Contractionary Fiscal Policy

• Budget surplus


  Also known as a fiscal surplus, occurs when tax revenue is greater than government spending in a year
• Structural budget surplus


  A budget surplus being run at full employment
• Cyclical budget surplus


  A budget surplus in a boom
• National debt


  The total stock of government debt over time
• Running a budget surplus or reducing a budget deficit and reducing the national debt implies that government spending is coming down and/or taxation is rising, which is contractionary fiscal policy, also known as austerity policies
• Reasons governments use these policies


  • To improve the state of government finances
  • To promote more confidence in the current state of government finances
• Reducing budget deficits or running a budget surplus


  Promotes greater confidence in the state of government finances
• Greater confidence in government finances


  Attracts inward FDI (foreign direct investment)
• Sustainable government finances


  Provides greater flexibility for fiscal policy whenever it's needed in the future
• Lower national debt


  Less spending on debt interest, freeing up fiscal policy
• Less debt-fueled government spending


  Less crowding out of the private sector, allowing private sector investment
• Reducing aggregate demand


  Can shock the economy into a deep recession
• Cutting government spending on education, healthcare, infrastructure, public sector wages and welfare can harm living standards and quality of services
• Increasing direct taxation like income tax and corporation tax can harm the long-run productive potential of the economy and constrain long-term growth rates and prosperity
• These policies can harm productivity and competitiveness through their impact on areas like education and health spending
• These policies can ignore the long-term tax revenue returns from higher government spending and lower taxation, which can boost long-term growth
• Higher direct taxation can create incentive distortions like lower incentive to work, be entrepreneurial, and greater incentive for tax evasion and avoidance
• If these policies reduce GDP at a quicker rate than national debt, debt-to-GDP ratios could actually rise, worsening the look of government finances
• Balancing spending cuts with keeping taxes relatively low


  Can mitigate some of the cons while still getting some of the major pros
• Using these policies in an economic boom

  Can cool down an overheating economy and reduce inflation
• Using these policies in a recession

  Can push the economy further into recession, harming growth and increasing unemployment