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What Is Optimal Fiscal Policy?

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  • Written By: Osmand Vitez
  • Edited By: PJP Schroeder
  • Last Modified Date: 29 October 2014
  • Copyright Protected:
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Fiscal policy represents the actions a government takes to alter an economy and adjust government spending and overall involvement in the economy. Optimal fiscal policy is that which will create the best environment for an economy to grow, individuals to engage in profitable actions, and businesses to expand. A government uses fiscal policy that mixes taxation with government spending in order to create a strong economy. When a government fails to use optimal fiscal policy, however, it can result in an unbalanced economy and huge fluctuations in the business cycle. Economists are often a part of making recommendations on fiscal policy.

Governments first need taxes in order to engage in spending and attempt to reach optimal fiscal policy. Taxes come from the citizens and businesses that reside within a nation’s borders or other individuals or countries that conduct business in the nation. From these tax receipts, the government attempts to create a spending schedule that will influence the economy through its fiscal policy. Repeated tax receipts need to remain at these levels or increase in order for a government to sustain itself. As governments grow, however, their appetite for taxes often increases, resulting in a heavier tax burden and more restrictions in the overall economy.

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Spending is a must for governments to engage in optimal fiscal policy; that is why a government often taxes its citizens to pay for government services and redistribute wealth. Failure to spend the tax receipts taken in from citizens can result in a weak economy. For example, taxes represent a reduction in the purchasing power of individuals as they have less money to spend on goods. If the government fails to spend its tax receipts in the economy, then this money is completely removed from the system. The supply and demand equilibriums may then falter, and the economy can begin to skid, possibly into a strong contraction period.

An optimal fiscal policy places a government’s tax receipts into proper activities or investments in the economy. For example, governments can spend money on items that businesses produce. This allows part of the available goods in the economy to go to the government, which helps maintain equilibrium in the overall market. In fact, Keynesian economics demands that governments purchase excess inventory in order to keep an economy running smoothly. Governments may also provide the money to lower-income individuals, who will then spend it in the economy and may maintain the economy’s equilibrium.

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