Fiscal PolicyChapter 6

Fiscal Policy

Fiscal policy is the use by public authorities of public spending and taxation to steer activity—stimulus, multiplier, deficit and debt. Alongside monetary policy, it is one of the two major levers of macroeconomic policy; it acts on aggregate demand directly through public spending, indirectly through household income, but it is subject to long-term sustainability constraints.

Last updated: 16 October 2026

Definition

Fiscal policy encompasses all public decisions regarding the revenues (mainly compulsory levies: taxes, duties, social contributions) and expenditures (administrative operations, public investment, social transfers) of general government: the central government, but also local authorities and social security. Its two main instruments are voted each year: the finance act, which sets the central government budget, and the social security financing act. The latter, in light of its revenue forecasts, sets social security spending targets.

The general government balance is the difference between revenues and expenditures: when spending exceeds revenue, the balance is in deficit and general government must borrow to finance the difference. The accumulation of these borrowings constitutes public debt. The public deficit and debt figures used in European comparisons, and in this explanation, cover general government as a whole, not the central government alone.

A distinction is drawn between discretionary fiscal policy (deliberate decisions by public authorities to change spending or taxes) and automatic stabilizers (budgetary mechanisms that activate without political decisions). To separate what is due to the business cycle from what persists regardless of it, a structural balance is computed, adjusted for the effects of the cycle and for one-off measures.

How it works

When the economy slows too much, the government (and more broadly general government) can spend more or cut taxes: this is a stimulus. Here is what usually follows.

The government injects money.
1. The government injects money
It places orders, hires, pays out benefits, or leaves households more income by cutting taxes.
Incomes rise.
2. Incomes rise
The firms that receive these orders pay wages and suppliers; households have more to spend.
Part of this income is spent in turn. Each purchase creates income for someone else: this is the multiplier effect.
3. Part of this income is spent in turn
Each purchase creates income for someone else: this is the multiplier effect. The rest is saved, paid in taxes or spent on imported goods.
Activity is supported. Output and employment rise, but so do the deficit and the debt.
4. Activity is supported
Output and employment rise, but so do the deficit and the debt. Part of the new income comes back to the government in taxes, which partly offsets the rise in the deficit; afterwards, the new debt costs interest every year.

The other way around: when the government cuts its spending or raises taxes to reduce its deficit (an austerity policy), activity generally slows in the short term.

Without any decision: in a recession, unemployment benefits rise and tax revenues fall on their own; these automatic stabilizers cushion the shock.

The effect of government purchases is smaller than in the simple textbook calculation: this calculation counts only saving as a leakage. If households spend 75 cents of every euro they receive, 1 euro spent by the government then becomes 4 euros of GDP. In reality, at each round, part of the money also goes to taxes and imports, and government borrowing can hold back private investment (see below). According to most estimates, 1 extra euro of government purchases adds on average, good and bad times combined, between 0.6 and 1 euro of GDP (Ramey, 2019). At that level, leakages and brakes absorb the whole multiplier effect; below 1, other activity even falls slightly. Some studies find a stronger effect in recessions (Auerbach and Gorodnichenko, 2012), others do not (Ramey and Zubairy, 2018).

The effect of tax cuts is not settled: in the simple Keynesian model, a tax cut supports activity less than a government purchase of the same amount, because households save part of it. Yet for cuts in tax rates, studies of past episodes, such as Romer and Romer (2010), often find 2 to 3 euros of GDP per euro of tax cut, more than the 0.6 to 1 euro for government purchases; the more complete models economists use today most often find less than 1 (Ramey, 2019).

When it does not go as planned

Households put the tax cut aside: if they expect to pay more taxes tomorrow, they save instead of spending. This is Ricardian equivalence (Barro, 1974); in its strict version, the whole cut would be saved, and empirical studies do not all point the same way.

The government takes the place of private borrowers: by borrowing heavily, it can push up interest rates, which holds back private investment. This crowding-out effect is weak when rates are close to zero.

