Concept of Fiscal Policy
A fiscal policy controls the government’s expenditures and receipts. It is the government’s budgetary policy. It operates through changes in government expenditures, taxation and public borrowing. A compensatory fiscal policy is when government expenditures and receipts are manipulated to achieve national objectives, such as high employment, price stability, economic growth, and balance of payments equilibrium.The government’s expenditures and revenues are used to produce desirable effects while avoiding negative effects on national income, employment, and production.
A government’s fiscal policy involves taxation, expenditures, and other financial operations to achieve certain national goals.The government uses this tool to regulate or modify the economic affairs of an economy.
The fiscal policy of a government includes measures of public expenditures, public revenues, and public debt or borrowing. Fiscal policy is concerned with the aggregate effect of government expenditure and taxation on income, production, and employment. An exercise where the government controls the public budget in order to achieve predetermined macroeconomic goals. Functional finance is an application of the principle of fiscal policy in the modern world. By adjusting the fiscal measures, inflation or deflation can be controlled, i.e. according to the changing conditions of the economy.Taxation and expenditure policies of a government, which together comprise its budget. Fiscal policy is government spending that influences macroeconomic conditions. The effect of these policies is to control the economy by influencing tax rates, interest rates, and spending.
Objectives of Fiscal Policy
a) To Allocate Resources Optimally
Economic resources, such as men, money, materials, and so on, should be used effectively and allocated optimally as they are a function of fiscal policy. The government should also avoid wasting resources and ensure maximum productivity from economic resources.
b) To maintain Price Stability
The government should also avoid wasting resources and ensure maximum productivity from economic resources. Economic activity decreases with falling prices (or depression) while steeply rising prices (or inflation) are beneficial to traders and speculators. By fighting inflationary and deflationary trends in the country, fiscal policy should aim to ensure price stability.
c) To Reduce Economic Inequalities through Equitable Distribution of Income and Wealth
The fiscal policy of a welfare state should aim to reduce economic inequality between the rich and the poor to the maximum degree possible. It should ensure a fair distribution of income and wealth among different sections of society.
d) To provide Full Employment
Providing and maintaining full employment is the ultimate objective of all economic policy, including fiscal policy. The economy can grow in proportion to the population growth if the economy keeps growing at the same pace. To ensure that the increase in income, and this in turn, increases employment opportunities, fiscal policy should be constructed in such a way as to ensure that the increase in income exceeds the increase in population.
e) To foster Economic Growth
The least developed countries are trapped in an endless cycle of poverty due primarily to a lack of capital. The basic goal of fiscal policy in a least developed country is to accelerate economic productivity and capital formation.
Instruments of Fiscal Policy
a) Public Expenditure
In underdeveloped countries, government expenditure is vital to meet the development requirements of heavy investment, as well as due to a lack of private initiative. Due to their risk and low and slow returns, private entrepreneurs are reluctant to invest in socially desirable and productive channels in these countries. The government has a responsibility to make these investments and create the basic infrastructure for economic development. Public expenditures contribute to economic development in the following ways:
- Increasing the rate of economic growth.
- Creating more job opportunities.
- Raising the standard of living of the people.
- Minimizing income and wealth disparities.
- Fostering entrepreneurship and private initiative.
- Bringing regional balance to the economy.
Taxation and public borrowing systems influence the efficiency of fiscal policy. For developing countries, taxation has historically been the most effective instrument of fiscal policy. Borrowing from the public will likely result in higher interest rates, which will adversely affect private investment. The banks tend to raise funds by raising prices. Taxation is the only means of decreasing private consumption and transferring resources to the government for economic development under such conditions. Taxation can be used for the following purposes in order to promote economic development:
- Reducing consumption and thereby shifting investment funds from consumption to investment.
- To increase the incentive to save and invest, i.e. taxes should be imposed so that, while taking away a portion of income, they also provide encouragement to save and invest.
- The transfer of public resources to the government for more productive utilization through public investments.
