Difficulties in using fiscal policy

There are several problems involved in implementing fiscal policy.  They include:

Theoretical problems

Monetarists and the Keynesians do not seem to agree on the efficacy of fiscal policy. Monetarists claim that budget deficits (or surpluses) will have little or no effect upon real national income while having adverse effect upon real national income while having adverse effects upon the interest rates and upon prices.

The net effects of the budget

Unlike the simple Keynesian view that various types of budgets have different effects, the empirical evidence is that the net effects of taxes and government expenditure are influenced by the marginal propensities to consume of those being taxed and governments expenditure.

The Inflexibility of government finances

Much of the government's finances are inflexible.  One of the reasons for this is that the major portion of almost any departments budget is wages and salaries, and it is not possible to play around with these to suit the short-run needs of the government.

Discretionary and automatic changes

Discretionary changes are those which come about as a result of some conscious decision taken by the government, e.g. changes in tax rates or a change in the pattern of expenditure.

Automatic changes come about as a result of some changes in the economy, e.g. an increase in unemployment automatically increases government expenditure on unemployment benefits.

In fact it is the case that deficits tend to increase automatically in times of recession and decrease in times of recovery.  (These fiscal weapons which automatically increase in times of recession and decrease in times of recovery are referred to as brick stabilizers).  It is possible for a government to compound the effects of a recession by raising taxes in order to recover lost revenues.  This, according to Keynesians, would cause a multiplier effect downwards on the level of economic activity.

Policy conflicts

When devising its fiscal policy, the government must attempt to reconcile conflicting objectives of policy.  For example, there is commonly supposed to be a conflict between full employment and inflation, i.e. that the attainment of full employment may cause inflation. 

Information

It is very difficult to assemble accurate information about the economy sufficiently quickly for it to be of use in the short-run management of the economy.

Time lag

It normally takes time for a government to appreciate the economic situation, to formulate a policy and them implement it.  This leads to lagged responses some of which may be long and difficult to predict.

For instance, there is an inside lag which is the time interval between the recognition of an economic problem or the shock and the implementation of appropriate policy measures.  This is the time it takes to recognize that the shock has taken place and then to formulate and implement an appropriate policy.  In general, fiscal policy is thought to have a longer inside lag than monetary policy.

Finally, there is an outside lag when the time interval between the implementation of policy measures and the resultant effects on the intended targets.