Fiscal Policy

The word 'Fisc' means 'state treasury' and 'fiscal policy' refers to policy concerning the use of 'state treasury' or government finances to achieve the macro-economic goals.

• economic stability

• price stability

• economic growth 

• BOP

The simple meaning of fiscal policy is the use of taxation and public expenditure by the government for stabilization or growth.

According to authors Smithies " A Policy under which the government uses its expenditure and revenue programmes to produce desirable effects and avoid undesirable effects on the national income, production and employment. "

Fiscal policy can be defined in more general terms that is fiscal policy is the government programme of making discretionary change in the pattern and level of its expenditure, taxation and borrowings in order to achieve intended economic growth, employment, income equality and stabilization of the economy on a growth path. fiscal policy is also called budgetary policy because the two sides of the govt budget are receipts and expenditure.

Objective -

1. To achieve full employment. 

A. Price stability 

B. To stabilize the growth rate of the economy.

C. To maintain equilibrium in the BOP

D. To ensure equitable distribution of income and wealth among peoples 

E. To mobilise resources for economic  growth

2. The ultimate aim of FP is the long run stabilization of the economy.

Instruments of FP-

FP through variations in government expenditure and taxation affects national income, employment output and prices. An increase in public expenditure during depression increases the aggregate demand (A. D.) For goods and services and leads to a large increase in income via the multiplier process while a reduction in taxes has the effect of raising disposable income there by increasing consumption and investment expenditure. So the government can control deflationary and inflationary pressure in the economy by a proper combination of expenditure and taxation programmes.

The major fiscal instruments are-

The budget is the principal instrument of F. P.

1. Budgetary Balance Policy --

When the government keeps its total expenditure equal to its revenue, it means the government has adopted a balanced-budget policy, when the government spends more than its expected revenue, it means that they have adopted deficit -budget policy. And when the government follows a policy of keeping its expenditure substantially below its revenue than it is following a surplus- budget policy this policy is adopted to control inflationary pressure within the economy.

2. Government expenditure -

The government expenditure is an injection of capital into the economy and through it ultimately manages aggregate demand. It includes total public spending on purchase of goods and services, payment of wages and salaries of public servants, transfer payment (Pension, subsidy, grants, aid, payment of interest etc.)

3. Taxation -

Direct tax - personal income tax

Corporate income tax

Indirect taxes- excise duty

Custom duty

Increase in tax rate is used for mobilising resources for capital formation in the public sector and also down consumption of goods and helps in checking inflation.

4. Public borrowings- it includes both internal and external borrowings. The government make borrowings generally to finance their budget deficits. Internal borrowings are of two types (a) borrowing from the public by means of government bonds and (b) borrowing from the central bank that is deficit financing. External borrowing includes borrowings from foreign governments, external organizations like the world bank and IMF etc.

Kinds of F.P. 

There is no unique fiscal policy suitable for all kinds of economic problems. in fact a variety of fiscal policies have been suggested by The Economists under different circumstances to achieve specific macroeconomic goals. however fiscal policy measures are generally classified under the following categories.

1. Automatic Stabilization of F.P.-

In this F.P., the tax structure and expenditure pattern are so designed that taxes and government spending vary automatically in the appropriate direction with the changes in national income. It means that these taxes and expenditure patterns without any special deliberate action by the government raises A.D in times of recession and reduces aggregate demand in times of boom and inflation that might occur in an economy.

These fiscal measures are therefore called Automatic or built in stabilizers.

Built in stabilizers means automatic adjustment in the government expenditure and tax revenue in response to raise and fall in GNP.

Since these automatic stabilizers do not require any fresh deliberate action by the government, they are also called non-discretionary F.P.

Built in stability of tax revenue new and government expenditure of transfer payments and subsidies is created because they vary with national income. these taxes and expenditure automatically bring about appropriate changes in aggregate demand and reduce the impact of recession and inflation that might occur in an economy. the various automatic stabilizers are personal income tax, corporate Income Tax, transfer payments such as unemployment compensation and other welfare benefits. these automatic stabilizer directly varies with change in N.I.

