BEE (2019-20) Handout-08

OBJECTIVES AND TOOLS OF FISCAL POLICY

INTRODUCTION:
The word 'fisc' means 'government treasury' and 'fiscal policy' refers to policy concerning the use of 'government treasury' or the
government finances to achieve certain macroeconomic goals. A narrow concept of fiscal policy is budgetary policy. While
budgetary policy refers to current revenue and expenditure of the financial year, fiscal policy refers to budgetary operations
including both current and capital receipts and expenditure. The essence of fiscal policy lies, in fact, in the budgetary operations of
the government. The two sides of the government budget are receipts and expenditure. The total receipts of the government are
constituted of tax and non-tax revenue and borrowings. The government expenditure refers to the total expenditure made by the
government in the fiscal year. The total government expenditure consists of payments for goods and services, wages and salaries,
interest and loan repayments, subsidies, pensions and grants-in-aid, and so on. From economic analysis point of view, receipt
items give the measure of the flow of money from the private sector to the government sector. The government expenditure, on
the other hand, represents the flow of money from the government to the economy as a whole. The government receipts are
inflows and expenditures are outflows. The government can, by using its statutory powers, change the magnitude and composition
of inflows and outflows and thereby the magnitudes of the macroeconomic variables – aggregate consumption expenditure and
private savings and investment. The magnitude and composition of inflows and outflows can be altered by making changes in
taxation and government spending. The policy under which these changes are made is called fiscal policy.

OBJECTIVES OF FISCAL POLICY:

