Fiscal Neutrality

Fiscal neutrality occurs when taxes and government spending are neutral, with neither affecting demand. Fiscal neutrality creates a condition where demand is neither stimulated nor diminished by taxation and government spending.

A balanced budget is an example of fiscal neutrality, where government spending is covered almost exactly by tax revenue – in other words, where tax revenue is equal to government spending.

A situation where spending exceeds the revenue generated from taxes is called a fiscal deficit and requires the government to borrow money to cover the shortfall. When tax revenues exceed spending, a fiscal surplus results, and the excess money can be invested for future use.

Fiscal neutrality centers on the idea that a tax should not distort economic behavior. For example, income tax may influence the number of hours a worker is willing to work, possibly their level of effort as well. This is an example of a tax that clearly alters or influences people’s behavior from a state that would have otherwise been different in the absence of a tax. On the other hand, a poll tax (a lump sum on each adult per year) is non-distortionary because it does not affect economic choice. Here, the tax does not affect one's behavior. This is also known as an efficient tax because it doesn’t distort economic behavior.

In general, a good tax considers features such as:

• Fair redistribution of income
• Influence on demand for demerit goods

A neutral fiscal stance will explicitly factor the influence on aggregate demand. If the stance is truly neutral, the government is neither trying to boost aggregate demand (reflationary fiscal policy) or reduce aggregate demand (deflationary fiscal policy). In reality, effects of globalization and free-trade have largely made fiscal neutrality impossible. Invariably, fiscal policy will ultimately nudge demand in one way or another.