Fiscal policy

The most important instrument of government intervention in the economy today is that of fiscal or budgetary policy. Fiscal policy refers to the taxation, expenditure and borrowing by the government. The economists now hold the government intervention through fiscal policy is essential in the matter of overcoming recession or inflation as well as of promoting and accelerating economic growth.

Meaning and Definitions

The fiscal policy is concerned with the raising of government revenue and incurring of government expenditure. The government frames a policy called budgetary policy or fiscal policy. So, the fiscal policy is concerned with government expenditure and government revenue. Fiscal policy has to decide on the size and pattern of flow of expenditure from the government to the economy and from the economy back to the government.

According to J.M. Culbertson, “By fiscal policy we refer to government actions affecting its receipts and expenditures which we Monetary and Fiscal  ordinarily takes as measured by the government’s net receipts, its surplus or deficit.” The Government may offset undesirable variations in private consumption and investment by anti-cyclical variations of public expenditures and taxes. 

Otto Eckstein defines fiscal policy as “Changes in taxes and expenditures which aim at short run goals of full employment and price -level stability.”  

During a recession or depression fiscal policy should help in increasing demand. For this purpose, the government can increase its expenditure and spend more on public works. This will provide employment to more people. The government can also increase its expenditure on subsidies to producers of consumer goods so as to increase consumption spending. Similarly, the government can lower its tax rates so as to stimulate consumption and investment. Thus, a budget deficit during a depression helps greatly in removing unemployment. On the other hand, during periods of inflation, there is too much of demand and hence the government should reduce its own expenditure and curb private spending by increasing taxes. Thus, in periods of inflation we should have surplus budgets. Therefore, there is no inherent superiority in a balanced or a surplus budget. It all depends on the prevailing economic situation. This view of public finance is called as functional finance because according to this view, public revenue and expenditure of the government are not to be considered as being governed solely by the requirements of government finances but by the requirements of attaining and maintaining full employment and price stability. 

 Objectives of Fiscal Policy

The importance of fiscal policy is high in underdeveloped countries. The state has to play active and important role. In a democratic society direct methods are not approved. So, the government has to depend on indirect methods of regulations. In this way, fiscal policy is a powerful weapon in the hands of government by means of which it can achieve the objectives of development.

The principle objectives of fiscal policy are given below : 

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 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 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, issue of government bonds, etc., loans from domestic and foreign parties and by deficit financing. 

2. Efficient Allocation of Financial Resources

The central and state governments have tried to make efficient allocation of financial resources. These resources are allocated for development activities which includes expenditure on railways, infrastructure, etc. While non-development activities includes expenditure on defence, interest payments, subsidies, etc. But generally the fiscal policy should ensure that the resources are allocated for generation of goods and services which are socially desirable. Therefore, India's fiscal policy is designed in such a manner so as to encourage production of desirable goods and discourage those goods which are socially undesirable. 

3. 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. 

4. Price Stability and Control of Inflation

One of the main objective 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. 

5. Employment Generation

The government is making every possible effort to increase employment in the country through effective fiscal measure. Investment in infrastructure has resulted in direct and indirect employment. Lower taxes and duties on small-scale industrial (SSI) units encourage more investment and consequently generates more employment. 

6. Balanced Regional Development

Another main objective of the fiscal policy is to bring about a balanced regional development. There are various incentives from the government for setting up projects in backward areas such as cash subsidy, concession in taxes and duties in the form of tax holidays, finance at concessional interest rates, etc. 

7. Reducing the Deficit in the Balance of Payment

Fiscal policy attempts to encourage more exports by way of fiscal measures like exemption of income tax on export earnings, exemption of central excise duties and customs, exemption of sales tax and octroi, etc. The foreign exchange is also conserved by providing fiscal benefits to import substitute industries, imposing customs duties on imports, etc. The foreign exchange earned by way of exports and saved by way of import substitutes helps to solve balance of payments problem. In this way adverse balance of payment can be corrected either by imposing duties on imports or by giving subsidies to export. 

8. Capital Formation

The objective of fiscal policy is to increase the rate of capital formation so as to accelerate the rate of economic growth. An underdeveloped country is trapped in vicious circle of poverty mainly on account of capital deficiency. In order to increase the rate of capital formation, the fiscal policy must be efficiently designed to encourage savings and discourage and reduce spending. 

