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UNIT – 4: FISCAL POLICY

Introduction

Fiscal policy is the deliberate policy of the government under which it uses the
instruments of taxation, public expenditure and public borrowing to influence both
the pattern of economic activity and level of aggregate demand, output and employment.
Fiscal policy is in the nature of a demand-side policy.
An economy which is producing at full-employment level does not require government
action in the form of fiscal policy.

The classical economists held the belief that the government should not intervene in
the economy because the market mechanism makes the economy self-adjusting and
keeps the economy at or near the natural level of real GDP at all times. The government
should have a balanced budget and any deliberate fiscal policies are unnecessary.

The Depression resulted in very low aggregate demand along with high levels of
unemployment. The classical economics could not provide any solution to this problem. In
1936, the British economist John Maynard Keynes in his book ‘The General Theory of
Employment, Interest, and Money’ advocated increase in government spending to combat
the recessionary forces in the economy and to solve the problem of unemployment. In
recent times, especially after being threatened by the global financial crisis and
recession, many countries have preferred to have a more active fiscal policy.
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Objectives of Fiscal Policy

Since nations differ in numerous aspects, the objectives of fiscal policy also may vary
from country to country. However, the most common objectives of fiscal policy are:
Achievement and maintenance of full employment,
Maintenance of price stability, Moderate Inflation
-
.

Acceleration of the rate of economic development, and

Equitable distribution of income and wealth

The importance as well as order of priority of these objectives may vary from country to
country and from time to time. For instance,
while stability and equality may be the priorities of developed nations,
economic growth, employment and equity may get higher priority in developing
countries.

Governments may directly as well as indirectly influence the way resources are used in
an economy. Fiscal policy is a powerful tool for managing the economy because of its
ability to influence the total amount of output produced viz. gross domestic product.
The ability of fiscal policy to influence output by affecting aggregate demand makes it
a potential instrument for stabilization of the economy.
Direct
AD/GDP = C + I + G + NX

The governments can influence the level of economic activity (GDP) by directly
controlling G (government expenditure i.e purchases of goods and services by the
government) and indirectly influencing C (private consumption), I (investment), and NX
(net exports or exports minus imports), through changes in taxes, transfer payments and
public expenditure.
 🎯
Tab contraction did I
1.
Expansionary -

Hume
Expansion Chahiye .

Types of Fiscal Policy

Contra cyclical fiscal policy or fiscal policy measures to correct different problems
created by business-cycle instability are of two basic types namely, expansionary fiscal
policy and contractionary fiscal policy.

Expansionary Fiscal Policy

boust
Expansionary fiscal policy is designed to stimulate the economy during the
contractionary phase of a business cycle or when there is an anticipation of a business
cycle contraction.
A recession is said to occur when the overall economic activity declines, or in other
words, when the economy ‘contracts’. A ‘demand-deficient’ recession sets in with a
period of falling real GDP, low aggregate demand and reduced consumer spending and
Fight such a slump
rising unemployment. To combat fall
in overall economic activity, the
government can resort to expansionary fiscal policies.
We may technically refer to this as a policy measure to close a ‘recessionary gap’.
-

How does the government achieve this? AD LAS

output
-

Income Tax GST

The government may cut all types of taxes, direct and indirect, leaving the
taxpayers with extra money to spend so that there is more purchasing power and more
demand for goods and services. Consequently aggregate demand, output and
employment increase.
An increase in government expenditure will pump money into the economy and
increase aggregate demand. This in turn will increase output and employment.
A combination of increase in government spending and decrease in personal income
taxes and/or business taxes.
34 R
While resorting to expansionary fiscal policy, the government may run into budget
deficits because tax cuts reduce government income and the government expenditures
exceed tax revenues in a given year.
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▪

Jab ExpansionCha , ADAS

,
Inflation" ,
Pica

Contractionary fiscal policy

control
Contractionary fiscal policy is designed to restrain the levels of economic activity
of the economy during an inflationary phase or when there is anticipation of a
business-cycle expansion which is likely to induce inflation.
Contractionary fiscal policy refers to the deliberate policy of government applied
decrease
to curtail aggregate demand and consequently the level of economic activity.
In other words, it is fiscal policy aimed at eliminating an ‘inflationary gap’. ADTAS
If the state of the economy is such that its growth rate is extraordinarily high causing
inflation and asset bubbles, contractionary fiscal policy can be used to confine it into
sustainable levels.
-

