Fiscal Policy: What It Is, How It Works, Types, and Why It Matters

Have you ever noticed that after the annual budget is passed, the prices of certain goods and services go up or down? Ever wondered why that happens? The answer lies in fiscal policy — one of the most powerful tools a government has to shape the economy.

Every time the government decides how much to spend, where to spend it, and how much to collect in taxes, it’s making fiscal policy decisions. These decisions ripple through the entire economy, affecting everything from the price of your morning coffee to the availability of jobs in your industry. Let’s break it all down.

Fiscal policy refers to the government’s use of spending and taxation to influence the economy. In simple terms, it’s the plan for how much money the government will collect through taxes and how much it will spend across various sectors in a given fiscal year.

Through fiscal policy, the government can stimulate economic growth, control inflation, reduce unemployment, and address income inequality. During an economic downturn, for instance, the government might increase spending or cut taxes to boost demand and get the economy moving again. Conversely, during periods of high inflation, it might raise taxes or reduce spending to cool things down.

It’s important not to confuse fiscal policy with monetary policy — they’re two different tools used by two different institutions.

• Fiscal policy is created and implemented by the government (through the legislature and treasury).
• Monetary policy is managed by the central bank (like the Federal Reserve in the U.S. or the Bank of England).

While monetary policy primarily targets microeconomic factors like interest rates and money supply, fiscal policy typically deals with macroeconomic objectives like GDP growth, employment, and price stability. However, both work together to keep the economy on track.

Most modern fiscal policy approaches trace back to the ideas of British economist John Maynard Keynes (1883–1946). Before Keynes, the prevailing economic wisdom — known as classical economics — held that recessions were self-correcting. The belief was that markets would naturally bounce back without government intervention.

Then came the Great Depression of the 1930s. The global economy collapsed, unemployment skyrocketed, and the classical approach of “wait and see” simply wasn’t working. Keynes argued that during severe downturns, the government must step in — by spending money and cutting taxes — to kickstart demand and pull the economy out of recession.

This school of thought, known as Keynesian Economics, holds that aggregate demand (total spending in the economy) is the primary driver of economic growth. Today, Keynesian principles form the foundation of fiscal policy in most countries around the world.

During the Great Depression, unemployment in the United States hit nearly 25%. Millions lost their livelihoods and were left destitute. In response, President Franklin D. Roosevelt launched the New Deal — a massive series of government programs and public works projects.

The New Deal included building roads, bridges, dams, and public buildings. It created jobs for millions of unemployed Americans. The government also introduced Social Security, unemployment insurance, and banking reforms. This was expansionary fiscal policy in action — the government spending more to stimulate the economy.

More recently, during the COVID-19 pandemic, governments worldwide deployed similar strategies — direct stimulus payments to citizens, enhanced unemployment benefits, and massive infrastructure spending — all classic examples of fiscal policy at work.

There are two main types of fiscal policy:

1. Expansionary Fiscal Policy

Expansionary fiscal policy is used during recessions or periods of slow economic growth. The goal is to stimulate demand and boost economic activity. The government achieves this by:

• Cutting taxes — putting more money in consumers' and businesses' pockets, encouraging spending and investment
• Increasing government spending — funding infrastructure projects, social programs, and public services that create jobs and inject money into the economy

When taxes are reduced, businesses earn more, invest more, and hire more workers. Consumers have more disposable income to spend. This creates a positive cycle of economic growth.

The trade-off? Expansionary fiscal policy leads to a budget deficit — the government spends more than it collects in revenue. While this is manageable in the short term, sustained deficits can lead to growing national debt.

2. Contractionary Fiscal Policy

Contractionary fiscal policy is the opposite — it’s used when inflation is rising too fast and the economy is overheating. The government aims to reduce demand and cool down the economy by:

• Raising taxes — reducing disposable income and discouraging excessive spending
• Cutting government spending — reducing the flow of money into the economy

However, contractionary policy comes with risks. If applied too aggressively, it can trigger a recession and spike unemployment. That’s why governments typically avoid contractionary measures unless inflation becomes truly problematic.

Unlike expansionary policy which creates budget deficits, contractionary policy often results in a budget surplus — the government collects more in taxes than it spends. Once inflation is under control, the government can shift back to expansionary policy.

The fundamental goal of fiscal policy is to protect the economy from recession and promote sustainable growth. Here are its main objectives:

1. Economic Growth and Stability

Fiscal policy aims to help the economy grow steadily over time. But the government must be careful — while increased spending can boost growth, too much spending can fuel inflation. Finding the right balance is crucial.

2. Employment Generation

Through government-funded projects and tax incentives for businesses, fiscal policy directly creates jobs. When the government builds highways, schools, or hospitals, it creates construction jobs. When it offers tax breaks to small businesses, those businesses can afford to hire more workers.

3. Price Stability

Keeping inflation in check is a critical function of fiscal policy. When prices rise too quickly, the government can increase taxes and cut spending to reduce demand and bring prices back to a manageable level.

4. Income Equality

Fiscal policy plays an important role in reducing the gap between rich and poor. Many countries use progressive taxation — where higher earners pay a larger percentage of their income in taxes. The revenue collected is then used to fund social programs that benefit lower-income citizens, such as healthcare, education, and housing assistance.

Fiscal policy consists of three main components:

1. Government Spending

This is the most visible component of fiscal policy. It’s not just about how much the government spends, but where it spends. Key spending areas include defense, healthcare, education, infrastructure, and social welfare programs. The allocation of spending across these sectors shapes the economy’s direction and priorities.

2. Taxation

Taxes are how the government collects revenue to fund its spending. The types and rates of taxes — income tax, corporate tax, sales tax, property tax — directly influence consumer behavior, business decisions, and overall economic activity. Higher taxes mean more government revenue but less money in the hands of citizens and businesses.

3. Debt Management

Since most countries follow expansionary fiscal policy most of the time, budget deficits are common. Governments cover these deficits by borrowing — issuing government bonds and taking loans from domestic and international institutions. Managing this debt responsibly is crucial; excessive borrowing can lead to higher interest payments, reduced credit ratings, and long-term economic instability.

Fiscal policy is one of the most important tools governments have to manage the economy. Through strategic adjustments in spending and taxation, governments can stimulate growth during downturns, control inflation during booms, create jobs, and work toward a more equitable distribution of wealth.

Understanding fiscal policy helps you make sense of why budgets change, why tax rates go up or down, and how government decisions directly impact your financial life. Whether it’s the New Deal of the 1930s or the COVID-19 stimulus packages of 2020, fiscal policy has always been — and will always be — at the heart of economic management.