Road to recovery – The role and economic impact of fiscal policy changes

Authors: Victor Kimanga and Julen Querejeta – IE Law School Alumni

Naturally, it is instinctive to get back on your feet when you stumble and fall. This is true for most people, especially as regards their daily routine. The desire to withstand adversity, survive and march on to a successful future is supreme. Similarly, even while still reeling from the effects of the COVID-19 pandemic, economies the world over are still expected to bounce back. Fiscal policy changes will be a key driver on the road to economic recovery.

What are Fiscal policies?

The economic impact of the COVID -19 pandemic is expected to be profound. Countries the world over are experiencing unprecedented levels of unemployment, scarcity of basic resources and a heightened fear of the unknown. The fact is, people are more uncertain about their immediate future than ever before.

The question today’s governments need to answer is how to instigate economic recovery. The answer may lie in the strategic implementation of restorative fiscal policy measures. Essentially, fiscal policies involve the use of government expenditures and tax levies to create an economic impact. When applied intelligently, fiscal policies become the key drivers for growth and economic stability.

Lessons from History

The delicate balancing act between reliance on free market dynamics and government intervention is fundamental to support a lively economy. This explains why governments periodically intervene when an economy is in distress.

Historically, governments have reverted to fiscal policies to revitalize their economies during troubled times. Certainly, we need to learn from the past in order to determine today’s solutions which are tailored to limit the impact of coronavirus on economies globally. Notable instances in the past where fiscal policies were applied by governments to mitigate the worst effects of an economic free-fall are the influenza pandemic (1918 -1920) and the 2008 global financial crisis.

The influenza pandemic was similar to the current COVID -19 pandemic because each has involved the enforced limitation of free movement of the people. This required a close down of various sectors of the economy.  Likewise, the 2008 crisis led to a major slowdown in global economies.

We now look back at significant fiscal policy changes and their economic impact. During the influenza pandemic, one of the measures taken by the United States (“US”) government was to increase the overall income tax rate.

The aim was to increase tax revenues collected by the government, incentivize an increase in government expenditure, and spur economic growth. Predictably, this did not work because people became more frugal with their spending, causing a further slump in economic activity.

To address the situation, the United States government introduced major income tax cuts leading to significant improvements in tax collections. Moreover, the increase in disposable income meant people spent more money, thus revitalizing the economy. Consequently, the United States government was able to make a surplus and reduce the economic shortfall.

More recently, during the 2008 financial crisis, the European Union (“EU”) acted quickly by providing a financial stimulus package to reduce the economic impact of the crisis. This comprised of a disbursement of funds across European Union member countries. These funds ensured the immediate needs of people in various countries were provided for. Additionally, the stimulus package gave critical support to national economies ensuring growth and stability was maintained.

The EU’s 2008 financial stimulus package was aimed at particular sectors. Principally, most governments were focused on incentivizing spending by their citizens. This objective accounted for over 50% of the disbursed funds and was done through reduction of income taxes and indirect taxes – i.e. Value Added Tax.  Additionally, EU governments increased government expenditure by focusing on investment in infrastructure. Moreover, to support businesses and reduce the impact on the labor market, some governments effected wage subsidies and reduced social security costs. These fiscal policy measures adopted by the EU ensured EU countries weathered the crisis and emerged with stronger and more flexible economies, and will surely guide current initiatives to limit the coronavirus impact on the economy.

Economic recovery: Building sustainable solutions

Evidently, fiscal policy measures play a significant role in stabilizing economies and ensuring growth. To promote beneficial and sustainable solutions, fiscal policy changes should primarily be aimed at instigating behavioral changes in people and businesses.

Behavioral changes directly impact the economy because they influence the demand for goods and services. One good example is the way income tax affects people’s spending habits. Reducing income tax incentivizes spending and ultimately contributes to economic resurgence.

Sustainable fiscal policy solutions should incentivize public spending. This will limit the need to subject people to extreme austerity measures, which only serve to worsen the overall state of the economy.

For instance, during the revitalization of the United States economy following the influenza pandemic, the government quickly realized that an increase in the income tax rate had detrimental effects on public spending. This also led to a decrease in the tax collected by the US government.

In contrast to the above action, the EU provided an adequate approach to revitalizing the European economies following the 2008 global crisis. They incentivized public spending by lowering taxes and adopting less stringent tax compliance requirements. These included lowering Value Added Tax rates and allowing the late filing of tax returns.

Additionally, policy makers should carefully consider the economic needs of their countries. This will inform the optimum balance between stop-gap measures and long-term fiscal policy initiatives. Although it is important to demonstrate agility in times of economic distress, policy makers always have to consider the future impact of fiscal policy changes.

What does the future hold?

The complexity of business and trade has increased tremendously over the last few decades. This has led to more complex legislative regimes and more intricate fiscal policy regulations.

This has compromised the ability of fluid measures and a unified approach to resolve economic crises. The need to ensure regulatory compliance has limited  governments’ ability to implement rapid domestic changes. Ultimately, an effective approach should promote the enhanced collaboration of multi-lateral bodies and the development of unified approaches to formulate solutions during times of crisis.

We should always look into the future and pose the question: “How will history judge us?”

Victor Kimanga is a Master in Global Tax alumni at the IE Law School. As a tax consultant he has been involved in both direct and indirect tax assignments covering various sectors of the economy including, energy, manufacturing, government and financial services. Victor has considerable experience in VAT and Customs duty, and his principal advisory focus is on business value chain impact and investments. Victor currently works in the Indirect taxes department at PricewaterhouseCoopers, Kenya.

Julen Querejeta is a graduate of IE University, Madrid. He has a keen interest in the impact of fiscal policy, particularly taxes on the value chain of a business and the impact on business operations. Julen has conducted extensive research on the impact of taxes on trade practices in developed and developing economies.

Note: The views expressed by the author of this paper are completely personal and do not represent the position of any affiliated institution.