- Through incentives like tax rebates, tax holidays, etc., to modify the pattern of private investment in the economy; i.e., to encourage private investment in more productive channels.
- Adopt a progressive tax system in order to reduce economic inequality.
- Increase the use of agricultural surplus for development.
c) Developmental Canons of Taxation
According to Adam Smith, there are four Canons of taxation: equity, certainty, convenience, and economy. In order to make these cannons more relevant to the conditions and problems of developing countries, they have been revised. The goods tax regime must meet the following criteria in these countries:
- There must be minimal adverse effects on production.
- Incentives should be provided to encourage saving and investment, resulting in the optimum allocation of resources.
- Essential consumption should not be curtailed.
- Taxes should be based on each individual’s ability to pay.
- Taxes should prevent the economy from being distorted by distributing resources in the wrong way.
- They should prevent consumption from increasing proportionately to income.
- It should maximize tax revenue and minimize tax collection costs in accordance with the canon of economy.
- Anti-inflationary measures should be taken.
d) Tax System
It is essential that taxation increases to meet the government’s development expenditures, but tax collection is an exceedingly difficult task. Additionally, taxation increases are dependent on the country’s taxing capacity and the kinds of taxes it can levy. Improving the tax system is therefore essential in order for the country to increase its tax revenue. Some of the most important changes include:
- Increasing taxable capacity. To achieve this, the government must optimize tax collection efficiency and minimize tax burdens.
- Tax structures should be improved. In order to achieve a balanced economic development in the country, various tax rates should be chosen so that they can increase saving and encourage productive investment.
e) Role of Public Borrowing
Other important sources of financing economic growth are public borrowings. It is an anti-inflationary source of mobilizing resources if the public lends that part of their income that would otherwise be spent. Public borrowing is a better tool than taxation in certain respects:
- Taxation is forced saving, borrowing is voluntary.
- While taxpayers don’t expect their money back, lenders lend it to them in order to get it back with interest.
- By contrast with taxation, borrowing may not adversely affect incentives to save and invest due to the lure of interest earnings.
In underdeveloped countries, public borrowing is limited by low levels of savings and income, large spending on unproductive channels by the rich, and a non-existent or small and ineffective government security market. The general public must also have trust in the government’s stability as well as a lack of inflation threat in order for public borrowing to succeed.
Importance of Fiscal Policy
a) Resources Mobilization
The primary aim of fiscal policy in underdeveloped countries is to mobilize resources from the private and public sectors. As a result of low savings rates, the national income and per capita income are very low. So, such governments push the rate of investment and capital formation through forced saving, which in turn accelerates the pace of economic development in such countries. The government also conducts planned investments in the public sector.
Inflation can be controlled in the economy by increasing private investment, curtailing conspicuous consumption and investing in unproductive channels. A further problem is the influx of foreign capital; therefore, public finance is necessary, as well as taxation and forced loans, to help increase the incremental saving ratio.
b) Accelerating the rate of growth
Increasing the rate of public as well as private investment is one way that fiscal policy accelerates economic growth. The use of various tools of fiscal policy such as taxation, public borrowing, deficit financing and excesses of public enterprises should be done in a balanced manner so as not to negatively affect consumption, production, and distribution of wealth.
Prof. J. Chelliah believes that a balanced development of agriculture and business is the most effective path toward achieving balanced economic growth. The two pillars of economic development in an underdeveloped economy are investment in basic and capital goods industries. In order to accelerate the growth of an economy all round, such investments should be given top priority.
c) Encouraging socially optimal investment
The fiscal policy of underdeveloped countries encourages investment in those productive channels considered economically and socially desirable. Accordingly, optimal investments are those which promote economic development and avoid wasteful and unproductive investments. Fiscal policy should focus on investing in infrastructure such as transportation, communication, training programs, education, health, and soil conservation.
