What are the Basic Fiscal Policy Tools?

Fiscal policy is one of two main types of control a government or its agencies can exercise over an economy. The main fiscal policy tools are taxation and spending; in contrast, monetary policy involves the availability and cost of money, or more specifically, credit. Fiscal policy tools can achieve, or at least attempt to achieve, both economic and political goals. All fiscal policy tools ultimately serve to answer two questions: how much a government should spend, and how it should fund this spending.

The decision of how much to spend can depend on both political and economic standpoints. As a very crude simplification, right wing governments tend to believe in lower government spending and leaving more elements of the economy to be determined by free markets. Left wing governments, on the other hand, tend to believe in higher government spending, often for social aims. It's important to remember that terms such as left and right wing are often relative terms. In many cases the positions taken by the main left and right wing parties in one country may appear to be relatively close when compared to the politics and economy of another country.

In most cases, government spending is funded largely by taxation. This is another example of how fiscal policy tools can have a social or political purpose, as well as an economic aim. Beyond simply deciding how much tax should be raised overall, a government can use tax as a form of redistribution, by taxing wealthier people to fund welfare payments. It can also use tax to encourage or discourage social behavior, such as heavily taxing tobacco to try to cut smoking levels.

There are other methods of raising money for spending. These include borrowing money, using an existing reserve built-up in the past, and selling off government owned assets. Over time, these methods can build up a public deficit and thus a rising debt. This can affect the decisions governments make about fiscal policy tools: for example, a political party that fundamentally believes in high spending funded by taxation may decide it needs to spend less than it raises in tax so that it can reduce a deficit.

Fiscal policy tools can be used alongside monetary policy tools. These include setting the base rates that, in most economies, have a knock-on effect on the rates banks charge to lend to the public or to businesses. Usually, the goal of such policies is to manage the level of inflation, the theory being that higher rates mean people spend more repaying mortgages and other loans, and thus have less to spend on goods. While some governments use fiscal and monetary policy together, others make monetary policy the responsibility of an independent monetary authority, such as a national bank.