Definition: Contractionary fiscal policy is when the government either cuts spending or increases revenue through higher taxes. The purpose is to slow growth to a healthy economic level.

Although you may think that there's no such thing as an economy that's growing too fast, an overheated economy has a lot of negative repercussions. First, it usually creates an asset bubble, similar to what happened to housing in 2006.

Second, it lowers unemployment to below the natural rate of unemployment. This makes it difficult for employers to find enough workers to meet market demand.

Third, it can create inflation. That's when prices, and often wages, rise higher and higher. This can destroy savings and your standard of living. Fourth, an economy that's growing too fast will inevitably burn out, leading to a recession. For more, see Business Cycle.

Contractionary fiscal policy is so named because it actually contracts the economy by reducing the amount of money available for businesses and consumers to spend.

Contractionary fiscal policy is used much less frequently than expansionary policy. That's because voters don't like tax cuts, and they don't like having benefits cut. Therefore, politicians that implement contractionary policy aren't popular, and tend to have a short career. Without contractionary policy, however, they can create out-of-control budget deficits that create unsustainable debt levels. 

This isn't a problem at the state and local levels, because most communities must follow balanced budget laws.

They aren't allowed to spend more than they receive in taxes. Although it's a good discipline, it limits lawmakers' ability to recover from a recession.  Unless they have a surplus when they recession hits, they must cut spending right when they need it most.

The U.S. federal government doesn't have this limitation because it can always issue new Treasury bills, notes and bonds to pay for any deficit. Unlike the states, it can print its own money. This, and the unpopularity of contractionary policy, has sent the national debt soaring to nearly $18 trillion. That exceeds what the United States produces in a year. For more, see debt to GDP ratio.

Purpose

The purpose of contractionary fiscal policy is to cool off growth and prevent inflation. That's only needed during the peak phase of the business cycle. That's the only time the government should increase spending beyond the level of revenue it receives. It's also the only time it should cut taxes below the level needed to support spending.

Unfortunately, both increased spending and lower taxes are often done even when the economy is doing fine. This creates asset bubbles that lead to irrational exuberance and the peak phase of the business cycle. You can guess what follows next...contraction and recession.

That's because politicians often use expansionary fiscal policy for reasons other than its true purpose. For example, they might cut taxes to become more popular with voters before an election. 

How It Works

Increasing some kinds of spending or cutting personal taxes puts more money into consumers' hands, giving them more purchasing power. To get funds right into the hands of consumers, the government will provide subsidies, transfer payments including welfare programs, contracts for public works, and hiring new government employees.This increases demand, boosting business profit and allowing them to increase employment. For more, see Do Tax Cuts Create Jobs?,

Supply-side economics prefers lower corporate taxes instead of income taxes. This makes it easier to do business, jumpstarting economic growth and allow companies to hire more workers. They also advocate lower capital gains taxes to increase business investment. However, there is evidence that shows this type of Trickle Down Economics doesn't usually work, unless tax rates are 50% or higher. For more, see What Does the Laffer Curve Really Say?.

Examples

President Bill Clinton used contractionary policy by cutting spending in several key areas. First, he required welfare recipients to work within two years of getting benefits, and cut benefits after five years. He raised the top income tax rate from 28% to 39.6%

President Franklin D. Roosevelt  used contractionary policy too soon after the Depression. He was reacting to political pressure to cut the debt. The Depression came roaring back in 1932, and didn't end until FDR  geared up spending for World War II, a return to expansionary policy.

For more examples, see

• U.S. Debt by President
• Unemployment Rate by Year 
• History of Recessions
• GDP by Year

Contractionary Fiscal Policy vs Contractionary Monetary Policy

Contractionary monetary policy is when a nation's central bank raises interest rates and decreases the money supply to prevent inflation. The long-term impact of inflation can be more damaging to the standard of living than a recession. Expansionary monetary policy boosts economic growth by lowering interest rates.  It's very effective in adding more liquidity in a recession.

The benefits of monetary policy is that it works faster than fiscal policy. The Fed votes to raise or lower rates at its regular FOMC meeting. It takes about six months for the added liquidity to work its way through the economy. Article updated December 14, 2014

More

• Unemployment Solutions
• How Extended Unemployment Benefits Boost the Economy
• 14 Ways to Create Jobs
•  U.S. Federal Budget - Overview and Impact on the U.S. Economy.