Fiscal Policy and Economic Growth: A Simple Framework

The effect of fiscal policy on economic growth is a
controversial and long-standing topic in economic
theory, empirical research, and economic policymaking.
It is at the heart of the policy debate surrounding
the sharp increases in official federal budget
surpluses in the 1990s, the equally sharp decline in the
fiscal outlook since January 2001, and the increasingly
imminent retirement of the baby boom generation. The
issue will receive further attention in the wake of recent
calls for new tax cuts and increased spending on
defense, homeland security, Medicare, and other programs.

In this article, we provide a brief overview of the
macroeconomic relations between budget surpluses
and deficits, the tax and spending policies that influence
those budget outcomes, and economic growth.
The article is intended to provide a framework for
thinking about the role of deficits, tax, and spending
policies in affecting medium—and longer—term economic
growth.

In the first section, we use national income accounting
identities to explore the relation between budget
outcomes, national saving, and future national income.
We show that, holding other factors constant, an increase
in budget deficits (or a reduction in surpluses)
will reduce future national income under conventional
views of how the economy operates. This occurs because
the deficit reduces national saving, which in turn
reduces national investment. The reduction in national
investment can take the form of lower domestic investment
and/or lower net foreign investment by
Americans. In either case, the expected future income
received by Americans falls.