Fiscal Policy

Quick Definition

Fiscal policy is the government's use of taxation and spending to influence the broader economy. In the United States, fiscal policy is determined by Congress (which controls the budget and tax code) and the President (who proposes the budget and signs or vetoes legislation). It is distinct from monetary policy, which is set by the independent Federal Reserve.

What It Means

When the economy enters a recession, the government has two major tools to respond: the Federal Reserve can cut interest rates (monetary policy), and the government can increase spending or cut taxes (fiscal policy). Both inject stimulus into the economy through different channels.

Fiscal policy reflects fundamental political choices: how much government should spend, on what, who should be taxed, and at what rates. These are inherently political decisions, which is why fiscal policy is set by elected officials while monetary policy is delegated to an independent central bank insulated from election cycles.

In 2025 and 2026, U.S. fiscal policy underwent its most significant shift in nearly a decade. The One Big Beautiful Bill Act (OBBBA), signed into law on July 4, 2025, permanently extended the individual income and estate tax cuts from the 2017 Tax Cuts and Jobs Act (TCJA), introduced new targeted tax deductions, enacted large business tax cuts, and increased spending on border security and defense. The changes were partially financed by cuts to Medicaid, the Affordable Care Act, SNAP, and clean energy incentives.

Types of Fiscal Policy

The U.S. Federal Budget in 2026

The Congressional Budget Office's February 2026 outlook projects worsening long-term federal deficits, driven largely by increased spending on Social Security, Medicare, and debt service payments:

The CBO projects that higher tariffs will partially offset some spending increases by raising federal revenue by approximately $3 trillion over the decade. However, those tariffs also come with higher inflation from 2026 to 2029.

The One Big Beautiful Bill Act: 2026 Fiscal Reality

The OBBBA is the dominant fiscal policy development of the current era. Here is what the major analytical institutions project:

The bill includes several notable tax provisions that took effect in 2025 and 2026:

Spending cuts that partially finance the tax reductions:

The Brookings Institution analysis describes the OBBBA as "the most regressive tax and budget law in at least 40 years." Permanent rate cuts and business provisions direct the largest benefits to high-income households, while many of the spending cuts fall on low-income and immigrant families.

How Expansionary Fiscal Policy Works

During a recession, the government can:

1. Increase government spending directly into the economy:

• Infrastructure projects (bridges, highways, broadband)
• Defense spending
• Social programs (expanded unemployment benefits, food assistance)
• Stimulus checks to households

2. Cut taxes, leaving more money with households and businesses:

• Individual income tax cuts (more disposable income)
• Payroll tax cuts (more take-home pay)
• Business tax cuts (incentivize investment and hiring)
• Investment tax credits

The multiplier effect: A dollar of government spending (or tax cut) creates more than a dollar of economic activity because the recipient spends part of it, and those recipients spend part of their windfall, and so on. The fiscal multiplier is estimated at roughly 0.6 to 1.5 depending on the economic environment and type of stimulus.

Major U.S. Fiscal Stimulus Programs

The COVID-era fiscal response (2020 to 2021) was unprecedented in peacetime: approximately $5 trillion in fiscal stimulus in under 18 months. This, combined with supply chain disruptions, contributed directly to the 2021 to 2022 inflation surge.

Fiscal Policy vs. Monetary Policy

The coordination problem: When fiscal policy is expansionary and monetary policy is contractionary simultaneously, they work at cross purposes. In 2022 and 2023, the U.S. had the most aggressive rate-hiking cycle in 40 years (tight monetary policy) while running $1.5 to $2 trillion annual deficits (expansionary fiscal policy). This tension continues in 2026, with the Fed holding rates at 3.50 to 3.75% while the OBBBA adds trillions to projected deficits.

The National Debt: Fiscal Policy's Cumulative Effect

Every year the government runs a deficit, it adds to the national debt:

The Yale Budget Lab projects that by 2054, the 10-year Treasury yield will be 1.2 percentage points higher than it would have been without the OBBBA. The CBO estimates that every 0.1 percentage point rise in rates, sustained over the coming decade, would increase government interest expense by $379 billion. If the recent rate moves are sustained, that implies approximately $1.8 trillion in additional interest costs over the coming decade.

Automatic Stabilizers: Fiscal Policy That Works Automatically

Not all fiscal policy requires a vote. Automatic stabilizers are built into the budget and expand spending automatically during recessions without legislative action:

These stabilizers act as an automatic floor during recessions, preventing economic spirals from becoming as severe as they otherwise would be. However, the OBBBA's cuts to SNAP and Medicaid may weaken these automatic stabilizers going forward.