By increasing productivity and extending the market to external economics, they tend to broaden the market. Meanwhile, unproductive investment is checked and diverted towards socially desirable and productive investment channels.
d) Boosting capital formation and investment
A fiscal policy plays a crucial role in underdevelopment countries by directing investments to strategic industries and services of public utility on the one hand, and by encouraging private sector investment by giving assistance to new industries and introducing modern production methods on the other. Therefore, investment in social overheads enables raising the social marginal productivity and, in turn, raising the marginal productivity of private capital formation and investment.
In this case, optimal patterns of investment can also yield fruitful results of economic development. Economic development entails changes in population size, tastes, knowledge, and social institutions, as it is the most dynamic process. The fiscal policy should be designed to raise social marginal productivity in social desirable projects and to divert resources to those productive channels where the social marginal productivity is highest.
e) Creating more job opportunities
Population growth is very rapid in developing countries. In such countries, fiscal policy is intended to increase employment opportunities by making high levels of expenditures and to reduce disguised unemployment and underemployment in rural areas in particular. Efforts should be made to introduce community development programs that involve more labour and less capital per person. In addition, tax concessions, tax holidays, cheap loans, and subsidies should be implemented to encourage private enterprise.
In addition to eradicating unemployment, this process will generate more employment opportunities for the domestic economy. More social amenities should be provided by the state, as well as an increased focus on family planning. Increased employment opportunities are meaningless if the population is not controlled.
f) Enhancing economic stability
The fiscal policy of a developing country also plays an important role in ensuring reasonable internal and external economic stability. Developing countries are generally susceptible to the effects of international cyclical fluctuations. Their main export is primary products, while they import manufactured goods and capital goods.
It is, however, important to view fiscal policy from a longer perspective in order to minimize the effects of international cyclical fluctuations. Diversification of the economy as a whole must be the goal. In order to achieve balanced growth and to reduce the effect of cyclical fluctuations, deficit budgeting and inflation are the most suitable measures for achieving balanced growth. A public works program financed with deficits can have significant effects in a recession. It is certain that an increase in purchasing power would cause inflationary pressures which can be controlled through preventive measures. A policy of this sort, however, must be accompanied by appropriate monetary measures.
g) Checking inflationary tendencies
Developing countries are afflicted by inflationary tendencies due to their heavy investment in their development activities. As a result, real resources are always in short supply compared to their demand. Demand rises as purchasing power increases, but supply remains inelastic due to structural rigidities, market imperfections, and other bottlenecks, which in turn lead to inflationary pressures.
Due to the rise in income of the people, the aggregate demand exceeds the aggregate supply. Consumer goods and capital goods cannot keep up with rising income. This leads to wage increases. It is natural and desirable for there to be mild inflation in a developing economy, but a galloping inflation distorts the economy.
h) Inequality is Reduced
Fiscal policy plays an important role in reducing inequality in underdeveloped countries due to the large income and wealth disparities. Fiscal measures to reduce the gap between poverty and prosperity include progressive taxation, heavy taxes on the rich, and exemption or tax concessions for goods of mass consumption, government assistance programmes, inputs for small businesses and agricultural farms, and provision of essential products at low prices to the poor.
Thus, fiscal policies play a significant role in removing these inequalities of income and directing these resources into productive channels for economic development.
Crowding-Out and Crowding-In Effect
Crowding out effect occurs when an increase in interest rates reduces private investment spending in a manner that dampens the initial increase in total investment spending. When the government increases its spending to boost economic growth, it adopts an expansionary fiscal policy stance. This increases interest rates. High interest rates affect private investment decisions. In an economy with a high magnitude of the crowding out effect, income may decrease. As interest rates increase, the cost of investing funds increases and makes debt financing less accessible. In the end, this causes less investment to be made and crowds out the effect of the initial increase in investment spending. Taxes and borrowing are usually used to fund the initial increase in government spending.
