programs associated with President Lyndon Johnson's Great Society initiative, the scope of aid sharply expanded. Many of these new grants were targeted as never before to urban areas. By 1980, state and local governments relied on federal grants-in-aid for 25.8 percent of state and local outlays (and these expenditures amounted to 3.5 percent of gross domestic product [GDP]) -- figures that declined somewhat in succeeding years but climbed again so that, by 1993, they stood at 21.9 percent and 3. 1 percent, respectively.
F. TED HEBERT
Rosen, Harvey, ed., 1988. Fiscal Federalism: Quantitative Studies. Chicago: University of Chicago Press.
Swartz, Thomas R., and John E. Peck, eds., 1990. The Changing Face of Fiscal Federalism. Armonk, NY: M. E. Sharpe.
U.S. Advisory Commission on Intergovernmental Relations, annual. Significant Features of Fiscal Federalism. Washington, DC: U.S. Advisory Commission on Intergovernmental Relations.
FISCAL POLICY. A policy that uses government expenditures and taxes to stimulate the level of economic activity, as typically measured by gross domestic product (GDP.). Fiscal policy advocates postulate that GDP responds to changes in the aggregate demand for goods and services. Aggregate demand includes consumption, investment, government and net export demand (exports minus imports). The government can influence aggregate demand by manipulating government expenditures and taxes. Government expenditures directly influence government demand; tax policy influences both consumption and investment demand.
Fiscal policy proponents recommend countercyclical fiscal policy to minimize macroeconomic fluctuations during business cycles. In essence, countercyclical fiscal policy offsets fluctuations in aggregate demand with changes in the federal budget deficit. The federal budget deficit is defined as net tax revenues minus government expenditures. During the business cycle's contractionary phase, the federal government stimulates aggregate demand and the economy by increasing government expenditures or reducing taxes. This action helps counterbalance the business cycle's contractionary phase but increases the federal budget deficit (or reduces the surplus). Conversely, contractionary fiscal policy reduces government expenditures or increases taxes; this reduces the federal budget deficit (or increases the budget surplus) and helps counterbalance an overheated economy during the business cycle's expansionary phase.
In the context of fiscal policy, government expenditures, on one hand, include the goods and services purchased by the federal government. National defense, highway construction and maintenance, education, and federal research and development projects are all examples of government expenditures. Government expenditures may vary from year to year, but they are not typically sensitive to changes in the GDP during the year. On the other hand, taxes include both programs to generate federal revenues (e.g., income taxes, corporate profits taxes, and social security taxes) and social programs that transfer income across individuals (e.g., Aid to Families with Dependent Children [AFDC], Social Security benefits). Net taxes are defined as tax revenues minus transfer payments. Net taxes fluctuate with the GDP.
Fiscal policy provides an alternative to monetary policy and supply-side economics. Monetary policy is also a demand-side policy. It influences aggregate demand indirectly by changing the money supply. Increasing the money supply directly increases consumption demand and decreases interest rates. Lower interest rates stimulate investment and consumption demand (see monetary policy). Supply-side economics hypothesizes that economic expansion must be supported by growth in productive capacity or it will increase prices rather than the GDP. Supply-side economics proposes reducing marginal tax rates to increase the labor supply and capital investment. Presumably, this increases economic capacity to accommodate growth while reducing prices (see supply-side economics).
Classical economics, the prevailing economic theory in the United States prior to the Great Depression, hypothesizes that market economies are inherently stable. In particular, the actual GDP automatically adjusts to the economy's productive capacity, called potential GDP. Economic capacity is determined by the quantity and quality of resources available (e.g., labor, capital, and natural resources). If resource prices are flexible, they will adjust until resources are fully employed and the economy is operating at economic capacity. If resources are underemployed, their prices will fall. Production becomes more profitable as resource prices fall, encouraging firms to expand output. The GDP expands until underemployment is eliminated. Conversely, prices will increase for overemployed resources, reducing profits, decreasing production, and eliminating overemployment.
With sufficient resource price flexibility, the economy will adjust to full employment relatively quickly. In this case, countercyclical fiscal policy is unnecessary in the short run and counterproductive in the long run. If resource price flexibility stabilizes the economy relatively quickly, fiscal policy is unnecessary in the short run. Furthermore, the economy cannot accommodate the increased aggregate demand after returning to full employment, assuming that the potential GDP is unaffected by expansionary fiscal policy.