Fiscal policy

Meaning
Fiscal policy is the set of principles and decisions of a government regarding the level of
public expenditure and mode of financing them. It is about the effort of government to influence
the economy's output, employment and prices by altering the level of public expenditure,
taxation and public debt. Arthur Smithies points out, 'Fiscal policy is 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'.
The Importance of Fiscal Policy
The significance of this policy was not at all recognized by economists before the
publication of Keynes's General Theory of Employment, Interest and Money. Keynes gave the
concept of fiscal policy new meaning and operation of the public finance a new perspective. He
made it clear that taxation, public spending and public debt are the effective instruments of
public policy capable of determining the level of output and employment.
The importance of fiscal policy in modern economies arises from the fact that the State
under democracy is called upon to play an active and important role in promoting economic
development and providing a vast number of essential public utilities and services like drinking
water, sanitation, civic services, primary education, public health, social welfare, defence, etc.
Most of these goods are characterized by the property viz. non-marketable; that it cannot be sold
in the market to the consumer. But payment has to be regulated in another way, through taxation.
In the underdeveloped economies, public finance has to assume yet another role, whereas in
developed economies, it aims at maintaining economic stability. In underdeveloped economies,
desirous of achieving rapid economic development, the function of public finance is to promote
rapid economic development of the country, besides maintaining economic stability.

Objectives of fiscal policy

The principal objectives of fiscal policy in an economy are as follows:

1. To mobilize resources for financing the development programmes in the pubic sector

Tax policy is to be directed towards effective mobilization of all available resources and to
harness them in the execution of development programmes. This implies, on the one hand,
diversion of wasteful and luxury spending to saving and on the other hand productive investment
of increments that accrue to production as a result of development efforts. Taxation can be a
most effective means of increasing the total quantum of savings and investments in any economy
where the propensity to consume is normally high.

2. To promote development in the private sector

 In a mixed economy, private sector forms an important constituent of the economy. In spite
of the growing importance of the public sector in accelerating the process of economic
development, the interest of the private sector cannot be neglected. Therefore rebates, reliefs and
liberal depreciation allowances may be granted to boost the private sector.

3. To bring about an optimum utilization of resources

The above objective can be achieved through proper allocation of resources. We must direct
investment in the desirable channels both in the public and private sectors by providing suitable
incentives. Productive resources are, within limits capable of being used in various ways, which
may accelerate economic growth. The available resources must find their way into the socially
necessary lines of development.

4. To restrain inflationary pressures in the economy to ensure economic stability

The fiscal policy must be used as an instrument for dealing with inflationary or deflationary
situations. One way to achieve this is to devise a tax structure, which will automatically counter
the economic disturbances as they arise. The second is to make changes in the tax system in
order to deal with inflationary or deflationary situations. In countries like India, it is through the
direction of the public expenditure rather than taxation that more effective action can be taken to
remove the effect of a deflationary spiral. In terms of inflation, anti-inflationary taxes such as
excess profit tax and commodity taxes on articles of both general and luxury consumption can be
imposed.

5. To improve distribution of income and wealth in the community for lessening economic
inequalities

The national income should be properly distributed so that the fruits of development are
fairly shared by all people. Equality in income, wealth and opportunities must form an integral
part of economic development and social advance. Moreover, redistribution of income in favour
of the poorer sections of the society is essential. This can be achieved through taxation. We can
also achieve this through an increase in public expenditure for promoting welfare to the less
privileged class. Expenditure on agriculture, irrigation, education and health and medical
expenses will improve the economic conditions of the weaker sections of the society.

Fiscal policy can affect total spending. (aggregate demand determinant) in two ways. The
first is the direct change in total spending brought about by the government increasing or
decreasing its own expenditure. And the second one is increasing or reducing private spending
by varying its own tax revenue.
6. To obtain full employment and economic growth

The fiscal policy to achieve full employment and to maintain stable price in the economy
has been developed in the recent past. The ineffectiveness of monetary policy as a means to
remove unemployment during the Great Depression paved the way for the development of fiscal
policy in achieving this objective. For accelerating the rate of growth, allocation of higher
proportion of the fully employed resources is needed. Those activities increase the productive
capacity of the economy. Therefore fiscal policy is used through its tax instrument to encourage
investment and discourage consumption so that production may increase. It is also necessary to
increase capital formation by reducing the high income tax on personal income. To increase
employment, the state expenditure should be directed towards providing social and economic
overheads. The state should undertake local public works of community development involving
more labour and less capital per head.