Fiscal policy has following main objectives:
A. Economic growth: Given the manpower, technology and the natural resources, the growth rate of a country depends on
the rate of savings and investment. Therefore, the roles that are assigned to fiscal policy in this regard are to create
conditions for increase in private savings and investment and to enhance investment in the public sector. In order to
promote savings, the rate of income tax is reduced; tax incentives are provided for savings; and corporate sector is
provided with a number of incentives and concessions to promote private investment. Such incentives and concessions
include tax holidays, high depreciation allowance, development rebate for capacity expansion, investment subsidies,
exemption of import duties on capital imports, and so on.
B. Employment: According to the Keynesian theory of employment, all fiscal measures that accelerate the pace of economic
growth promote employment also. However, employment would not keep pace with growth if there is increasing use of
capital-intensive or labour-saving technology in general in the process of growth. In such situation, the government can
use its expenditure measure to promote employment. The government needs to allocate an adequate sum to labour-
intensive public works programs like construction of roads, dams, canals and bridges, schools, colleges and hospitals, etc.
The government may also be required to undertake employment-specific projects.
C. Stabilization: Economic stability is one of the important objectives of fiscal policy. It implies that the government needs
to adopt contra-cyclical fiscal policy. To fight recession/depression the government needs to increase its spending and cut
down its taxation which will boost aggregate demand in the economy. During the boom period, the economy expands at
a faster rate. But there is generally a risk of overheating the economy, making the economy to down turn. Overheating of
an economy occurs when its productive capacity is unable to keep pace with growing aggregate demand. It is generally
characterized by an above-trend rate of economic growth, where growth is occurring at an unsustainable rate. In case of
overheating inflation increases due to prolonged good growth rate. When there are indications of overheating of the
economy, the government is required to control the growth rate. Thus, the government has to increase taxation and cut
down its spending with the objective of controlling rise in aggregate demand.
D. Economic Equality: Fiscal policy is a powerful instrument of reducing economic disparities. Both taxation and
expenditure measures are used to reduce income and wealth gaps between rich and poor. Tax policy aimed at economic
equality includes: (a) taxation of personal and corporate incomes at progressive rates; (b) imposition of wealth and
property tax; and (c) taxation of high priced and luxury goods at higher rates. Government expenditure policy to reduce
economic inequality include: (a) spending government money on projects that enhance the earning capacity of the low
income people like free education and medical facility; (b) re-allocation of capital expenditure so as to enhance the
employment opportunities for unemployed and underemployed people; (c) making provision for financial aid for the
unemployed for their self-employment; and (d) making provision for unemployment relief. These tax and expenditure
measures make two-way attack on economic disparity. Tax measures limit the growth of incomes in the high-income
groups and transfer a part of rich people's income to the government treasury which enhances government resources to
help the poor. Expenditure policy, on the other hand, creates condition for the growth of incomes in low-income groups,
especially when it is at employment promotion.
E. External Balance: External imbalances arise when external payment obligations exceed the foreign exchange earnings. A
short-run gap of small magnitude does not cause much concern. But, when the gap between foreign payment obligations
and the external earnings is of large magnitude and persistent, and BoP deficit increases over time, it becomes a matter of
serious concern. This gap arises mainly due to unfavorable trade balance or current account deficits. Fiscal policy,
especially tax policy, can be used as an effective tool of restoring the external balance where current account deficits
increase mainly due to the widening gap between exports and imports. The fiscal measures that are adopted for this
purpose are: (a) imposition of heavy import duty, especially on the import of consumer goods, and (b) subsidization of
exports. These measures, however, work efficiently only when both imports and exports are price-elastic and
countervailing measures are not adopted by the trading partners.
INSTRUMENTS OF FISCAL POLICY:
Fiscal instruments refer to the budgetary measures which the government uses and manipulates to achieve some predetermined
objectives. The major fiscal instruments include budgetary policy (deficit or surplus budget policy), government expenditure,
taxation and public borrowings.
A. Budgetary policy: In narrow sense of the term, budgetary policy refers to government's plan to keep its budget in balance
(balanced budget policy), in surplus (surplus budget policy) or in deficit (deficit budget policy). Balanced, deficit and
surplus budgets affect the economy in different ways, to different extents, and in different directions.
B. Government expenditure: The government expenditure includes total public spending on purchase of goods and services,
payment of wages and salaries to public servants, public investment, infrastructure development, transfer payments (e.g.,
pensions, subsidies, unemployment allowance, grants and aid, payment of interest, and amortization of loans). The
government expenditure is an injection into the economy; it adds to the aggregate demand. The overall effect of
government expenditure on the economy depends on how it is financed and what is its multiplier effect.
C. Taxation: A tax is a non quid pro quo payment by the people to the government, i.e., tax is a payment by the people to
the government against which there is no direct return to the taxpayers. Taxes are classified as direct taxes and indirect
taxes. Direct taxes include taxes on personal incomes, corporate incomes, wealth and property. Personal income tax and
corporate income tax are the two most important direct taxes imposed by the central government in India. Indirect taxes
include taxes on production and sale of goods and services. Indirect taxes are also called as commodity taxes. In India,
the two most important central indirect taxes are excise duty (or VAT) and customs.
D. Public borrowings: Public borrowings include both internal and external borrowings. The governments make borrowings,
generally, with a view to financing their budget deficits. Internal borrowings are of two types: (i) borrowings from the
public by means of government bonds and treasury bills, and (ii) borrowings from the central bank. The two types
borrowings have different effects on the economy. Borrowing from the public is, in effect, simply a transfer of
purchasing power from the public to the government, whereas borrowing from the central bank for financing budget
deficits is straightway an injection into the economy. External borrowings include borrowings from (a) foreign
governments, (b) international organizations like World Bank and IMF, and (c) market borrowings. External borrowing
has the same effect on the economy as borrowing from central bank.

Out of above 4 fiscal instruments, government expenditure and taxation are the most important instruments of fiscal policy.

TARGET VARIABLES OF FISCAL POLICY:

In the Keynesian framework of analysis, the ultimate target variable of fiscal policy is the intended change in the aggregate
demand. The change in the aggregate demand is sought through the change in its various components and level, and in the price
structure. The target variables of fiscal policy, i.e., the variables which are sought to be changed through fiscal instruments
include: (a) Private disposable incomes, (b) Private consumption expenditure, (c) Private saving and investment, (d) Exports and
imports, and (e) Level and structure of prices. Fiscal instruments and target variables are interrelated and interdependent.
Therefore, a change in one policy variable affects all other macro variables. For example, a change in taxation changes first the
disposable income which in turn changes the consumption expenditure, savings and investment. Thus, the government can change
the aggregate demand: (a) by changing aggregate consumption expenditure by changing disposable income through direct
taxation, (b) by changing imports through tariffs, (c) by changing investment through tax incentive or disincentive, and (d) by
changing government expenditure. The aggregate demand can be changed by changing any one or more of these factors.

