Question

Explain how the fiscal policies of the US in the next few years could impact the nation's economic growth. Are some types of government spending and tax cuts more effective than others in building long-term sustainable growth?

Answer 1

The use of government spending and taxation in influencing the economy is fiscal policy. When the state chooses on the products and services it buys, the transfer payments it distributes, or the taxes it collects, it becomes involved in fiscal policy. Specific groups feel the main financial effect of any change in the public budget— a tax cut, for instance, for families with kids, increases their disposable revenue.

It is said that fiscal policy is narrow or contractionary when income is greater than expenditure (i.e., the government budget is in surplus) and loose or expansive when expenditure is greater than income (i.e., the budget is in deficit). Often, the focus is not on the deficit level, but on the deficit shift. Fiscal policy's most instant impact is to alter overall demand for products and services. For instance, a fiscal expansion increases aggregate demand via one of two channels. First, if the state increases its purchases but maintains steady taxes, it directly raises demand. Second, if the state cuts taxes or raises transfers, the disposable income of families will rise and spend more on consumption. This increase in consumption, in turn, will increase aggregate demand.

Fiscal policy also influences the exchange rate and the equilibrium of trade in an open economy. The increase of interest rates due to government borrowing draws foreign assets in the event of a fiscal expansion. Foreigners bid the dollar's price in their effort to get more money to invest, causing a short-term appreciation of the exchange rate. This appreciation makes imported products cheaper in the United States and more costly exports overseas, resulting in a decrease in the trade balance of merchandise. Foreigners sell more to the U.S. than they purchase from it and obtain U.S. assets (including government debt) in exchange. However, in the long run, accumulating external debt resulting from constant public deficits can lead foreigners to distrust U.S. assets and can lead to exchange rate deprecation.

The true benefit of tax reductions is that they are fast–taxpayers have more cash in their paychecks instantly, and businesses often start investing before the cuts have come into effect–while the impact of facilities or other expenditure takes much longer, even years, to work its way through the economy. But both of them have a position in excellent economic policy.

Very often those who advocate important tax cuts argue that in terms of ultimate tax revenue, the reductions will pay for themselves. That's an empirical problem, of course, but the point is missing. No one ever argues that spending is increasing on its own (in terms of future tax revenue). The relevant point is how much does each encourage economic growth.