Question

Real GDP has declined during the past quarter, and the forecast is for a continued decline in real GDP because of a gloomy business outlook. Business investment is expected to plummet next year. As chairman of the President's Council of Economic Advisers, what type of discretionary fiscal policy would you recommend for the coming year?

Answer 1

Updated June 01, 2019

Discretionary fiscal policy is a change in government spending or taxes. Its purpose is to expand or shrink the economy as needed.

Tools

Discretionary fiscal policy uses two tools. They are the budget process and the tax code. The first tool is the discretionary portion of the U.S. budget. Congress determines this type of spending with appropriations bills each year. The largest is the military budget. All other federal departments are part of discretionary spending too.

The budget also contains mandatory spending. This

There are two types of discretionary fiscal policy. The first is expansionary fiscal policy. It’s when the federal government increases spending or decreases taxes. When spending is increased, it creates jobs. It happens directly through public works programs or indirectly through contractors. Spending on public works construction is one of the four best ways to create jobs.

Job creation gives people more money to spend, boosting demand. According to Keynesian economic theory, that increases economic growth.  

When the government cuts taxes, it puts money directly into the pockets of business and families. They have more money to spend. This also boosts demand and drives growth. When spending and tax cuts are done at the same time, it puts the pedal to the metal. That's why the Economic Stimulus Act ended the Great Recession in just a few months. It used a combination of public works, tax cuts, and unemployment benefits to save or create 640,000 jobs between March and October 2009. Studies show that unemployment benefits are the best stimulus.

Supply-side economics says that a tax cut is the best ways to stimulate the economy. Stronger economic growth will make up for the government revenue lost. That's because it generates a larger tax base. But tax cuts 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. Tax cuts are not the best way to create jobs.

Expansionary fiscal policy creates a budget deficit. This is one of its downsides. It’s because the government spends more than it receives in taxes. Often there’s no penalty until the debt-to-GDP ratio nears 100%. At that point, investors start to worry the government won't repay its sovereign debt. They won’t be as eager to buy U.S. Treasurys or other sovereign debt. They will demand higher interest rates. This makes the debt even more expensive to pay back. It can create a downward spiral. For example, look at the Greek debt crisis.