9. Increasing National Income

The fiscal policy aims to increase the national income of a country. This is because fiscal policy facilitates the capital formation. This results in economic growth, which in turn increases the GDP, per capita income and national income of the country. 

10. Development of Infrastructure

Government has placed emphasis on the infrastructure development for the purpose of achieving economic growth. The fiscal policy measure such as taxation generates revenue to the government. A part of the government's revenue is invested in the infrastructure development. Due to this, all sectors of the economy get a boost. 

The objectives of fiscal policy such as economic development, price stability, social justice, etc. can be achieved only if the tools of policy like public expenditure, taxation, borrowing and deficit financing are effectively used. The success of fiscal policy depends upon taking timely measures and their effective administration during implementation.

 Instruments of Fiscal Policy

Fiscal policy is an important instrument to stabilize the economy, that is, to overcome recession and control inflation in the economy. Fiscal policy through variations in government expenditure and taxation profoundly affects national income, employment, output and prices. An increase in public expenditure during depression add the aggregate demand 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 thereby increasing consumption and investment expenditures of the people.

On the other hand, a reduction of public expenditure during inflation reduces aggregate demand, national income, employment, output and prices while an increase in taxes tends to reduce disposable income, and thereby reduces consumption and investment expenditures. Thus the government can control deflationary and inflationary pressures in the economy by a judicious combination of expenditure and taxation programmes. 

Fiscal policy is of two kinds- Discretionary fiscal policy and nondiscretionary fiscal policy of automatic stabilizers. By discretionary policy we mean deliberate change in the government expenditure and taxes to influence the level of national output and prices. Fiscal policy generally aims at managing aggregate demand for goods and services. On the other hand, non-discretionary fiscal policy of automatic stabilizers is a built- in tax or expenditure mechanism that automatically increases aggregate demand when recession occurs and reduces aggregate demand when there is inflation in the economy without any special deliberate actions on the part of the government. 

At the time of recession the government increases its expenditure or cuts down taxes or adopts a combination of both. On the other hand, to control inflation the government cuts down its expenditure or raises taxes. In other words, to cure recession expansionary fiscal policy and to control inflation contractionary fiscal policy is adopted. Fiscal policy aims at changing aggregate demand by suitable change in government spending and taxes. Thus, fiscal policy is mainly a policy of demand management. When the government adopts expansionary fiscal policy to cure recession, it raises its expenditure without raising taxes or cut down taxes without changing expenditure or increases expenditure and cuts down taxes as well. With the adoption of any of these types of expansionary fiscal policy government’s budget will have a deficit. Thus expansionary fiscal policy to cure recession and unemployment is a deficit budget policy. On the other hand, to control inflation, government reduces its expenditure or increases taxes or adopts a combination of the two, it will be planning for a budget surplus. Thus policy of budget surplus or at least reducing budget deficit is adopted to remedy inflation. 

The various instruments of fiscal policy are

1. Budgetary Policy – Contra Cyclical Fiscal Policy

The budget is the principle instrument of fiscal policy. Budgetary policy exercises control over size and relationship of government receipts and expenditures. There are two common budget policies that can be adopted for stabilizing the economy.  

A. Budget Deficit-Fiscal Policy During Depression:

Deficit budgeting is an important method of overcoming depression. When government expenditures exceed receipts, larger amounts are put into the stream of national income than they are withdrawn. The deficit represents the net expenditure of the government which increases national income by the multiplier times the increase in net expenditure. Thus the budget deficit has an expansionary effect on aggregate demand whether the fiscal process leaves marginal propensities unchanged or whether a redistribution of disposable receipts occurs.

Budget deficit may also be secured by reduction in taxes and without government spending. Reduction in taxes tends to leave larger disposable income in the hands of the people and thus stimulates increased consumption expenditure. This, in turn, would lead to increase in aggregate demand output, income and employment. However, reduction in taxes is not so expansionary via increased consumption expenditure because the tax relief may be saved and not spent on consumption. 

