Discretionary fiscal policy refers to government spending and tax changes to influence aggregating spending in the economy and thus influence real Gross Domestic Product (GDP). It’s a form of economic policy that allows the government to increase or reduce taxes and spending levels to adjust aggregate demand.
Change in government spending and taxes are essential tools most governments use to stabilize the economy and ensure consumer income is optimal. Only when the economy is growing can governments cut taxes and increase spending.
If there’s a contraction in economic activity, then tax revenue will decrease, leading to reduced government spending. There are tough decisions that the government must make to have stable economic growth. Still, it’s all worth it when the economy takes off and citizens begin to experience the benefits.
However, the government’s type of discretionary policy depends on two major factors; the amount of money in circulation(inflation) and the unemployment rate.
Let’s have an in-depth discussion about fiscal policies, demand-pull inflation, and how taxes and government expenditures are applied effectively.
What Are Two Types of Discretionary Fiscal Policy?
Discretion fiscal policy has two main types: expansionary and contractionary fiscal policy. These two types of discretionary fiscal policy make up the government’s tools to stabilize the economy.
1. Expansionary Fiscal Policy
The most common form of expansionary fiscal policy is lowering the income tax. This allows consumers to keep more money in their pockets and spend it. The government can also increase their spending to increase the money in circulation and, therefore, its growth.
Under this policy, through various agencies and the related ministries, the government comes up with projects to create employment when there is an increase in the unemployment rate.
For instance, the ministry of Roads and Construction may hire a contractor to repair the existing roads or complete the stalled projects initiated before.
By doing this, the government absorbs the unemployed into such projects. Job creation means people have more money to spend, which influences economic growth.
The only downside of this policy is that it leads to budget deficits for the government. Here, the government spends more than it gets in taxes. This inflicts fear in investors as they may worry that the government may fail to repay their sovereign debts.
When a state fails to pay its debts in time, the debtors may demand high-interest rates, making the deficit even more expensive.
2. Contractionary Fiscal Policy
Contractionary fiscal policy is carried out in times of economic crisis when the economy is overheated. Here, the government will cut spending and increase taxes to slow down the economy.
Increasing taxes reduces the amount of disposable income available for businesses and families to spend. It forces them to save most of the money, leaving only a small margin for day-to-day expenditures.
In addition, governments can reduce spending on public sector projects. This lowers firms’ income, leading to layoffs and reduced spending by individuals and firms.
This policy also inflicts fear on investors who withdraw their investments, making the economy lose its strength. This will lead to a slowdown in economic growth since consumer spending and investment are reduced. That is why the people employed by the government need to know precisely what discretionary fiscal policy refers to and how it is fully implemented to avoid over and underdoing it and putting the economy at risk.
Uses of Contractionary Fiscal Policy
Contractionary fiscal policy is one of the best good policies many governments have used to boost their economies. Contractionary fiscal policy is a way of dealing with the problem of high government spending by reducing it.
The policy is reduced by reducing the number of government employees, cutting down their wages or hours of work, reducing subsidies, and cutting in transfer payment, to mention a few.
The following are some of the examples of the use of contractionary fiscal policies:
1. A tool for reducing government debt
When there is a steady rise in the economy, the government uses this policy to reduce the governments’ national debt, save money for the future to effect expansionary policy, set interest rates, and curb the deficits.
2. Ensures unemployment is at an optimal level
As much as the government works tirelessly to create employment, experts point out that zero unemployment might impact the economy negatively. Whether the economy is booming or not, there must be some level of unemployment according to the concept, ‘natural level of unemployment.
In a situation where the unemployment rate shifts below the natural level of unemployment, some upcoming or expanding businesses may struggle to get employees.
Contractionary fiscal policy is among the best tools most government applies to ensure optimal unemployment rate.
3. Controls inflation
Individuals who understand what discretionary fiscal policy refers to will agree that it is among the best ways for controlling inflation. The thought behind this claim is that when the government reduces its spending, it will reduce total spending.
