hand, workers' wages rise. A higher wage automatically increases these workers' tax obligations, which helps prevent the economy from overheating. In a similar way public transfer payments inject additional money into the economy during downturns and withdraw money during expansions. One type of transfer payment is unemployment insurance (UI), a major public transfer payment offered to the temporarily unemployed. UI payments increase during recessions when the unemployment rate is high and decrease during expansions when unemployment subsides. For example the number of unemployed workers collecting UI payments was just 2.6 million in 2007, before the start of the Great Recession. By 2010 the number of workers receiving UI payments had jumped to 9.7 million. During this same period of time, UI payments increased from $31 billion to $150 billion, nearly a fivefold increase.[1] Other transfer payments, such as Temporary Assistance for Needy Families (TANF) and the Supplemental Nutrition Assistance Program (SNAP), also inject additional money into a depressed economy.

  • [1] Council of Economic Advisors, “Table B-45: Unemployment Insurance Programs, Selected Data, 1980-2012,” Economic Report of the President: 2013, 2013, 377
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