By initializing spending (whether by the government or tax-cut recipients), new income is created for other individuals, who continue to spend a portion of this income, thereby creating more income for still more individuals, and so on. The result of this series of income additions means that the total amount of GDP increases by more than the original increase in government expenditures or reduction in taxes. Multiplier refers to the increase in real GDP divided by the increase in spending. The standard Keynesian view implies a multiplier greater than one. Increasing the total demand for a nation’s output through expansionary policies is less effective because of the crowding-out effect.
Difference between Crowding-Out and Crowding-In Effect
The crowding-out effect of government spending on private investment can be seen directly or indirectly. Direct crowding-out occurs when physical resources available to the private sector are reduced, whereas indirect crowding-out occurs when interest rates and prices rise.
When private expenditure doesn’t decrease with an increase in government expenditure, there is no crowding expenditure crowding out effect. High public investment leads to an increase in private investment, which is the most likely cause of the crowding-in effect. Government investment leads to an increase in private investment through the crowding-in effect.
According to the Ricardian equivalence proposition (also known as the RiCardo-De Viti-Barro equivalence thesis), consumers are forward-looking and internalize a government’s budget constraint when deciding which products or services to purchase. This results in the finding that, for a given amount of government spending, the method of financing that spending does not influence the consumption decisions of agents, and thus does not affect aggregate demand. This theorem is therefore used to argue against tax cuts and spending increases intended to boost aggregate demand.
The concept of Ricardian Equivalence has been invoked by some economists to argue that government spending will not stimulate aggregate demand. Our goal in this paper is to explain the idea of Ricardian Equivalence, explain why it is controversial among economists, and explain how the idea and criticisms that stem from it apply to current debates about fiscal policy. The government finances its spending in modern times through two methods: taxation and borrowing. When taxation is used, current taxpayers fund government spending. A government is required to pay the interest on its debt if it borrows money to fund its activities and if its bonds aren’t defaulted on by the government when it borrows (what economists call a “government budget constraint”). Deficits allow governments to avoid taxation when they spend, but borrowing simply shifts future tax burden onto future taxpayers. According to Ricardian Equivalence, the question for our purposes is whether this shift in the timing of taxation affects the ability of government spending to stimulate (or constrain aggregate demand).
Stabilization through Fiscal Policy
Governments and central banks implement macroeconomic strategies to stabilize economic growth, price levels, and unemployment. As part of ongoing stabilization policy, benchmark interest rates are adjusted to control aggregate demand in the economy. By stabilizing gross domestic product (GDP) and inflation, the employment rate is generally also moderately affected. It is important to avoid erratic changes in total output as measured by Gross Domestic Product (GDP). In order to highlight the role played by fiscal policy in stabilizing economic activities, the following points can be used:
- Economic conditions can be influenced by fiscal policy, and policy lags do not seem to preclude the use of discretionary policy for stabilization purposes.
- Despite budget restrictions that might make such interventions more difficult, governments have not lost their taste for using fiscal policy to achieve short-term goals.
Although automatic stabilizers play an important role, higher marginal tax rates may lead to longer-run economic distortions. Taxes and transfers that affect individuals lower in the income distribution may become the focus of automatic stabilizers in the future, as demand effects and distortions may be greater there. Fiscal policies that rely on policy durability may be less effective as budget pressures increase. The same forces may be applied to tax cuts that work by intertemporal substitution. Most of those policies, however, are closely related to the purchase of durable goods, where there may be more of a risk of exacerbating rather than reducing fluctuations in economic activity. Thus, fiscal policy may be used to stabilize the economy, and formulated in part with this purpose in mind, although the instruments of discretionary and automatic fiscal stabilization policies may differ from traditional instruments. Although, based on theory and evidence, it remains unclear whether these policies will succeed or should be adopted as frequently as they have in the past.