Key Points to Remember

• Fiscal policy uses government spending and taxation to influence the economy
• Congress and the President control fiscal policy; the Fed controls monetary policy
• The One Big Beautiful Bill Act (July 2025) is the dominant fiscal policy shift of the current era, adding an estimated $2.4 to $5.1 trillion to deficits over 10 years
• The CBO projects the deficit-to-GDP ratio will average 6.1% over the next decade, far above the 3% target
• Debt held by the public is projected to rise from 101% to 120% of GDP by 2034, and could reach 183% by 2054 with the OBBBA
• Automatic stabilizers (unemployment insurance, SNAP, progressive taxes) act as built-in recession buffers, though some were weakened by the OBBBA
• Higher tariffs partially offset deficit growth ($3 trillion over a decade) but bring higher inflation

Common Mistakes to Avoid

• Confusing the deficit with the national debt: The deficit is the annual shortfall, the amount by which spending exceeds revenue in a single year. The national debt is the cumulative total of all past deficits minus any surpluses. A $1.8 trillion deficit adds $1.8 trillion to the debt in one year.
• Assuming tax cuts pay for themselves: The OBBBA's tax cuts are not self-financing. CBO, Brookings, and Yale all project that the bill increases deficits by trillions of dollars, even after accounting for economic growth effects. Dynamic scores actually show higher deficits than conventional scores because the growth effects are weak relative to the revenue loss.
• Ignoring the interest cost spiral: As debt grows, interest payments grow. As interest rates rise, the cost of servicing existing debt rises when old bonds mature and are refinanced at higher rates. The CBO estimates every 0.1 percentage point increase in rates costs $379 billion over a decade. This creates a feedback loop where higher debt pushes rates higher, which pushes debt higher.
• Treating fiscal policy as separate from monetary policy: When fiscal policy is expansionary (large deficits) while the Fed is trying to control inflation, the two work against each other. The Fed must keep rates higher to offset fiscal stimulus, which means borrowers pay more for mortgages, car loans, and business loans.

Related Concepts

Fiscal policy connects to many other economic concepts. Monetary policy is the other main lever policymakers use to manage the economy. GDP is the denominator in deficit-to-GDP and debt-to-GDP ratios. A recession is when expansionary fiscal policy is typically deployed. The Federal Reserve controls monetary policy independently of fiscal policy decisions. Inflation can be caused or worsened by expansionary fiscal policy, as the COVID-era stimulus demonstrated. Economic growth is the ultimate goal of fiscal stimulus, and the business cycle determines when stimulus or austerity is appropriate.

Frequently Asked Questions

Q: Does deficit spending always cause inflation? A: Not necessarily. Deficit spending during a recession (when the economy has unused capacity) typically stimulates growth without significant inflation. Deficit spending during full employment (when the economy is already at capacity) is more likely to cause inflation. The 2020 to 2021 COVID stimulus contributed to inflation because it was so large it overstimulated an economy that was also experiencing supply constraints. The OBBBA's deficit increases are particularly concerning from an inflation standpoint because they occur during an economy already near full employment.

Q: What is the difference between the deficit and the national debt? A: The deficit is the annual shortfall, the amount by which spending exceeds revenue in a single year. The national debt is the cumulative total of all past deficits (minus any surpluses), representing the total outstanding obligations of the federal government. The FY2026 deficit is projected at roughly $1.8 trillion. The total national debt is approximately $30 trillion and growing.

Q: How does fiscal policy affect investors? A: Fiscal stimulus tends to be positive for stocks in the short term (more economic activity, higher earnings). However, large deficits can eventually push interest rates higher as the government competes for capital, which is negative for fixed-income securities and can compress stock valuations. The Yale Budget Lab projects the OBBBA will push the 10-year Treasury yield 1.2 percentage points higher by 2054. Tax policy changes (capital gains rates, corporate tax rates) directly affect after-tax investment returns.

Q: What is the "current policy baseline" budget gimmick? A: The Senate Republican majority used a "current policy baseline" to score the cost of extending TCJA tax provisions scheduled to expire. Under this approach, extending an existing tax cut is treated as having zero fiscal cost, because it continues current policy rather than changing it. This departed from long-standing budget conventions that score extending expiring provisions as a new cost. The result is that the OBBBA appears to cost less on paper than it actually does, which is why CBO's conventional scoring shows $2.4 trillion in added deficits while Brookings estimates $3.7 to $5.1 trillion.