Taxation And Government Spending In The Governments Budget Economics Essay

1057 words (4 pages) essay in Economics

5/12/16 Economics Reference this

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Fiscal policy refers to the use of taxation and government spending in the government’s budget, to achieve economic objects. It is important for fiscal policy to work because “it not only determines the size and nature of the welfare state, but also affects the distribution of incomes and the performance of the economy” (O.U.P.,2005). Using the fiscal policy, government can manage the economy’s short-term and long-term growth rate by affecting the level of Gross Domestic Product (GDP) and the economic growth rate can be measured by the real rate of growth in a country’s total output of goods and services. However, by using fiscal policy to manage an economic growth rates (short-term and long-term) will implies costs and benefits. In this report, it wills analysis about these costs and benefits.


The government can affect the level of GDP and therefore manage the short-term and long-term economic growth rate by change the government spending and taxation. When there is a boom, the government can increase government spending and cut tax to increase the Level of GDP therefore increases the short-term economic growth rate and stabilizes economy’s long-term growth rate, vice versa. However, there are number of costs and benefits of using fiscal policy to manage an economy’s short-term and long-term growth rates. Deficit, time lags and crowding out are costs of using fiscal policy to manage an economy’s short-term and long-term growth rate while increase potential output, stabilizes the economy and reduce income inequality are the benefits.

Deficit is one of the largest costs of using fiscal policy to manage the economy’s short-term and long-term growth rate. The government can increase the government spending to directly increase the PAE and decrease the taxation in order to boost the consumption (expansionary fiscal policy) in the period such as recession in order to increase the level of GDP and therefore the government can be indirectly mange the short-term economic growth rate. However, this may lead the government to make a large deficit in short-term and long-term if the government willing to continuous the expansionary fiscal policy for manages the long-term economic growth. A large deficit will be harmful because they reduce national saving, which in turn reduces investment in new capital goods-an important source of long-run economic growth (Bernanke., Olekalns. and Frank., 2008). Large deficit cannot be easily solved. For example, “although Ireland implemented sharp spending cuts and tax hikes amounting to 4.5% of GDP in 2009, the house prices are still collapse and meant its primary deficit actually worsened” (The economist, 2010).

Another cost of using fiscal policy to manage the economic growth rate is time lags. Even though the government can react quickly for the changes of economic growth rate, especially for economy’s short-term growth rate, it also take household and firms several months to start modify their activities because of changes of the taxation. Also, it often takes twelve or eighteen months before such changes in behavior show up in the economic indicators of the economy. Also, “one of the difficulties in using fiscal policy to combat recessions is getting Congress to agree on what measures to implement” (Thoma, 2010). It means that fiscal policy is not flexible enough to be useful for manage the economic growth rate.

Moreover, crowding out effect is also one of the costs. Crowding out effect explains “the increase in interest rates due to rising government borrowing in the money market” (Investopedia, 2010). When government spending is larger than taxation received, the government will borrow money from different ways in such bank, oversea or RBA. This may leads to additional demand for funds in the domestic economy and uses the available domestic savings and putting upward pressure on interest rates. Higher interest rates can lead to lower private sector investment and consumption expenditure. In this situation, the government debts “crowd out” other firms and individuals from the lending market.

Although there are some costs of using fiscal policy to manage the economy’s short-term and long-term growth rate, there are also have some benefits.

Automatic stabilizer is one of the benefits of using the fiscal policy to manage the economic growth rate even though fiscal policy is not a really flexible tool. “Automatic stabilizers are those elements of fiscal policy that tend to mitigate output fluctuations without any explicit government action”(Romer, Taylor, Ziliak, Auerbach, Feenbery. Jel No.,2000). Automatic stabilizers’ “effectiveness can reduce the severity of economic shocks, and it has an additional advantage of being outside the political process” (Thoma, 2010). For example, during the recession, government expenditure will increase automatically because of the increase of unemployment and therefore increase in the transfer payment.

Another benefit is in long-term is that the government spending can helps increase the potential output. Spending in public capital or infrastructures such as roads, airport, school, rails ports, health care services and national boarding network can play a major role in the growth of potential output. Also, reduce taxation can increase incentives of the people to work and spend more. Therefore, it can indirectly increase the long-term economic growth. As are result, it can finally raise the living standards of future generations of Australians (the treasury, 2010)

By using the fiscal policy to manage an economy’s short-term and long-term growth rate will reduce the income inequality. Fiscal policy can helps redistribute the income. The government can manage the economic growth by increase the government expenditure such as transfer payment when there is recession. By the transfer payment (e.g. unemployment benefit) which is made directly to disadvantaged and poor persons and no work requires, the income can be redistributed. Also, the government can have a progressive taxation system and so that high income earners need to pay proportionally more of their income in tax. Therefore the government can uses this tax revenue to make the transfer payments.


Fiscal policy not helps manage the economy’s short-term and long-term growth rate, it also have numbers of cost and benefits while the managing process. Costs such as large deficit, fiscal policy time lags and the crowding out effect and the benefits such as automatic stabilizers, increase in the potential output and reduce in the income equality.

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