TYPES OF FISCAL POLICY

 Contractionary Fiscal policy: Contractionary Fiscal Policy is used to fight high rate of inflation by tax increase and/or
decrease in government spending which reduces aggregate demand in the economy. Such policy may control inflation, but at
the same time it will constrain growth and developmental activities.
 Expansionary Fiscal policy: Expansionary Fiscal Policy is used to fight a recession or a slowdown by a tax reduction and /or
increase in government spending which increases aggregate demand in the economy. Expansionary fiscal policy will boost
growth of the economy but at the same time it can fuel inflation in the economy.

BUDGET CONCEPTS
The two major heads of the budget are the receipts and the expenditure. Receipt items show the flow of money from private sector
to the government sector. The government expenditure on the other hand, represents flow of money from government to the
economy as a whole.

Receipt Budget
A. Revenue receipt: All government receipts which neither create liability nor reduce assets of Government are called
revenue receipts
a. Tax revenue
i. Corporation tax
ii. Income tax
iii. Wealth tax
iv. Customs duty
v. Union Excise duty
vi. GST
b. Non-Tax revenue
 i. Interest receipts
ii. Dividends and profits from public sector enterprises
iii. Fiscal services
iv. General services (administration, police, etc)
v. Social services (education, medical, etc)
vi. Economic services (agriculture, animal husbandry, dairy, etc)
vii. Railway revenue
viii. Grants-in-aid from international organizations and other countries
ix. Non-tax revenue of Union Territories
B. Capital Receipt: Government receipts that either create liabilities (e.g., borrowing) or reduce assets (e.g., disinvestment)
are called as capital receipts. Thus when government raises funds either by incurring a liability or by disposing off its
assets, it is called as capital receipt.
a. Recoveries of loans
b. Other receipts (disinvestment)
c. Borrowings

Expenditure budget

A. Revenue expenditure: An expenditure that neither creates assets nor reduces liabilities is categorized as revenue
expenditure. Generally, expenditure incurred on normal running of the government departments and maintenance of
services is treated as revenue expenditure. Examples are give below:
a. Salaries of government employees
b. Interest payment on loans taken by the government
c. Pensions
d. Subsidies
e. Grants
f. Rural development
g. Education and health services, etc
B. Capital expenditure: An expenditure which either creates an asset (e.g., school building) or reduces liability (e.g.,
repayment of loan) is called capital expenditure. Examples are:
a. Expenditure on land, buildings, machinery
b. Loans to state/foreign governments
c. Acquisition of valuables
d. Repayment of loan

Deficit Concepts:
Revenue Deficit: refers to the excess of revenue expenditure over revenue receipts.
Effective Revenue Deficit: is the difference between revenue deficit and grants for creation of capital assets.
Fiscal deficit: is the difference between the revenue receipts plus non-debt capital receipts and the total expenditure. This indicates
the total borrowing requirements of Government from all sources.
Primary deficit: is measured by fiscal deficit less interest payments.

Public Borrowings
 A deficit Budget leads to public borrowings. Public borrowings include both internal and external borrowings. Internal
borrowings are from public through government bonds or treasury bills. External borrowings include borrowings from
foreign governments and international organizations.
 Public borrowings and crowding out: When government borrows from the market, it sells bonds. As a result bond prices
fall and interest rates go up. High interest rates contract private investment or crowd out private investment. On the other
hand, increase in government spending increases aggregate demand in the economy due to which demand for money rises,
leading to a rise in interest rates. Crowding out effect can be represented as follows:
Y= C + I + G + G -  I
Amount of crowding out depends on: rise in interest rates and interest elasticity of investment (as I=Ia-hr).
 Public borrowings and crowding in: When government borrows to finance additional spending, aggregate demand
increases. To meet additional demand, additional investment needs to be made in capital stock. Thus deficit spending by
government may lead to crowding in of private investment. The extent of crowding out and crowding in due to increase in
government spending may vary in different economies and at different times.