Contractionary fiscal policy works through:

Decrease in government spending: With decrease in government spending, the

total amount of money available in the economy is reduced which in turn has the effect
of reducing the aggregate demand.
Increase in personal income taxes and/or business taxes: An increase in personal
income taxes reduces disposable incomes leading to fall in consumption spending and
aggregate demand. An increase in taxes on business profits reduces the surpluses
available to businesses, and as a result, firms’ investments shrink causing aggregate
demand to fall. Increased taxes also dampen the prospects of profits of potential
entrants who will respond by holding back fresh investments.
A combination of decrease in government spending and increase in personal income
taxes and/or business taxes. DeficitA Deficity
↓&> R↑
Surplus -
R2

Contractionary fiscal policy should ideally lead to a smaller government budget

deficit or a larger budget surplus. Revenue ↑
Exp1
~

,
 INFLATION DEFLATION
fiscal policy aims at fiscal policy aims to increase
controlling excessive effective demand by
aggregate spending boosting aggregate spending.

Contractionary Expansionary
Fiscal policy Fiscal policy

THE INSTRUMENTS OF FISCAL POLICY

1) Government Expenditure as an Instrument of Fiscal Policy

Rev Exp
Public expenditure includes governments’ expenditure towards consumption,
.

investment, and transfer payments.

cap Exp
Fiscal policy relates to decisions that determine whether the government’s
expenditure is more or less than what it receives. A reduction or increase in it may result
in significant variations in the country’s total income. As such, public expenditure can be
instrumental in adjusting consumption and investment to achieve full employment.

Public expenditures are income generating and include all types of government
expenditure such as capital expenditure on public works, relief expenditures, subsidy
payments of various types, transfer payments and other social security benefits
 ▪
👉
But Taxes Can't be
"

Exp *
Paisa
Requires Borrowing Printing"
Government expenditures include:
current expenditures to meet the day to day running of the government,
capital expenditures which are in the form of investments made by the government in
capital equipments and infrastructure, and
transfer payments i.e. government spending which does not contribute to GDP because
income is only transferred from one group of people to another without any direct
contribution from the receivers.

During a recession, it may initiate a fresh wave of public works, such as construction
of roads, irrigation facilities, sanitary works, ports, electrification of new areas etc.
Government expenditure involves employment of labour as well as purchase of
multitude of goods and services.
These expenditures directly generate incomes to labour and suppliers of materials
and services.
Apart from the direct effect, there is also indirect effect in the form of working of
multiplier. The incomes generated are spent on purchase of consumer goods. The extent
of spending by people depends on their marginal propensity to consume (MPC). There is
generally surplus capacity in consumer goods industries during recession and an increase
in demand for various goods leads to expansion in production in those industries as well.

A relevant question here is; from where will the government find resources to increase
its expenditure?
We know that if government resorts to increase in taxes, it is self- defeating as
increased taxes will reduce the disposable incomes and therefore aggregate demand. The
government should in such cases go for a deficit budget which may be financed either
through borrowing or through monetization (creation of additional money to finance
expenditure).

Additionally, a programme of public investment will strengthen the general confidence of

businessmen and consequently their willingness to invest.
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ADTAS

Public expenditure is also used as a policy instrument to reduce the severity of inflation
and to bring down the prices. This is done by reducing government expenditure when
there is a fear of inflationary rise in prices. Reduced incomes on account of decreased
public spending help eliminate excess aggregate demand.

2) Taxes as an Instrument of Fiscal Policy

Tax as an instrument of fiscal policy consists of changes in government revenues or in

rates of taxes aimed at encouraging or restricting private expenditures on consumption
and investment.
~
Tax Taxa
Taxes determine the size of disposable income in the hands of the general public
which in turn determines aggregate demand and possible inflationary and deflationary
gaps.
The structure of tax rates is varied in the context of the overall economic conditions
prevailing in an economy:

During recession and depression, the tax policy is framed to encourage private
consumption and investment. A general reduction in income taxes leaves higher
disposable incomes with people inducing higher consumption. Low corporate taxes
increase the prospects of profits for business and promote further investment. The
extent of tax reduction and /or increase in government spending required depends on the
size of the recessionary gap and the magnitude of the multiplier. MP 2 +
L
In.