Fiscal Policy Quiz/ MCQs
Who decides what problems should be addressed through fiscal policy?
a) special interest groups
b) college professors
c) government leaders
d) special task forces
One of the most significant fiscal policy objectives in India is to bring the revenue expenditures and receipts to the same level. Which of the following steps will help to achieve that objective?
a) The efforts to raise the total profits for public sector units
b) The efforts to improve the revenues from tax collection
c) The efforts to slow the growth rate for expenditures in the country
d) All of the above
Which of the following represents the most expansionary fiscal policy?
a) A $10 billion tax cut.
b) A $10 billion increase in government spending.
c) A $10 billion tax increase.
d) A $10 billion decrease in government spending
Which of the following items is classified as a Capital Receipt in the budget for the Government of India?
a) The receipts from the collection of income tax
b) The borrowings made by the government from the public
c) The dividends and profits received from the public sector units
d) The interest receipts for loans given by the government to its debtors
The problem of time lags in enacting and applying fiscal policy is that
a) in the time it takes to identify the situation, enact a policy, and allow it to work, economic circumstances may have changed.
b) for a policy to have its full effect on the economy, it must be enacted in three months; however, it usually takes longer.
c) there are offsetting circumstances that can occur in the private market.
d) discretionary fiscal policy only works in particular economic situations.
The importance of fiscal policy in a country like India is that ___________.
a) It plays a major role in increasing the rate of formation of capital both for public and private sector units
b) It aims to reduce the imbalance in the distribution of income and wealth
c) It helps to generate sufficient resources, through direct and indirect taxes, to finance the government projects
d) All of the above
Which of the following is not a part of the revenue receipts for the Government of India?
a) The receipts from the collection of interest amount from its debtors
b) The receipts from the collection of corporate taxes
c) The dividends and profits received from the public sector units
d) The receipts from disinvestment of public sector undertakings
Which of the following is the definition of a budget deficit?
a) Excess of the total expenditure over the total receipts minus interest payments and borrowings
b) Excess of the total expenditure over the total receipts minus borrowings
c) Excess of the revenue expenditure over the revenue receipts
d) Excess of the total expenditure over the total receipts
Which of the following is a development that can occur as a result of deficit financing?
a) The rise in inflation within the Indian economy
b) The improvement in money supply in the Indian economy
c) The increase in government debt
d) All of the above
Which of the following steps under the fiscal policy is an example for stabilising the economy?
a) Making payments towards unemployment insurance benefits
b) Making payments towards pensions for retired military personnel
c) Allocating more capital for spending on construction of national highways
d) Decreasing the supply of money within the economy
Which of the following is included as a part of the capital budget for the government of India?
a) Loans provided to foreign governments
b) Financial assistance provided by institutions like the World Bank and International Monetary Fund
c) Expenditure made towards acquiring of foreign aircrafts
d) All of the above
Which of the following is the best explanation for ‘Capital Gains Tax’ in India?
a) It is a tax levied on the profits from the selling of shares that were held for more than 12 months
b) It is a tax levied on the interest that was received from bank fixed deposits
c) It is a tax levied on the profits from the sale of a capital asset during the financial year
d) It is the tax levied on dividends received from corporate bonds
Which of the following is not a part of the development expenditure undertaken by the Government of India?
a) The grants provided to state governments
b) The expenditure towards providing community and social services
c) The expenditure towards providing economic services
d) The expenditure as a part of the defence budget
Which of the following is true about the annual budget prepared by the Government of India?
a) It is a part of the money-saving policy of the government
b) It is a part of the fiscal policy of the government
c) It is a part of the monetary policy of the government
d) It is a part of the commercial policy of the government
Which of the following describes the correct scenario if the Government of India fails to pass the budget?
a) The entire council of ministers have resigned and the government falls down
b) The Finance Minister requests the speaker of the house for extra time to pass the budget
c) The budget from the last year continues
d) None of the above
Which of the following is the correct meaning for the revenue budget?
a) It is the difference between revenue expenditure and revenue receipts
b) It is the total revenue deficit excluding grants in aid to create assets for states
c) It is the total revenue deficit including grants in aid for developing assets for states
d) It is the difference between total expenditure and total receipts