7. Fiscal policy and capital formation

Fiscal policy such as taxes, tariffs, transfer payments, rebate and subsidies are expected to
spur long run economic growth through increased capital formation. Capital formation is
considered an important determinant of economic growth. The economic theory tells us that the
optimal amount of capital formation serves a useful key to economic growth in developing
economies. At the same time, the economic distortions brought about by lack of adequate fiscal
incentives can cause capital formation to fall short of the socially optimal level.

Limitations to fiscal policy

Though the fiscal policy has an important place in economic development and in particular,
in the stepping up of saving and investment both in public and in private sectors, it has the
following limitations.

1) Size of fiscal measures

The budget is not a mere statement of receipts and revenues of the government. It explains
and shapes the economic structure of a country. When the budget forms a small part of the
national income in developing economies, fiscal policy cannot have the desired impact on the
economic development. Direct taxation at times become an instrument of limited applicability, as
the vast majority of the people are not covered by it. Further, when the total tax revenue forms a
smaller portion of the national income, fiscal measures will not step up the sagging economy
requiring massive help.

2. Fiscal policy as ineffective anti-cyclical measure

 Fiscal measures- both loosening fiscal policy and tightening fiscal policy- will not stimulate
speedy economic growth of a country, when the different sectors of the economy are not closely
integrated with one another. Action taken by the government may not always have the same
effect on all the sectors. Thus we may have for instance the recession in some sectors followed
by a rise in prices in other sectors. An increasing purchasing power through deficit financing, a
policy advocated by J.M. Keynes in 1930s may not have the effect of reviving the recession hit
economies, but merely result in a spiralling rise in prices.

3. Administrative delay

Fiscal measures may introduce delay, uncertainties and arbitrariness arising from
administrative bottlenecks. As a result, fiscal policy fails to be a powerful and therefore a useful
stabilization policy.

Other Limitations

Large scale underemployment, lack of coordination from the public, tax evasion, low tax base is
the other limitations of fiscal policy.
What is the difference between discretionary and automatic fiscal policy?
Discretionary fiscal policy is the government actively making a change to spending or taxes.
Automatic fiscal policy happens as a result of taxes or government programs that are already in
place. For example in a recession more people will be out of work meaning welfare usage will
increase. This will automatically increase government spending without the government having
to make an active change.
Discretionary Fiscal Policy are tools used by the government to achieve their macroeconomic
goals of price stability and potential output so that the economy is stable. The economy can be in
one of three states: a recessionary gap, a healthy economy meeting its potential output, and an
inflationary gap. The government uses discretionary fiscal policy to help the economy get back
to a healthy state when its in either a recessionary gap where prices are deflated, unemployment
is high, and output is low or when it's in an inflationary gap where prices are inflated, output is
unsustainably high, and unemployment is unsustainably low. The main tools the government has
when enacting discretionary fiscal policy are changing the tax code or altering the level of
government spending (military being the biggest budget item) which can be updated year-by-
year.
It's important to know the difference between fiscal policy and monetary policy, because they
have the same end goals which can make it confusing. Fiscal policy is enacted by the
government and has to be approved by congress. Monetary policy is enacted by the central bank,
for instance the US Federal Reserve, which is not part of the government.
What is the Importance of Discretionary Fiscal Policy
The importance of discretionary fiscal policy can not be understated. It is vital to the health of a
country's economy, and is one of the best tools at dealing with recession or an economy that's
overheated. There are two main ways a government can deal with one of these issues, through
altering the tax code or changing the level of government spending. In either case, the goal is to
increase or decrease aggregate demand by altering the level of spending in the economy.
Aggregate demand measures the total amount of domestic goods and services demanded by
consumers, firms, the government, and foreign countries. When aggregate demand is increased,
firms have to increase output to match the new level, growing the economy's gdp. However,
prices also rise when aggregate demand is increased because companies can now charge more
for their goods. When aggregate demand decreases the opposite effect happens on both ouput
and price.
Instruments of Fiscal Policy
Instruments of Fiscal Policy Fiscal policy is based on a fundamental idea that it can influence the
total level of aggregate spending which further influence the income of the economy, corporate
bodies and individuals. There are five major instruments of fiscal policy which are used to
maintain stability and economic growth of an economy. They are given below:
 Budget: The government budget or the revenue and expenditure process of the
government (either balanced or unbalanced) can be used effectively to maintain stability
and economic growth.
 Taxation: It is also a powerful instrument of fiscal policy by means of which the
government can directly affect disposable income of the people and hence aggregate
demand of the economy. The government can encourage or discourage economic growth
and can combat inflationary and deflationary tendencies of the economy by applying
suitable tax policies.
 Public Expenditure: Public expenditure is that expenditure incurred by the government to
satisfy those common wants which the people in their individual capacity are unable to
satisfy efficiently. It thus tends to satisfy collective social wants. The appropriate
variation in public expenditure can have more direct effect upon the level of economic
activity than even taxes. It will have a multiple effect upon income, employment and
output. Hence by increasing or decreasing public expenditure the fluctuations in
economic activities can be checked effectively.
 Public Works: Keynes in his book “General Theory of Employment, Interest and Money”
highlighted public works program as the most significant anti- depression device. There
are two main forms of expenditure i.e., public works and Transfer payments. Public
works include expansion of roads, rail ways, hospitals, parks, irrigation, transport and
communications etc. Transfer payments include interest on public debt, subsidies,
pension, relief payment, social security benefits etc. All these activities affect the level of
income and employment in an economy.
  Public Debt: Public borrowing or public debt is nothing but loans taken by the
government (both from internal and external sources) when current revenues fall short of
public expenditures. The instruments of public borrowing are in the form of various types
of government bonds and securities. Public debt is a very powerful instrument to fight
against deflation. I t also brings about economic stability and full employment in an
 economy. By means of public debt the government can meet unprecedented expenses
during War, natural calamities and associated relief and rehabilitation works. In
developing economies it is the most important source of development finance