Multiplica
During inflation, new taxes can be levied and the rates of existing taxes are raised to
reduce disposable incomes and to wipe off the surplus purchasing power. However,
excessive taxation usually stifles new investments and therefore the government has to
be cautious about a policy of tax increase.
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3) Public Debt as an Instrument of Fiscal Policy

Public debt may be internal or external; when the government borrows from its own
people in the country, it is called internal debt.
On the other hand, when the government borrows from outside sources, the debt is
called external debt.
Public debt takes two forms namely, market loans and small savings.

In the case of market loans, the government issues treasury bills and government
securities of varying denominations and duration which are traded in debt markets. For
financing capital projects, long-term capital bonds are floated and for meeting short-term
government expenditure, treasury bills are issued.

The small savings represent public borrowings, which are not negotiable and are not
bought and sold in the market. In India, various types of schemes are introduced for
mobilising small savings e.g., National Savings Certificates, National Development
NSC
Certificates, etc.
-
Borrowing from the public through the sale of bonds and securities curtails the
aggregate demand in the economy.

Repayments of debt by governments increase the availability of money in the economy

and increase aggregate demand.
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4) Budget as an Instrument of Fiscal Policy

The budget is simply a statement of revenues earned from taxes and other sources and
expenditures made by a nation’s government in a year. The net effect of a budget on
aggregate demand depends on the government’s budget balance.

A government’s budget can either be balanced, surplus or deficit.

A balanced budget results when expenditures in a year equal its tax revenues for
that year. Such a budget will have no net effect on aggregate demand since the leakages
from the system in the form of taxes collected are equal to the injections in the form Tex
of expenditures made. en.

/Exp
.

RE
A budget surplus that occurs when the government collects more than what it
spends, though sounds like a highly attractive one, has in fact a negative net effect on
aggregate demand since leakages exceed injections.
<Exp
Taxes

A budget deficit wherein the government expenditure in a year is greater than the
tax revenue it collects has a positive net effect on aggregate demand since total
injections exceed leakages from the system.
2) T

While a budget surplus reduces national debt, a budget deficit will add to the national
debt. Tax Rev >
Exp E> R
 AD > AS

Fiscal Policy for Long-run Economic Growth High Inflation

We know that economic growth is indispensable for sustainable development and

favourable social outcomes. The demand-side fiscal policies unaccompanied by policies to
stimulate aggregate supply cannot produce long-run economic growth.

Fiscal policy influence economic growth through its effects on the incentives faced by
individuals and firms. For example;

Fiscal policies such as those involving infrastructure spending generally have positive
supply-side effects. When government supports building a modern infrastructure, the
Support/Services
private sector is provided with the requisite overheads it needs.
Government provision of public goods such as education, healthcare, nutrition,
research and development etc. provide momentum for long-run economic growth
through human capital formation. Increase in human capital makes physical capital
more productive.
Taxes can have either positive or negative impact on economic growth depending on
whether it encourages or discourages saving and investment.
A well designed tax policy that rewards innovation and entrepreneurship, without
discouraging incentives will promote private businesses who wish to invest and
thereby help the economy grow. For example, an increase in corporate taxes to raise
extra revenue may have adverse consequences on incentives and output.
Tax and spending policies (e.g. subsidies) can be effectively used to correct market
failures resulting from externalities.
Increase in environment taxes increase the cost of firms and reduce their output
Subsidies on inputs and support prices to producers (e.g. farmers) generate higher
output.
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Fiscal Policy for Reduction in Inequalities of Income and Wealth

Many developed and developing economies are facing the challenge of rising inequality in
incomes and opportunities. Fiscal policy is a chief instrument available for governments
to influence income distribution and plays a significant role in reducing inequality and
achieving equity and social justice.

The distribution of income in the society is influenced by fiscal policy both directly and
indirectly. We shall see a few such measures as to how each of these can be manipulated
to achieve desired distributional effects.

A progressive direct tax system ensures that those who have greater ability to pay
to pay
contribute more towards defraying the expenses of government and that the tax
burden is distributed fairly among the population.
Indirect taxes can be differential: for example, the commodities which are primarily
consumed by the richer income group, such as luxuries, are taxed heavily and the
commodities the expenditure on which forms a larger proportion of the income of the
lower income group, such as necessities, are taxed light or not taxed at all.

