You might have heard about fiscal policy in the news—and promptly changed the channel to something more exciting. Who wants to watch politicians and economists debate the best way of running the economy? But there are as many reasons to pay attention as there are dollars on your paycheque and tax bill—more, in fact. Fiscal policy is an abstract name for a topic that has a real impact on your job, your family and your finances.
What is fiscal policy?
The government uses fiscal policy to grow the economy while achieving other goals, such as providing education and healthcare. It can do this in three ways: through borrowing, taxing and spending. Government spending has a direct impact, while taxation is indirect because it drives people and companies to act.
When not enough people are working or production is too low, governments use fiscal policy to “push the economy back to its potential,” says University of Toronto economics professor Peter Dungan.
How does fiscal policy affect the economy?
It’s difficult to know how much specific fiscal policies boost the economy, says Queen’s University economics professor Thorsten Koeppl. Suppose the government finances a road-building project that employs 1,000 people. If those people didn’t have jobs before, they benefit. But the secondary effects are harder to track. For instance, those workers now have money to spend. Some can now buy new clothes or go out for dinner. Their spending prompts the local mall to hire and the effect continues. And what about the busier construction material suppliers? That economic benefit has to be counted too.
Economists call these echoes the fiscal multiplier. But there’s debate about how big the effect is, says Koeppl.
Suppose those 1,000 road workers have debts. If they all used their wages to pay off loans, there wouldn’t be any wider benefit to the economy, Koeppl explains.
Some economists argue government spending simply replaces private sector investment. For instance, if the government invests $10 million in scientific research, the private sector won’t have to. In that case, it’s not really a new investment. Bank of Canada Governor Stephen Poloz says that’s only the case when private companies are already spending and the economy is running at full capacity.
But if it’s not, there’s a gap between how much it can produce and what’s actually happening. In that case, Poloz says fiscal policy helps add demand to the economy (see our article on supply and demand).
Even when the economy is working well, there’s still a case for government spending, says Dungan. Projects like the road building one help the economy grow in the long term because they help businesses get goods to buyers, and people get to their jobs.
Where does the money come from?
Taxes. The government runs a deficit when it spends more money than it collects. In that case, it borrows on the financial markets by issuing bonds. That money, which it will have to pay back with interest, is the government’s debt.
Of course, people have to be willing to lend to Canada. Lenders want assurances that they’ll be paid back. To measure that ability, they look at Canada’s debt-to-GDP ratio, which is the amount of debt compared to the size of the economy. The lower the ratio, the better.
“If you have a higher debt-to-GDP ratio, your default [i.e., bankruptcy] probability goes up,” Koeppl says. “So, higher debt-to-GDP ratios usually go hand in hand with higher interest rates for the government.”
Canada’s federal debt-to-GDP ratio is 31%, according to the 2016 federal budget. Other G7 countries have an average of more than 80%.
Due to low economic growth and the stimulus plan, the projected federal deficit is $29.4 billion for 2016-2017—and that will be added to the debt. Because interest rates are low, the government argues now is a good time to borrow, since it will be relatively easy to pay back these loans.
Is deficit spending a good idea?
Depends. There are two main schools of thought: “hawkish” and “dovish.”
Deficit hawks argue that private companies should power an economy. They “worry about running a big deficit because the debt would get worse and the interest on the debt would be a problem,” says Dungan.
Deficit doves argue that while the private sector should sustain the economy, the government should intervene in times of crisis or low growth. If that means running a deficit or debt, that’s okay.
Most countries move between hawkish and dovish policies, depending on economic conditions and who is in power. “It tends to be ideological: people who don’t like big government will always find a reason to complain about deficit financing,” says Dungan. “People who like big government will find reasons to do more.”
To get an objective idea of whether deficit spending is wise, look to the debt-to-GDP ratio, says Koeppl. If a country’s economy is growing faster than its debts, its debts will be a smaller portion of its income and it’ll be more likely to keep paying.
How do fiscal and monetary policies interact?
While the government controls fiscal policy, the Bank of Canada controls monetary policy. Monetary policy influences how money moves through the economy.
“Monetary policy has a clear goal, which is controlling inflation,” says Koeppl. But since the financial crisis, the central banks have been trying to use it to stimulate the economy. That’s a job usually left to fiscal policy.
But fiscal policy can intrude on monetary policy, too. Stimulating the economy pushes up inflation, says Dungan. In the road building example, when more people are employed, demand for goods go up, and companies might increase their prices. At the same time, when there’s more demand for workers, people can charge more for their services—which companies pass on to consumers through higher prices.
Whether this is good or bad depends on how high inflation is already, says Dungan. The Bank of Canada wants inflation around 2%. It’s been around 1.3%, which means that it’s good for government spending to force it higher—monetary and fiscal policy have the same goal.