OBJECTIVES OF FISCAL POLICY

Economic Growth: For accelerating rate of economic growth of the developing economies, fiscal
policy can be used as an effective instrument. Economic growth simply means rise in real
national income as well as per capita real income over time. Less developed and poor countries
suffer from the vicious circle of poverty and to break this vicious circle a large dose of
investment (big push) is necessary. Government can directly interfere on economic activities and
design fiscal policy to raise the level of savings and to reduce potential consumption of the
people. Different fiscal measures can induce the process of capital formation and create
favourable environment for rapid economic growth .In addition, the government can redesign its
tax policies to encourage both private and public investment in those economies. A mounting
investment on social overhead capital (development of roads and communications, generation of
electricity etc.) also creates a favourable a favourable environment for rapid economic growth.
All these can be achieved by means of appropriate fiscal policy.
 Economic stabilization: We know that in capitalist countries economic activities fluctuate over
time and these economies suffer from the problem of business cycles. To stabilize the economy,
i.e. to overcome recession (business downswing) and control inflation (business upswing and
over expansion) in the economy fiscal policy may be regarded as an important 7 n Management
Fiscal Policy Managerial Economics instrument .At the time of recession the government
increases its expenditure or cuts down taxes or adopts a suitable combination of both .On the
other hand to control inflation or business upswing the government cuts down its expenditure or
raises taxes. This type of budgetary policy is known as contra-cyclical fiscal policy.
 Full Employment: In an economy those who are willing to work at the going wage rate but do
not get job are called involuntarily unemployed. In a situation of full employment all those who
are willing to work get jobs and all are absorbed. If there is unemployment in an economy, the
government may adopt various expansionary measures for increasing income and employment.
There are various ways of achieving this goal. Once full employment level is reached, it has to
be constantly maintained by adopting appropriate fiscal measures from time to time.
 Balance of payment Equilibrium: When a country is engaged in international trade then the
country can get money (foreign currency) by exporting goods and services and the country
spends money for importing goods and services from foreign countries .The difference between
the value of exports and imports is known as balance of trade and if it is added to the capital
account, then it is called balance of payment. If the value of exports is less than value of imports
then there will be a deficit in trade balance and surplus if opposite happens. In particular if a
country has a deficit in trade balance, then to correct such deficit the government should
encourage exports and discourage imports. For doing this, the government can grant different
types of benefits and exemptions to exporters, and impose hardships on imports. In this way by
increasing exports and decreasing imports the problem of deficit in trade balance can be
corrected and equilibrium in balance of payment can be achieved. The government can 8 n
Management Fiscal Policy Managerial Economics also import funds in different forms to cover
such deficit. Just its opposite mechanism will come into the picture in the opposite when there is
a surplus in trade balance.
 Social Justice or Equality in the Distribution of Income and Wealth: The great motto of any
welfare state is to provide greatest benefits for the greatest number of people. A welfare state can
provide social justice by giving equitable distribution of income and wealth. Fiscal policy means
should be designed in such a manner that the distribution of income and wealth will move in
favours of the poor and against the rich. Thus, fiscal policy insists on the programmes like free
medical care, free education, old age pension scheme, widow pension scheme and other social
security measures to provide social justice to the society. Public expenditure, particularly grants
and subsidies to poor helps in redistributing income from the rich to the poorer section of the
society. Suitable fiscal policy means can also reduce regional developmental imbalance in an

economy.