A carefully planned policy of public expenditure helps in redistributing income from

the rich to the poorer sections of the society. This is done through spending programmes
targeted at welfare measures for the disadvantaged, such as
(i) poverty alleviation programmes
(ii) free or subsidized medical care, education, housing, essential commodities etc. to
improve the quality of living of the poor
(iii) infrastructure provision on a selective basis (e.g. rural roads, water supply for tribal
-

area)
(iv) various social security schemes under which people are entitled to old-age pensions,
unemployment relief, sickness allowance etc.
(v) subsidized production of products of mass consumption
(vi) public production and/ or grant of subsidies to ensure sufficient supply of
essential goods, and
(vii) strengthening of human capital for enhancing employability etc.
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Choice of a progressive tax system with high marginal taxes may act as a strong
discourage to work, save and invest. Therefore, the tax structure has to be carefully
deterrent
framed to mitigate possible adverse impacts on production and efficiency.
Additionally, a highly redistributive fiscal policy with excessively generous social
programs can reduce incentives to work and save.

Limitations of Fiscal Policy

One of the biggest problems with using planned fiscal policy to counteract
fluctuations is the different types of lags involved in fiscal-policy action. There are
significant lags namely:
Recognition lag: The economy is a complex phenomenon and the state of the macro
understood
·

economic variables is usually not easily comprehensible. There is difficulty in collecting

accurate and timely data. There may be delay on the part of the government to recognize
the need for a policy change.
Decision lag: Once the need for intervention is recognized, the government has to
evaluate the possible alternative policies. Delays are likely to occur to make a decision
on the most appropriate policy.
Implementation lag: even when appropriate policy measures are decided on,
there are possible delays in bringing in legislation and implementing them on
account of bureaucracy. This is specially so under a democratic set up.
Impact lag: impact lag occurs when the outcomes of a policy are not visible for
some time.

Fiscal policy changes may at times be badly timed due to the various lags so that it is
highly possible that an expansionary policy is initiated when the economy is already
on a path of recovery and vice versa.
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There are difficulties in instantly changing governments’ spending and taxation

policies.

It is practically difficult to reduce government spending on various items such as

defence and social security as well as on huge capital projects which are already
midway.

Public works cannot be adjusted easily along with movements of the trade cycle
because many huge projects such as highways and dams have long gestation period.
- -

Besides, some urgent public projects cannot be postponed for reasons of expenditure
cut to correct fluctuations caused by business cycles.

Supply-side economists are of the opinion that certain fiscal measures will cause
disincentives. For example, increase in profits tax may adversely affect the incentives of
firms to invest and an increase in social security benefits may adversely affect incentives
to work and save.
ADA but AS" ADTAs - Prices
ER Empt Income" , >
-
< ,

Deficit financing increases the purchasing power people. The production of goods and
services, especially in under developed countries may not catch up simultaneously to
meet the increased demand. This will result in prices spiraling beyond control.
in
Increase is government borrowing creates perpetual burden on even future
-

generations as debts have to be repaid. If the economy lags behind in productive

utilization of borrowed money, sufficient surpluses will not be generated for servicing
debts. External debt burden has been a constant problem for India and many developing
countries.

If governments compete with the private sector to borrow money for spending, it is
likely that interest rates will go up, and firms’ willingness to invest may be reduced.
Individuals too may be reluctant to borrow and spend and the desired increase in
aggregate demand may not be realised.
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Crowding Out

Some economists are of the opinion that government spending would sometimes
substitute private spending and when this happens the impact of government spending on
aggregate demand would be smaller than what it should be. In such cases, fiscal policy
may become ineffective.

Substantial government borrowing in the credit market tends to reduce the amount of
funds available and pushes the interest rates up. Higher interest rates slow down
business investment expenditures and consumption expenditures that are sensitive to
interest rates. An increase in the size of government spending during recessions
will ‘crowd-out’ private spending in an economy. In other words, when spending by
government in an economy replaces private spending, the latter is said to be crowded out.
As a result, the effectiveness of expansionary fiscal policy in stimulating aggregate
demand will be diminished to a great extent. This may also possibly reduce the economy’s
prospects of long-run economic growth.

However, during deep recessions, crowding-out is less likely to happen as private

sector investment is already minimal and therefore there is only insignificant private
spending to crowd out. Moreover, during a recession phase the government would be able
-

to borrow from the market without increasing interest rates.

Govt
Exp"- Govt
Borrowing"-Demand for
"
Loans

AD for Goods &

services
Private Busines Int Rate" (O2]
7 Sector wants to INC ↑ Discoviage ,

Investment Disincentive

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