Personal Income Tax 

In our country this tax is progressive type. when national income increases during inflation, then increasing percentage of the peoples income are paid to the government and this will decline their disposable income. so automatically people will reduce consumption and therefore A.D. will be reduced. This decline in A.D. will reduce inflation. on the other hand, when national income decline at times of recession, the tax revenue which are based on percentage of national income automatically decline. at the same time government expenditure on unemployment compensation and social security benefits automatically increases. so there would be an automatic budget deficit which would counteract deflationary tendencies and finally recession.

The same will happen in case of corporate income tax. 

Corporate income tax 

Corporations or companies pay a percentage of their profit as tax to the government. Like personal income tax corporate income tax rate. Is also generally higher at higher levels of corporate profits. The revenue of corporate rises greatly during inflation and boom which will reduce their consumption and ultimately reduce A. D. And revenue from then falls during recession which tends to offset the decline in A.D.

Limitations -

1. Through Automatic stabilizers reduce the intensity of inflation and recession. but they cannot alone correct the recession and inflation significantly. therefore the role of discretionary fiscal policy that is deliberate change in the tax rate and amount of government expenditure are required to cure recession and inflation.

2. Automatic stabilization model works efficiently only in the advanced economies. when the economy is subjected to external socks, automatic stabilizers fail to work efficiently. in this case it becomes necessary to make discretionary changes in the fiscal policy.

Compensatory Fiscal policy-

 The compensatory F.P. is a deliberately budgetary action taken by the government to compensate for the deficiency in or excess of A.D. the compensatory action is taken by the government in the form of surplus budgeting or deficit budgeting. In this kind of fiscal policy, the government uses a greater degree of discretion than in automatic stabilization policy and this policy can be revised year after year.

During the period of depression, the government is required to boost up the A. D., especially when the economy is facing depression due to lack of effective demand. The government in this case is required to take compensatory fiscal measures. The compensatory measures may be in the form of tax reduction and increased government expenditure. This kind of fiscal measures increases A.D. increase in A.D. leads first to rise in price level. It adds to the producers profit and this increase in profit creates an optimistic environment. Entrepreneurs will encourage investment. And ultimately this will pusp up the level of employment and output. In this case the government adopts a deficit budget policy.

The policy of surplus budgeting is adopted and works effectively during the inflation, especially when inflation is caused by excessive demand.

This is a powerful tool to control the A.D. 

Under this policy the government keeps its expenditure lower than its revenue and the government may resort to a higher rate of taxation and cut its expenditure. Higher rate of taxation reduces disposable income. As a result the A.D. decreases at the rate of tax multiplier. On the expenditure side a cut in the government expenditure reduces the A.D. at the rate of expenditure multiplier. And ultimately inflation.

Tax multiplier-  It refers to multiple effects of a change in tax on the N.I.

Government expenditure multiplier - It shows the impact of a change in government expenditure on the equational level of the national income.

Discretionary Fiscal policy

It refers to deliberate change in the government expenditure and taxes to influence the level of national output and prices. On the other hand non discretionary F.P. of automatic stabilizers is a built in tax or expenditure mechanism that automatically increases A.D. when recession occurs and reduces A.D. when there is inflation without any special deliberate actions on the part of the government.

In discretionary F.P. government makes deliberate changes in,

1. Changing taxes with government expenditure constant 

2. Changing government expenditure with taxes constant 

3. Variation in both expenditure and taxes simultaneously 

4. The size and composition of public debt.

The main aim of F.P. is to change A.D. by suitable change in government expenditure and taxes so F.P. is mainly a policy of demand management.

At the time of recession the government increases its expenditure or cuts down taxes or adopts a combination of both that is to cure recession expansionary fiscal policy is adopted. In this condition the government will have a budget deficit. So we can say that the expansionary FP will cure the recession and unemployment is a deficit budget policy. On the other hand to control inflation the government cuts down expenditure or raises taxes that is to cure inflation, contractionary fiscal policy is adopted. In this condition the government will have a surplus budget. So we can say that the contractionary F.P. to cure inflation is a surplus budget policy.