4. Contractionary fiscal policy reduces interest rates
When the government applies contractionary fiscal policy, it reduces government debt and thus enables lower interest rates. And since borrowing costs fall, many individuals and businesses will borrow more, leading to an increase in spending.
5. Regulates economic growth
Economic growth is essential and is always a sign of a healthy economy. If, by chance, economic growth spikes, then it may mean that a recession may take place soon.
To ensure such recessions get no space and a slow, steady pace through the business circle, the government can adopt a Contractionary fiscal policy to decrease people’s disposable income—the reason, to stabilize the economy.
Problems Associated with Discretionary Fiscal Policy
By this time, we understand what discretionary fiscal policy refers to, and it is now time to analyze its strengths and weaknesses. As it is of such importance, we can’t omit this policy’s problems.
There are several aspects that a government can be measured in. The most common would be the economy and unemployment rate, but other points to consider, such as inflation rates.
The following are some of the problems associated with a discretionary fiscal policy that we need to take into account:
Increases Economic Instability
One of the problems that discretionary fiscal policy refers to is economic instability. The government has to act when the economy faces problems and setbacks; due to this, it tends to fine-tune the economy.
Doing so keeps intervening in the economy, which makes them irresponsible. The government is now responsible for rescuing the economy when they intervene too much or not enough.
Increases the Level of Conflict with the Congress
Another problem associated with discretionary fiscal policy is that it increases conflict with Congress. Congress has to approve it, and they don’t always agree with the President.
Even though this policy creates economic benefits, it is a political advantage for the President, as most of them rarely want to approve the expenditures made by Congress. So, both parties will try to use it in their favor.
Another aspect of the discretionary fiscal policy refers to reduced transparency. In fact, there is little transparency in this type of fiscal policy because it requires the President and his advisors to have accurate forecasts about the economy.
It is difficult to keep track of where every dollar comes from and how it is being spent, impacting how the economy is doing.
Which Branch of Government Sets Discretionary Fiscal Policy?
For instance, fiscal policy is affected by both the legislator and the executive branches in the US. There are two most influential offices occupied by the Secretary of the Treasure and the President in the executive.
The decision to adopt a monetary policy, change tax rates, and the President does not allocate funds. Instead, they rely on a council of economic advisors on such policies and tax changes to stabilize the economy.
In the legislature wing, Congress passes the law and estimates the spending for any fiscal measures. The process involves participation and approval from both Houses of Representatives.
Judiciary too has a say in this process as far as law interpretation is concerned. The law has to be applied in equal measures. An individual may want to challenge the approved fiscal policy, taxes, and government expenditures programs or policies that affect the business cycle personally.
The Judicial Branch of government interprets, legitimizes, amend, or declares such law unconstitutional.
What is an Example of Non-Discretionary Fiscal Policy?
Non-discretionary fiscal policy refers to daily programs of government spending or taxes. This fiscal policy refers to activities the government carries out daily to provide excellent services to its citizens.
These policies are rarely changed as they are the core reasons the government is in place. The policies include social security, unemployment benefits, and welfare.
Payment of unemployment compensation is the perfect example of non-discretionary fiscal policy. When the unemployment rate increases, the government spending on paying the unemployed increases. This is usually during an economic slowdown.
On the other hand, government spending on the unemployed decreases when the economy recovers and the unemployed are absorbed into the employment cycle.
Mandatory Discretionary and Supplemental Spending
Mandatory spending is based on laws previously established that dictate the money budgeted for spending annually. Programs like Medicare, Social Security, and various income security are dictated by prior laws or voted on in the annual appropriations process.
On the other hand, discretionary spending is money voted on by Congress during the appropriation process every year. The President later approves the cash after getting proper advice from the economics.
Discretionary spending is always directed towards national defense, and the remaining is budgeted to other federal agency programs like education, transportation, housing, social service programs, science, and environmental organizations.
With the above information on what discretionary fiscal policy refers to, we trust that you are now fully equipped with relevant know-how concerning government spending or taxes, changes in taxes, and the economic curve.