Fiscal policy

by: deepsi khandelwal

Meaning of fiscal policy

The fiscal policy is concerned with the raising of government revenue and incurring of government expenditure. To generate revenue and to incur expenditure,

To generate revenue and to incur 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.

in broad term fiscal policy refers to "that segment of national economic policy which is primarily concerned with the receipts and expenditure of central government.

Main Objectives of Fiscal Policy In India

Development by effective Mobilisation of Resources

Efficient allocation of Financial Resources

Reduction in inequalities of Income and Wealth

Price Stability and Control of Inflation

Employment Generation

Balanced Regional Development

Reducing the Deficit in the Balance of Payment

Increasing National Income

Foreign Exchange Earnings

Development by effective Mobilization 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 central and the state governments in India have used fiscal policy to mobilise resources.

The financial resources can be mobilised by:

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 in India is taxation.

Public Savings : The resources can be mobilised through public savings by reducing government expenditure and increasing surpluses of public sector enterprises.

Private Savings : Through effective fiscal measures such as tax benefits, the government can raise resources from private sector and households.

 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.

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.

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.

The objective of fiscal policy in India is also to increase the rate of capital formation so as to accelerate the rate of economic growth.

In order to increase the rate of capital formation, the fiscal policy must be efficiently designed to encourage savings and discourage and reduce spending.

Increase capital

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.

Foreign Exchange Earnings

Fiscal policy attempts to encourage more exports by way of Fiscal Measures like, exemption of income tax on export earnings, exemption of sales tax and octroi, etc.

Foreign exchange provides fiscal benefits to import substitute industries.

Types of fiscal policy

Discretionary Fiscal Policy 

Expansionary Fiscal Policy

Contractionary Fiscal Policy

Expansionary Fiscal Policy

Expansionary fiscal policy uses increased government spending, reduced taxes or a combination of the two. The chief objective of a fiscal expansion is to increase aggregate demand for goods and services across the economy, as well as to reduce unemployment. 

Contractionary Fiscal Policy

When government policy-makers cut spending or increase taxes, they engage in contractionary fiscal policy. Governments may enact contractionary measures to slow an economic expansion and prevent inflation..

In addition, governments may enact contractionary policy for ideological reasons. These include reducing the overall size and scope of government activity or lowering budget deficits, in which the government spends more money than it collects. 

Discretionary fiscal policy

Discretionary fiscal policy is the portion of the Federal government's actions that can be changed year to year by Congress and the President. It is usually executed through each year's budget or through changes in the tax code.

Fiscal policy in India

FiscalcanbeexplainedasFinancial,soapolicyinrelationtoFinanceandsomethingsimilartoMonetarypolicy.NowamonetarypolicyisformedbytheReservebankofIndiaandthefiscalpolicyisformedbytheCentral

Government.

MinistryofFinance.ThemainaimoftheFiscalPolicyistoseethethreechildrenarefinei.e.PublicDebt,PublicExpenditureandPublicRevenuetoachievecertainobjectiveslikegrowth,stability,unequaldistribution of

Income.

Measures of fiscal policy

Fiscal policy is the policy under which the government of a country uses fiscal measures (or instruments) to correct excess demand and deficient demand and to achieve other desirable objectives. There are mainly three types of fiscal measures, viz.

A) TaxesB) Public expenditure

public borrowing

Taxes

Excess of aggregate demand over aggregates supply is caused due to the excess amount of money income is the hands of the people in relation to the available output in the country. 

In order to correct such situation personal disposable incase should be reduced. Therefore, government should increase the rate of personal income tax, and corporate income tax so that people will have less money in their hands and aggregates demand will fall.

Public expenditure

Public expenditure is an important component of aggregate demand. Therefore, excess demand can be corrected by reducing government expenditure. Reduction in government expenditure also leads to a decline in the volume of national income due to the backward operation of investment multiplier. Reduction in national income leads to a decline in aggregate demand and fall in the price level.

On the other hand, government should increase expenditure on public works programmes such as the construction of roads, expansion of railways, setting up of power projects, construction of irrigation projects, schools and colleges, hospitals and parks and so on. Besides, government should also enhance expenditure on social security measures, like old age pensions, unemployment allowances, sickness benefits etc. 

