Discretionary fiscal policy can either be used to expand the economy or contract it. Expansionary fiscal policy is when the Federal government increases spending or decreases taxes. This usually spurs economic growth, creating more profitable businesses and more jobs. If both are done simultaneously, it drives the economy even faster. However, it also creates a budget deficit, because the government is spending more than it receives in taxes. This works well, until the debt-to-GDP ratio nears 100%. At that point, investors start to worry that the government won't repay its sovereign debt, and aren't as eager to buy government bonds to finance the debt.
Contractionary fiscal policy is the opposite, and has the opposite effect. It's when the Federal government cuts spending or increases taxes, and it slows economic growth. That's because there is less money in taxpayers' pockets, and fewer contracts going to government contractors and employees.
Unfortunately, the political process ensures that discretionary fiscal policy will nearly always be expansionary. Why? Because lawmakers get elected by spending money. That's how they reward voters, special interest groups and those who donate to campaigns. In other words, everyone wants to see the budget cut, just not their portion of the budget.
Discretionary fiscal policy is supposed to work like a counterweight to the business cycle. During boom years, Congress and the President should cut spending and programs to cool the economy. If done well, the reward will be an ideal economic growth rate of around 2-3% a year. Instead, politicians keep spending, stimulating the economy even more and creating asset bubbles, and ensuring a more devastating bust.
Discretionary BudgetThe most noticeable example of discretionary fiscal policy is the discretionary budget. These are expenditures within the U.S. budget that are within the appropriations bills that are negotiated between the Branches of Congress and the President's Office each year. It includes military spending, and nearly all other Federal departments.
It does not include mandatory programs, such as Social Security, Medicare, and Medicaid. These have been mandated by Federal law, and can only be changed through a Congressional vote amending or revoking that law.
TaxationDiscretionary fiscal policy can also be implemented through changes in taxation. When taxes are raised or new taxes are levied, that's contractionary fiscal policy. Higher taxes reduce the amount of disposable income available for families or businesses to spend. This decreases demand, slowing economic growth.
When taxes are lowered or eliminated, that's expansionary fiscal policy. It puts more money into the economy by allowing companies and people the ability to spend more for things they want.
Supply-side economics argues that one of the best ways to stimulate the economy is through reducing taxes. Lowering taxes give consumers and businesses more money to spend, increasing demand. Over time, this stronger economic growth will make up for the government revenue lost by generating a larger tax base. However, it will only work if taxes were high in the first place. According to the underlying economic theory, the Laffer Curve, the highest tax rate must be above 50% for supply-side economics to work.
Discretionary Fiscal Policy and Monetary PolicyAt its best, discretionary fiscal policy should work in alignment with monetary policy enacted by the Federal Reserve. If the economy is growing too fast, fiscal policy can apply the brakes by raising taxes or cutting spending at the same time the Fed enacts contractionary monetary policy by raising the Fed funds rate.
If the economy is in a recession, discretionary fiscal policy can lower taxes and increase spending while the Fed enacts expansive monetary policy as it lowers the Fed funds rate, or pumps liquidity into the financial system with its other tools, such as quantitative easing. When working together, fiscal and monetary policy can act very powerfully to take the pain out of the stages of the business cycle.
However, since politicians usually enact expansive fiscal policy no matter what, then it's up to the Fed to manage the economy alone. Relentless expansionary fiscal policy forces the Federal Reserve to use contractionary monetary policy as a brake when the economy is booming. Higher interest rates reduce capital and liquidity, especially for small business and in the housing market. This ties the hands of the Fed, reducing its flexibility. Article update March 7, 2012