B. Surplus Budget-Fiscal Policy During Boom:

Surplus in the budget occurs when the government revenues exceed expenditures. The policy of surplus budget is followed to control inflationary pressures with in the economy. It may be through increase in taxation or reduction in government expenditures or both. This will tend to reduce income and aggregate demand by the multiplier times the reduction in government and private consumption expenditure. There may be budget surplus without government spending when taxes are raised. Enhanced taxes reduce the disposable income with the people and encourage reduction in consumption expenditure. The result is fall in aggregate demand, output, income and employment. 

 2. Compensatory Fiscal Policy

The compensatory fiscal policy aims at continuously compensating the economy against chronic tendencies towards inflation and deflation by manipulating public expenditures and taxes. It, therefore, necessitates the adoption of fiscal measures over the long run rather than once for all measures at a point of time. When there are deflationary tendencies in the economy, the government should increase its expenditures through deficit budgeting and reduction in taxes. This is essential to compensate for the lack in private investment and to raise effective demand employment, output and income with in the economy. On the other hand, when there are inflationary tendencies, the government should reduce its expenditures by having a surplus budget and raising taxes in order to stabilize the economy at the full employment level.

The compensatory fiscal policies have two approaches –

A.) Built – in stabilizers and ,

B.) Discretionary fiscal policy. 

A. Built-in-Stabilizers :

The technique of built-in flexibility or stabilizers involves the automatic adjustment of the expenditures and taxes in relation to cyclical up swings and down swings with in the economy without deliberate action on the part of the government. Under this system changes in the budget are automatic and hence this technique is also known as one of automatic stabilization. The various automatic stabilizers are corporate profits tax, income tax, excise taxes, old age, survivors and unemployment insurance and unemployment relief payments. As instruments of automatic stabilization, taxes and expenditures are related to national income given an unchanged structure of tax rates, tax yields vary directly with movements in national income, while government expenditures vary inversely with variations in national income. In the downward phase of the business cycle when national income is declining, taxes which are based on a percentage of national income automatically decline, thereby reducing the tax yield. At the same time, government expenditures on unemployment relief and social security benefits automatically increase. Thus there would be an automatic budget deficit which would counteract deflationary tendencies. On the other hand, in the upward phase of the business cycle when national income is rising rapidly, the tax yield would automatically increase with the rise in tax rates. Simultaneously, government expenditures on unemployment relief and social security benefits automatically decline. These two forces would automatically create a budget surplus and thus inflationary tendencies would be controlled automatically. 

B. Discretionary Fiscal Policy:

Discretionary fiscal policy requires deliberate changes in the budget by such actions as changing tax rates or government expenditures or both.

It may generally take three forms:

i) Changing taxes with government expenditure constant,

ii) Changing government expenditure with taxes constant and

iii) Variations in both expenditures and taxes simultaneously.

The First method is, when taxes are reduced, while keeping government expenditure unchanged, they increase the disposable income of household and businesses. This increases private spending, but the amount of increase will depend on whose taxes are cut, to what extent and on whether the tax payers regard the cut temporary or permanent. If the beneficiaries of tax cut are in the higher middle income group, the aggregate demand will increase much. It they belong to the lower income group, aggregate demand will not increase much. It they are businessmen with little incentives to invest, tax reduction will not induce them to invest. Lastly, if the tax payers regards tax reductions as temporary, this policy will again be less effective so this policy is more effective in controlling inflation by raising taxes because high rate of taxation will reduce disposable income of individuals and businesses there by curtailing aggregate demand.

The second method is more useful in controlling deflationary tendencies, when the government increases its expenditure on goods and services, keeping taxes constant, aggregate demand goes up by the full amount of the increase in government spending. On the other hand, reducing government expenditure during inflation is not so effective because of high business expectations in the economy which are not likely to reduce aggregate demand. 

The third method is more effective and superior to the other two methods in controlling inflationary and deflationary tendencies. To control inflation, taxes may be increased and government expenditure reduced. On the other hand, taxes may be increased and government expenditure be raised to fight depression. 

To conclude that automatic stabilizers reduce the intensity of business fluctuations, that is both recession and inflation, however, the automatic or built-in stabilizers cannot alone correct the recession and inflation significantly. 

Therefore, The role of discretionary fiscal policy, namely, deliberate and explicit changes in tax rates and amount of government expenditure are required to cure recession and curb inflation.