What Is Discretionary Fiscal Policy?

Discretionary fiscal policy involves deliberate and active government intervention in the economy. This policy uses changes in government spending or taxation to influence the overall demand for goods and services. It serves as a tool to achieve specific macroeconomic goals, such as fostering economic growth or stabilizing prices. Unlike other economic adjustments, discretionary fiscal policy requires explicit legislative action by policymakers.

Key Instruments of Discretionary Fiscal Policy

Discretionary fiscal policy primarily utilizes two main instruments: government spending and taxation. These tools can be adjusted to either stimulate or cool down economic activity.

Government Spending

Government spending involves the direct allocation of public funds towards various sectors. This can include investments in infrastructure projects, such as roads and bridges, or expenditures on defense, education, and healthcare. When the government increases its spending, it directly injects money into the economy, boosting demand for goods and services and creating employment opportunities. For instance, a government contract for a new highway increases demand for materials and labor, stimulating related industries.

Taxation

Taxation, the second instrument, involves adjusting tax rates or introducing new tax provisions. This includes various types of taxes, such as income tax on individuals, corporate tax on businesses, or sales taxes on goods and services. Changes in tax policy affect the disposable income of individuals and the profitability of businesses. Lowering income taxes leaves more money in the hands of consumers, potentially encouraging increased consumption and investment. Conversely, raising corporate taxes can reduce business profits, potentially leading to less investment and slower economic activity.

Discretionary Fiscal Policy Versus Automatic Stabilizers

Discretionary fiscal policy stands apart from automatic stabilizers in its method of implementation and responsiveness to economic shifts. It requires new legislative action.

In contrast, automatic stabilizers are built-in features of the economy that automatically adjust to economic fluctuations without requiring any new legislative intervention. Examples include progressive income tax systems and unemployment benefits. During an economic downturn, a progressive tax system automatically collects less tax revenue as incomes fall, while unemployment benefits automatically increase as more people lose their jobs.

The fundamental distinction lies in the need for active decision-making. Automatic stabilizers operate passively and immediately, providing an inherent cushioning effect against economic booms and busts. They are structural components designed to temper economic volatility without the need for policymakers to intervene with new laws.

The Policy-Making Process

Enacting discretionary fiscal policy involves a structured procedural path within the government. This process typically begins with the initiation of policy proposals. These proposals can originate from the executive branch, such as presidential administrations, or from within the legislative branch, often through congressional committees responsible for budget and taxation matters.

Once a proposal is developed, it enters the legislative action phase. Here, proposed changes to government spending or taxation are introduced as bills. These bills undergo review by various committees, where they may be debated, amended, and refined. The legislative body, consisting of both chambers, must then vote on the proposed measures.

The final step in the process is enactment. If a bill successfully passes through both chambers of the legislative body, it is typically sent to the executive branch. The head of the executive branch then signs the legislation into law, officially implementing the discretionary fiscal policy measure. This ensures changes are formally approved and integrated into the legal framework.

Primary Objectives of Discretionary Fiscal Policy

Discretionary fiscal policy is employed by governments with several main macroeconomic goals in mind.

Stimulating Economic Growth

A primary objective is stimulating economic growth, particularly during periods of recession or slow activity. Expansionary fiscal policy, which involves increasing government spending or decreasing taxes, aims to boost overall demand for goods and services. This increased demand can lead to higher production levels and job creation, helping the economy expand.

Controlling Inflation

Another objective is controlling inflation, especially when the economy is experiencing rapid, unsustainable growth. Contractionary fiscal policy, characterized by decreased government spending or increased taxes, works to reduce aggregate demand. By cooling down an overheated economy, this approach helps to mitigate inflationary pressures and stabilize prices.

Reducing Unemployment

Reducing unemployment is also a significant aim of discretionary fiscal policy. Expansionary policies can directly create jobs through public works projects or indirectly by encouraging private sector investment and consumption. When businesses experience increased demand, they are more likely to hire additional workers, thereby lowering the unemployment rate.

Stabilizing the Business Cycle

These policies stabilize the business cycle. Governments aim to smooth out the natural fluctuations of economic activity, minimizing the severity of recessions and preventing excessive booms. The goal is to foster more stable and sustainable economic growth over time.