Markets doubt the debt: in the United Kingdom, in September 2022, the government announced large tax cuts financed by borrowing. Over three market days (Friday 23, Monday 26 and Tuesday 27 September), the rate at which the government borrows for 30 years jumped by about 1.3 points; forced sales by funds managed for pension schemes amplified the move. The Bank of England had to buy government bonds in an emergency, and most of the measures were dropped the following month.

Stimulating an economy already running at full capacity: with no idle machines or workers, the extra spending mostly pushes up prices, with little effect on output.

To learn more, read the full explanation, then follow the guided notions at the end of the explanation.

Why it matters

The debate between Keynesians and classicals is one of the oldest and most structuring in macroeconomics. Keynesians argue that expansionary fiscal policy is an effective tool for exiting a recession, because the multiplier is high when the economy operates below potential and interest rates are near zero (the central bank does not raise its rates, so crowding out becomes weak). Proponents of Ricardian equivalence (Barro, 1974) dispute the effectiveness of a stimulus through debt-financed tax cuts: in their view, households save the whole cut in anticipation of future taxes; debt financing is then equivalent to tax financing, and the multiplier of a tax cut is zero.

Mankiw notes that the answer depends on the time horizon: in the short run, when unused productive capacity exists, fiscal stimulus can indeed boost output. In the long run, chronic deficits increase debt, push up interest rates, and reduce private investment through crowding out, lowering the level of potential output.

Key points

The lever: by spending more or cutting taxes, public authorities can support activity when it slows. Conversely, spending less or raising taxes to reduce the deficit generally holds activity back in the short term.

The multiplier effect: each euro spent becomes someone's income, and they spend part of it in turn. The simple textbook calculation counts only saving as a leakage; in reality, part of each euro also goes to taxes and imports, so the actual effect is smaller.

Spending or cutting taxes: in the simple textbook model, a government purchase (an order, a public employee's wage) supports activity more than a tax cut of the same amount. The purchase counts in full from the first round, whereas households immediately save part of a tax cut. Studies of past episodes do not always confirm this ranking.

Automatic stabilizers: in a recession, unemployment generally rises and incomes fall; unemployment benefits then increase and tax revenues decrease on their own. These mechanisms act without waiting for a political decision, so they generally work faster than a measure that first has to be decided.

The limits: a stimulus can disappoint. Households may put a tax cut aside in anticipation of future taxes. Government borrowing can push up interest rates and hold back private investment. If the economy is already running at full capacity, the extra spending mostly pushes up prices. Finally, if lenders lose confidence in the debt, the cost of borrowing can rise sharply.

Short run and long run: the effect of a stimulus depends on the time horizon. In the short run, it can support output as long as machines and workers remain idle; in the long run, repeated deficits add to the debt and can hold back private investment, and therefore future output.

The debt: each deficit adds to the debt, which costs interest every year. Debt relative to GDP is driven mainly by the deficit excluding interest, the interest rate paid, and growth including inflation. If that rate persistently exceeds growth, it puts upward pressure on this ratio, and public authorities must sooner or later run surpluses excluding interest to keep the debt sustainable. If growth wins out, it instead puts downward pressure on the ratio.

Concrete example

Examples

The post-Covid European recovery plan "NextGenerationEU" (€750 billion in 2018 prices, around €807 billion in current prices, from 2021 to 2026), financed for the first time at this scale by joint EU borrowing, illustrates coordinated expansionary fiscal policy at the supranational level. In France, the recession and the "whatever it costs" approach brought the public deficit to nearly 9% of GDP in 2020 and debt to nearly 115% (8.9% and 114.9%, revised series). In 2025, public debt stands at 115.7% of GDP and the deficit at 5.1%, after 5.8% in 2024 (INSEE, May 2026)—well above the 3% reference value. The Stability Pact, which enforces these reference values, was reformed in 2024 (the 3% and 60% values are unchanged, but governance now runs through multi-year net-expenditure paths).

Why did the debt-to-GDP ratio keep rising in 2025 even though the deficit was falling? An approximation helps explain why: it calculates how much the debt-to-GDP ratio changes in a year. Besides the level of the debt, it involves three things: the interest rate, growth and the primary balance. It is called a "first-order" formula because it leaves out very small terms. The sign ≈ means "approximately equal to".