Fiscal policy to cure recession 

The recession in an economy occurs when A. D. Decreases due to fall in private investment. Private investment may fall when business becomes highly pessimistic about making profits in future. As a result of this fall in private expenditure A.D. shifts down and creates deflationary gap or recessionary gap. Here F.P. plays an important role by filling up this gap by increasing government expenditure or reducing taxes.

A. I Option

Increase in government expenditure -

As for the discretionary F.P. is concerned about the government may start increasing expenditure on public works. There is a direct and indirect effect of this expenditure.

The direct effect is that it increases income of those who sell materials and supply labourers for these projects and also output of these related public work also increases together with the increase in income and the indirect effect of this expenditure comes in the form of the working of the multiplier.

Those who get more income spend them further on consumer goods depending on their MPC.

This increase in demand for consumer goods brings about further expansion in their output which further generates employment and incomes for the unemployed workers and so these new incomes are spent and respect further.

Here the question arises that how large should be the increase in expenditure depends on the magnitude of GNP gap caused by a deflationary gap on the one hand and the size of the multiplier on the other.

The impact of this government expenditure is given by diagrammatic presentation.

When government expenditure exceeds receipts (Budget deficit) larger amounts are put into the stream of N.I.

Involuntary unemployment -

It means that people are willing to work at the existing wage rates but are unable to unemployment find jobs.

B. II Option

Reduction in taxes to overcome recession -

The reduction in taxes increases the disposable income of the people and thus stimulates increase in consumption expenditure. So reduction in taxes will cause an upward shift upward. This will have an expansionary effect and the economy will be lifted out of recession.

Policy option 

Increase in government expenditure or reduction in taxes (Deficit Budget Policy)

The choice between tax reduction and increase in government expenditure depends  on the magnitude of the effect of expenditure multiplier and tax multiplier.

The value of the tax multiplier is less than the government expenditure multiplier.

Fiscal policy to control inflation (6)

(Surplus budget policy)

When A.D. increases beyond what the economy can potentially produce by fully employing its given resources, it will give rise to inflationary pressure in the economy.

1. Reducing government expenditure 

2. Increasing taxes.

Crowding out and F.P

The term crowding out refers to the reduction in private investment due to an increase in government expenditure. An increase in government expenditure raises AD, N.I and interest rates which ultimately reduces private investment this is called the crowding out effect of F.P.

Generally it happens that an increase in government expenditure (deficit budget) adversely affects private investment which offsets to some extent the expansionary effect of budget deficit. This adverse effect comes about as an increase in government expenditure or reduction in taxes causes the rate of interest to go up.

Rise in ROI is due to-

1. Increase in government expenditure leads to a rise in N.I which raises transaction demand for money given the supply of money in the economy, the increase in transaction demand for money will cause the ROI to go high.

2. To finance its budget deficit the government will borrow funds from the market. This will raise the demand for loanable funds which bring about a rise in the ROI.

A high ROI will crowd out (Reduce) private investment. So the crowding - out effect reduces the multiplier effect of the government expenditure on th N.I and the magnitude of crowding out reduces.

Crowding In

Crowding - in means rise in the private investment due to deficit budgeting (deficit spending) adopted by the government.

This is the country to the crowding - out effect.

Deficit expenditure leads to the rise in the ROI which discourages private investment. But government deficit expenditure leads to a rise in the A.D. this demand is met by increasing the production from the existing capital stock. This brings the acceleration principal in force and intensive use of existing capital results in a greater depreciation of capital. Therefore demand for capital increases. That deficit expenditure stimulates investment. But this argument holds only when there are unutilized resources.

The Acceleration Principals

Explains the process by which an increase (or decrease) in the demand for consumption goods leads to an increase (or decrease ) in investment in capital goods.

It is the ratio between induced investment and an initial change in consumption expenditure.