A contractionary fiscal policy is a fiscal policy that is meant to slow an economy down. It is meant to decrease aggregate demand (AD) to slow an overheating economy. An economy that is “overheating” is one that is suffering from excessive demand-pull inflation. Demand-pull inflation occurs when there is too much money in the economy. Consumers, having a great deal of money, are able to pay more for goods and services and producers raise prices accordingly. The solution to this is to raise taxes, decrease government spending, or both. These actions take money out of the pockets of consumers and AD declines.
The last time that the United States has used a contractionary fiscal policy was in the late 1960s. This was a time when the country was experiencing demand-pull inflation due mainly to government spending. The government was spending on the Vietnam War and was also trying to maintain domestic spending on the “Great Society” programs that had been pushed by President Lyndon Johnson. All of this government spending led to inflation.
In order to combat this, both President Johnson and his successor, Richard Nixon, used contractionary fiscal policy. In 1968, Johnson imposed a 10% tax surcharge on American taxpayers. Nixon ordered reductions in government purchasing. In both cases, what the presidents were trying to do was to reduce the amount of money in the consumers’ pockets so as to reduce AD and lower inflation.