What is fiscal policy?

Fiscal policy is the use of government spending and taxation to influence economic conditions. When a government increases public spending or cuts taxes, it injects money into the economy, stimulating activity. When it cuts spending or raises taxes, it withdraws money, slowing activity. Fiscal policy is one of the two main levers available to manage an economy. The other is monetary policy, which operates through interest rates set by the central bank.

The two tools of fiscal policy

Fiscal policy works through two mechanisms. The first is government spending: direct expenditure on public services, infrastructure, benefits, and transfers to households and businesses. When the government spends more, it directly increases aggregate demand in the economy. The second is taxation: changing the tax burden on individuals and businesses alters disposable income and corporate cash flows, which in turn affects spending and investment.

Expansionary fiscal policy involves increasing spending, cutting taxes, or both. It is typically used during recessions or periods of weak demand to support economic activity. Contractionary fiscal policy involves cutting spending, raising taxes, or both. It is used to reduce inflation, bring down a budget deficit, or reduce the national debt. The UK's post-pandemic fiscal consolidation, which included the April 2025 increases in employer National Insurance contributions and the freeze on income tax thresholds, is an example of contractionary fiscal policy.

Fiscal policy versus monetary policy

Fiscal and monetary policy are the two main instruments for managing economic conditions, and they are distinct in both mechanism and control. Monetary policy is set by the Bank of England's Monetary Policy Committee, which operates independently of the government. It works primarily through interest rates, which affect the cost of borrowing across the economy. Fiscal policy is set by the government through the Budget and Spending Review process. It works through the direct impact of public spending and tax changes on household and business finances.

The two policies interact. Loose fiscal policy, meaning high spending or low taxes, can put upward pressure on inflation, forcing the central bank to keep rates higher than it otherwise would. Tight monetary policy, meaning high interest rates, can slow the economy enough to make the government's fiscal position harder to manage by reducing tax revenues and increasing benefit costs. The relationship between fiscal and monetary policy was central to the UK's economic debate from 2022 to 2026, as the government's spending choices and the Bank's rate decisions pulled in different directions at different points.

Automatic stabilisers

Part of fiscal policy operates automatically without any deliberate government decision. These are automatic stabilisers. When the economy weakens, unemployment rises and benefit payments increase automatically, putting money into the economy without the government needing to pass new legislation. Tax revenues fall automatically as profits and incomes decline. Both effects cushion the downturn. When the economy strengthens, the same mechanisms work in reverse: benefit costs fall and tax revenues rise, acting as a natural brake on overheating. Automatic stabilisers reduce the amplitude of economic cycles without requiring the government to act.

The UK fiscal position in 2026

The UK government is operating under significant fiscal constraint in 2026. Public debt as a share of GDP is close to 100 percent, the highest level in decades outside the immediate post-pandemic period. The OBR's fiscal rules, which require debt to be falling as a share of GDP over a rolling five-year period, limit the scope for additional discretionary spending. The government has limited room to use expansionary fiscal policy as a response to a potential economic slowdown without breaching its own fiscal commitments. For the detail on the national debt position, see our note on UK national debt and who owns it.

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