Fiscal Policy Guide: Understanding Contractionary Fiscal Policy

Fiscal policy is any financial policy implemented by a national government, either by altering spending or taxation. There are two types of fiscal policy: Contractionary fiscal policy and expansionary fiscal policy. Contractionary fiscal policy is when the government taxes more than it spends. Expansionary fiscal policy is when the government spends more than it taxes.

Fiscal policy goes hand-in-hand with monetary policy, which is financial influence implemented by a central bank (in the United States, the central bank is the Federal Reserve)—usually in the form of increasing or decreasing interest rates.

Contractionary fiscal policy is a type of fiscal policy in which the government collects more money in tax revenue than it spends—these types of policies are usually used during times of economic prosperity. To enact contractionary fiscal policy, the government may decrease spending, increase taxes, and enact a combination of decreased spending and increased taxation.

Contractionary policy is used in times of economic prosperity because it:

• Slows inflation. During times of high economic growth, inflation can often jump to dangerous rates, quickly devaluing currency and worrying consumers. To slow inflation, governments may enact contractionary fiscal policy in order to decrease the money supply and aggregate demand, which will lead to decreased output and lower price levels.
• Paces economic growth. While economic growth is a sign of a healthy economy, the ideal growth is slow and steady—if, on the other hand, economic growth spikes too severely, it can mean that a recession will follow in order to compensate. To ensure a slow, steady pace through the business cycle (a term in Keynesian economics for the natural boom-bust economic rhythm), governments can enact contractionary fiscal policy to maintain the aggregate demand curve, reduce citizens’ disposable income, and continue a healthy economic growth rate at 3 percent.
• Keeps unemployment at optimal levels. Lowering the unemployment rate may seem like an important issue for governments, but zero unemployment can actually have a negative effect on the economy. A concept known as the natural level of unemployment—the level in which an economy is perfectly balanced between workers and employers—suggests that there will always be some level of unemployment, whether or not the economy is performing well. If unemployment dips lower than the natural level of unemployment, businesses start to struggle to find employees—and the economy suffers. Contractionary fiscal policy stops the unemployment rate from going below optimal levels, maintaining it at what economists call “full employment,” which is when unemployment reaches its lowest point without causing inflation.
• Reduces government debt. When the economy is booming, governments may make use of contractionary fiscal policy in order to reduce the government’s budget deficit and the national debt, saving money for future times when expansionary policy may be necessary.

While expansionary fiscal policy is especially popular among voters because it means tax cuts or increased opportunities for government money, contractionary fiscal policy is significantly less popular due to its tax increases or slashing of government purchases, and many policymakers avoid it.

In the United States, the most recent large-scale use of contractionary fiscal policy came during President Bill Clinton’s time in office (1993–2001), when he increased taxes on high-income taxpayers and decreased government spending on both defense and welfare. As a result, the United States government went from being in debt to having a budget surplus.

Fiscal policy, or a government’s way to influence the economy, has two opposing forms: contractionary fiscal policy and expansionary fiscal policy.

• Contractionary fiscal policy: In contractionary fiscal policy, the government taxes more than it spends—either by increasing tax rates, decreasing spending, or both. This type of fiscal policy is best used during times of economic prosperity. Contractionary fiscal policy is the opposite of expansionary fiscal policy.
• Expansionary fiscal policy: In expansionary fiscal policy, the government spends more than it taxes—either by decreasing tax rates, increasing transfer payments, increasing spending, or all three. This type of fiscal policy is best used during times of economic downturn, and it can increase a country’s gross domestic product (GDP) through a principle called the “fiscal multiplier” (or the amount in which government spending can increase the national income). Expansionary fiscal policy is the opposite of contractionary fiscal policy.

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