Types of fiscal policy

There are two main types of fiscal policy: expansionary and contractionary.
Expansionary fiscal policy

Expansionary fiscal policy, designed to stimulate the economy, is most often used during a
recession, times of high unemployment or other low periods of the business cycle. It entails the
government spending more money, lowering taxes or both.

The goal of expansionary fiscal policy is to put more money in the hands of consumers so they
spend more to stimulate the economy. Explained in economic language, the goal of expansionary
fiscal policy is to bolster aggregate demand in cases when private demand has decreased.

Contractionary fiscal policy

Contractionary fiscal policy is used to slow economic growth, such as when inflation is growing
too rapidly. The opposite of expansionary fiscal policy, contractionary fiscal policy raises taxes
to cut spending. As consumers pay more taxes, they have less money to spend, and economic
stimulation and growth slow.

Under contractionary fiscal policies, the economy usually grows by no more than 3% per year.
Above this growth rate, negative economic consequences – such as inflation, asset bubbles,
increased unemployment and even recessions – may occur.

The crowding out effect is an economic theory that argues that rising public sector
spending drives down or even eliminates private sector spending.To spend more, the
government needs added revenue. It obtains it by raising taxes or by borrowing through the sale
of Treasury securities. Higher taxes can mean reduced income and spending by individuals and
businesses. Treasury sales can increase interest rates and borrowing costs. That can reduce
borrowing demand and spending. All told, these government activities are thought to result in
the crowding out of spending by private individuals and companies.
KEY TAKEAWAYS

 The crowding out effect theory suggests that rising public sector spending drives down
private sector spending.
 To spend more, the government needs more revenue, which it gets through higher taxes
and/or sales of Treasuries.
 This can reduce private sector income and loan demand, thus decreasing spending and
borrowing.
 There are three main crowding out effects: economic, social welfare, and infrastructure.
 Crowding in suggests that government borrowing and spending can increase demand.

Understanding the Crowding Out Effect

The crowding out effect is based on the supply of and demand for money. According to the
theory, as the government takes revenue-raising actions, such as increasing taxes or debt
security sales, the consumer and business demand for resulting higher interest rate loans
decreases.
So does their desire to spend a potentially reduced amount of income. (Their desire to earn a
higher rate of interest on their savings may also come into play.) Thus, the government crowds
out their spending by increasing its own.
Bear in mind that the crowding out effect theory runs counter to older, well-known economic
theories that hold that government spending during periods of slowing economic activity
actually increases spending by consumers and businesses by, essentially, putting more money in
their pockets.
One of the most common forms of crowding out takes place when a large government, such as
that of the U.S., increases its borrowing and sets in motion a chain of events that results in the
curtailing of private sector spending.
The sheer scale of this type of borrowing can lead to substantial rises in the real interest rate.
This can absorb the economy's lending capacity and discourage businesses from making capital
investments.
Companies often fund capital projects in part or entirely through financing. The increased cost
of borrowing money makes traditionally profitable projects that are funded through loans cost-
prohibitive.
Crowding out refers to the negative impact that government spending can have on private
investment. The theory of crowding out suggests that when the government increases its
spending, it will increase the demand for goods and services, which can lead to higher interest
rates and inflation. This, in turn, can make borrowing more expensive for private investors,
reducing their ability to invest in new projects and businesses. As a result, private investment
may decrease or "crowd out" as the government spending increases.
The effect of crowding out can also occur through the use of monetary policy. When the central
bank increases the money supply to finance government spending, it can lead to inflation and
higher interest rates. This can make borrowing more expensive for private investors and reduce
their ability to invest in new projects and businesses.
Crowding out can be more or less pronounced depending on the state of the economy, if the
economy is at full employment and resources are scarce, the crowding out effect is more likely to
happen, while if the economy is in a recession and resources are idle, the crowding out effect is
less likely to happen.
It's important to note that crowding out is not a universally accepted theory and there are other
arguments that suggest that government spending can have a positive impact on private
investment. For example, the Keynesian theory of multiplier effect suggests that government
spending can increase economic activity and boost private investment.
Additionally, some critics argue that the crowding out effect is overstated and that government
spending can have a positive impact on private investment by increasing aggregate demand and
creating a more stable economic environment. Thus, the crowding out effect is still a matter of
debate among economists and it's important to consider the specific economic conditions of a
country when evaluating the potential impact of government spending.