Δ(D/Y) ≈ (r − g) × (D/Y) − s

Δ(D/Y): the change over the year in the debt-to-GDP ratio, that is, debt (D) divided by GDP (Y), in percentage points of GDP.

r: the average interest rate paid on the debt: the year's interest divided by the debt at the end of the previous year.

g: nominal GDP growth, that is, growth including inflation.

D/Y: the debt-to-GDP ratio at the end of the previous year.

s: the primary balance as a percentage of GDP, that is, revenues minus spending excluding interest. It is negative when there is a primary deficit, and the −s term then adds that deficit to the debt-to-GDP ratio.

With a balanced primary budget, the debt grows at the interest rate (r) and GDP at the growth rate (g). If r exceeds g, the debt grows faster than GDP: the ratio climbs on its own, like a snowball growing as it rolls. The first term of the formula, (r − g) × (D/Y), measures this "snowball" effect. For example, with debt at 115.7% of GDP (end of 2025), if r exceeds g by one point, the ratio rises by about 1.2 points a year (1% of 115.7). When g exceeds r, this first term instead pushes the ratio down.

If r persistently exceeds g, public authorities cannot keep borrowing forever to pay the interest. The debt is then sustainable only if the present value of future primary balances, that is, their value today, at least covers the current debt: this is the intertemporal budget constraint.

The 2025 breakdown, according to the French Court of Audit (Cour des comptes, June 2026), based on INSEE figures: debt went from 112.6% to 115.7% of GDP, an increase of 3.1 points.

Snowball effect: about 0.1 point. Interest in 2025 (€65.7 billion according to the Court of Audit; INSEE counts €64.7 billion), divided by the debt at the end of 2024 (€3,306 billion), gives r ≈ 1.99%, or about 2.0%, an average rate paid on the whole debt, lower than recent market rates, because much of the debt was borrowed when rates were low; nominal GDP grew by 1.9%. With debt at 112.6% of GDP, interest therefore adds about 2.2 points of GDP. Growth takes away about 2.1, because the same debt weighs less in a larger GDP. About 0.1 point remains.

Primary deficit: 2.9 points. Out of a deficit of 5.1% of GDP, interest accounts for 2.2 points; the primary balance is therefore −2.9% of GDP, and −s adds 2.9 points.

Stock-flow adjustments: about 0.1 point. They change the debt without showing up in the deficit; examples include a loan granted by the government or a change in the money it keeps in its accounts. The formula does not count them: they are added separately.

In total, 0.1 + 2.9 + 0.1 = 3.1 points. In 2025, the debt therefore rose mainly because of the primary deficit: general government spent more than it took in, leaving interest aside. The rise in the ratio is the same as in 2024, despite a lower deficit, because growth slowed. In 2024, growth was well above the rate paid (3.6% versus 1.9%): it took away more than interest added, and the snowball effect pushed the ratio down by about 1.7 points according to the Court of Audit. In 2025, this effect pushed it up by about 0.1 point. This 1.8-point swing offset the fall in the primary deficit (from 3.7 to 2.9 points) and in stock-flow adjustments (from 1.1 to 0.1 point).

Market impact

Markets

Fiscal policy announcements primarily influence bond markets: an increase in the deficit raises the supply of sovereign debt, which can push up bond yields (and hence the government's borrowing costs). In the euro area, a persistent deficit shows up first as an interest-rate spread over Germany if investors doubt debt sustainability; outside a monetary union, it can also weigh on the currency. In France, the 10-year spread over Germany stood at 0.70 point on January 1, 2026 (3.58% for France versus 2.88%) and exceeded 0.90 point in mid-September 2026, amid a general rise in rates in which Italy's spread followed the same path, according to the report on general government debt annexed to the 2027 draft budget bill. Massive stimulus plans can support equity markets in the short term by boosting activity, but raise sustainability questions that can weigh on long-term bonds.

Official source