Fiscal Policy

• Fiscal policy refers to the use of government spending and tax

policies to influence economic conditions,
especially macroeconomic conditions, including aggregate demand
for goods and services, employment, inflation, and economic
growth.
• Fiscal policy is largely based on ideas from John Maynard Keynes,
who argued governments could stabilize the business cycle and
regulate economic output.
• During a recession, the government may employ expansionary fiscal
policy by lowering tax rates to increase aggregate demand and fuel
economic growth.
• In the face of mounting inflation and other expansionary symptoms,
a government may pursue contractionary fiscal policy.
 Constituents of Fiscal Policy
• Fiscal policy has three components.
1. Government outlays or expenditure, which includes
predetermined sequences of government purchases of goods,
services and transfer/entitlement payments.
2. Tax structure: This includes time invariant tax rates on
consumption, labour income, capital income production of goods
and services.
3. Government debt: It comprises of government borrowings
from internal as well as external sources.
• The fiscal policy is designed to achieve certain objectives as follows:-
• 1. Development by effective Mobilisation of Resources: The principal objective of
fiscal policy is to ensure rapid economic growth and development. This objective
of economic growth and development can be achieved by Mobilisation of
Financial Resources. The central and state governments in India have used fiscal
policy to mobilise resources.
• The financial resources can be mobilised by:-
• a. Taxation: Through effective fiscal policies, the government aims to mobilise
resources by way of direct taxes as well as indirect taxes because most important
source of resource mobilisation in India is taxation.
• b. Public Savings: The resources can be mobilised through public savings by
reducing government expenditure and increasing surpluses of public sector
enterprises.
• c. Private Savings: Through effective fiscal measures such as tax benefits, the
government can raise resources from private sector and households. Resources
can be mobilised through government borrowings by ways of treasury bills,
issuance of government bonds, etc., loans from domestic and foreign parties and
by deficit financing.
• 2. Reduction in inequalities of Income and Wealth: Fiscal policy aims
at achieving equity or social justice by reducing income inequalities
among different sections of the society.
• The direct taxes such as income tax are charged more on the rich
people as compared to lower income groups.
• Indirect taxes are also more in the case of semi-luxury and luxury
items which are mostly consumed by the upper middle class and the
upper class.
• The government invests a significant proportion of its tax revenue in
the implementation of Poverty Alleviation Programmes to improve
the conditions of poor people in society.
• 3. Price Stability and Control of Inflation: One of the main objectives
of fiscal policy is to control inflation and stabilize price. Therefore, the
government always aims to control the inflation by reducing fiscal
deficits, introducing tax savings schemes, productive use of financial
resources, etc.
• 4. Employment Generation: The government is making every possible
effort to increase employment in the country through effective fiscal
measures. Investment in infrastructure has resulted in direct and indirect
employment.
• Lower taxes and duties on small-scale industrial units encourage more
investment and consequently generate more employment. Various rural
employment programmes have been undertaken by the Government of
India to solve problems in rural areas.
• Similarly, self employment scheme is taken to provide employment to
technically qualified persons in the urban areas.
• 5. Balanced Regional Development: there are various projects like
building up dams on rivers, electricity, schools, roads, industrial
projects etc. run by the government to mitigate the regional
imbalances in the country. This is done with the help of public
expenditure.
• 6. Reducing the Deficit in the Balance of Payment: some time
government gives export incentives to the exporters to boost up the
export from the country. In the same way import curbing measures
are also adopted to check import. Hence the combine impact of these
measures is improvement in the balance of payment of the country.
• 7. Increases National Income: it’s the strength of the fiscal policy that is
brings out the desired results in the economy. When the government want
to increase the income of the country, it increases the direct and indirect
taxes rates in the country. There are some other measures like: reduction in
tax rate so that more people get motivated to deposit actual tax.
8. Development of Infrastructure: when the government of the concerned
country spends money on the projects like railways, schools, dams,
electricity, roads etc to increase the welfare of the citizens, it improves the
infrastructure of the country. A improved infrastructure is the key to further
speed up the economic growth of the country.
9. Foreign Exchange Earnings: when the central government of the country
gives incentives like, exemption in custom duty, concession in excise duty
while producing things in the domestic markets, it motivates the foreign
investors to increase the investment in the domestic country.
 • Countercyclical fiscal policy during recession
Here, the Government’s responsibility is to generate demand by
fine-tuning taxation and expenditure policies. Reducing taxes and
increasing expenditure will help to create demand and producing
upswing in the economy.
• Countercyclical fiscal policy during boom
In the case of boom, economic activities will be on upswing. Amplifying
the boom is disastrous as it may create inflation and debt crisis and the
government’s responsibility here is to bring down the pace of economic
activities. Increasing taxes and reducing public expenditure will make
boom mild. Thus, slowing down demand should be the nature of
countercyclical fiscal policy during boom.
 Contractionary Fiscal Policy
• When an economy is in a state in which growth is getting out of control and
therefore causing inflation and asset price bubbles, a contractionary fiscal
policy can be used to rein in this inflation—to bring it to a more sustainable
level.
• A contractionary policy will lower government spending and/or increase
taxation. This policy will shift aggregate demand to the left (this denotes a
decrease).
• A fiscal policy is said to be tight or contractionary when revenue is higher
than spending (i.e. the government budget is in surplus) and loose or
expansionary when spending is higher than revenue (i.e. the budget is in
deficit).
• Contractionary fiscal policy slows growth, which includes job growth. With
fewer jobs, and higher taxes, both families and businesses are left with less
income available for spending. With this decreased demand, then, the
economy’s growth is slowed.
 Expansionary Fiscal Policy
• Since, Aggregate Demand = Consumption + Investment + Government
Spending + Net Exports, an expansionary policy will shift aggregate
demand to the right. This kind of policy involves decreasing taxes
and/or increasing government spending.
• An expansionary fiscal policy is typically used during a recession. A
decrease in taxation will lead to people having more money and
consuming more. This should also create an increase in aggregate
demand and could lead to higher economic growth. However, it can
also lead to inflation because of the higher demand within the
economy.
• Expansionary fiscal policy creates jobs. With more jobs, the overall
populace has more funds to spend, leading to higher levels of
demand. This creates growth in the economy. Along with tax cuts,
growth is especially accelerated. Among the best stimuli for the
economy are unemployment benefits, proven empirically via
economic studies. Tax cuts are less effective in creating jobs, as the
tax rate must already be high for lowering taxes to do so.
• The drawback of expansionary fiscal policy is that it can lead to
budget deficits. This is because the government is effectively
spending more than it ends up receiving in taxes.
 Criticisms of Fiscal Policy
• 1. Time Lag
Fiscal policy is characterized by a time lag, which is the time between the
implementation of policy and the actual effects of that policy being felt in the
economy.
• 2. Expansionary Bias
It has an expansionary bias. No government or politician would implement a
contractionary policy, so this means that expenditure will keep rising and taxes
would probably not rise too.
• 3. Execution
Contractionary policy is difficult to implement because no one wants cuts in
spending. Education, defense, and health are priorities and most people want to
ensure that they are adequately funded. It also cannot be maintained indefinitely. It
is considered to be a short-term tool, not a long-term solution.
 • 4. Trade Deficit
Expansionary fiscal policy can lead to a higher trade deficit, as higher
income leads to more expenditure on imports and a higher negative
trade balance.
• 5. Crowding Out
An expansionary policy may lead to crowding out. Crowding out occurs
when a big government borrows money. This leads to higher interest
rates for the private sector, which ultimately leads to less private
investment.