Public borrowing Like tax and public expenditure, public borrowing

is also an important anti – inflationary instrument. Government of a country should resort to borrowing from the non-bank public to keep less money in their hands for correcting the state of excess demand and inflationary situation.

On the other hand, to correct deficient demand, government should reduce borrowing from the general public so that purchasing power in the hands of the people is not reduced

Besides the above fiscal measures, government should resort to deficit financing to correct deficient demand. Deficit financing is a technique of financing a deficit budget by (i) printing notes, & (ii) borrowing from the central bank or drawing down the cash balances on part of the government from the central bank., deficit financing makes an addition to the total money supply of the country and can correct deficient demand.

Criticisms of Fiscal Policy

Disincentives of Tax Cuts. 

Side Effects on Public Spending.

Poor Information

  Time Lags.

Budget Deficit

Other Components of AD

Disincentives of Tax Cuts

 Increasing Taxes to reduce AD may cause disincentives to work, if this occurs there will be a fall in productivity and AS could fall. However higher taxes do not necessarily reduce incentives to work if the income effect dominates.

Side Effects on Public Spending.

Reduced govt. spending to Increase AD could adversely effect public services such as public transport and education causing market failure and social inefficiency.

Poor Information

 Fiscal policy will suffer if the govt. has poor information. E.g.  If the govt. believes there is going to be a recession, they will increase AD, however if this forecast was wrong and the economy grew too fast, the govt. action would cause inflation.

Time lags

 If the govt. plans to increase spending this can take along time to filter into the economy and it may be too late. Spending plans are only set once a year. There is also a delay in implementing any changes to spending patterns.

Budget Deficit  Expansionary fiscal policy

(cutting taxes and increasing G) will cause an increase in the budget deficit which has many adverse effects. Higher budget deficit will require higher taxes in the future and may cause crowding out 

Other Components of AD

If the government uses fiscal policy its effectiveness will also depend upon the other components of AD,.

 for example if consumer confidence is very low, reducing taxes may not lead to an increase in consumer spending.

What is the difference between fiscal and monetary policy?

Monetary policy is the process by which the monetary authority of a country controls the supply of money, often targeting a rate of interest for the purpose of promoting economic growth and stability

Fiscal policy are policies that influnce the tax rates and government expenditure in the country 

Fiscal Policy and Development in Madhya Pradesh

The greatest damage of the influence of neo-liberal macroeconomic advice from the Asian Development Bank is its emphasis on 'self-sufficient' state governments exercising 'fiscal discipline'. Obviously wasteful expenditure is a bad thing. State governments must reduce the slack in resource mobilisation and expenditure. 

This however is not the fundamental problem for Madhya Pradesh today. The problem is that MP has too little public investment and a low growth of state income, etc. There is little merit in the argument in favour of a smaller or zero fiscal deficit, if the spending is aimed towards increasing state income and employment.

Who control fiscal policy

In India the president and congress together control the fiscal policy.

Effect of fiscal policy

Unemployment

Expansion

Contraction

Inflation Issues

Unemployment

Unemployment is often stable in the long term, with a certain amount of the population unable to work simply because of the constraints of a free market economy. Governments often choose to develop fiscal policies that attempt to decrease this stable rate of unemployment. 

Expansion Governments also work to encourage

economic growth as a whole, funding expansion through subsidies, tax cuts and new contracts with domestic and international partners. In many cases, this can actually encourage inflation if a government only works to help increase demand and buying power within its economy. Demand goes up, prices rise and then wages rise.

Contraction Governments worried about inflation can

attempt to decrease inflation rates through contraction, using fiscal policy to reign in natural inflation. The government usually switches interest rates, raising them to discourage too much rampant spending, or raises a certain sector of taxes by a small amount to accomplish the same effect. Product continues, but spending becomes safer and more concentrated, and inflation tends to decrease as a result.

Inflation Issues

Economists often discuss how much effect any fiscal policy can have on inflation. Government policies may seem to control inflation, especially in the short term, but long term changes are much more difficult to ascertain.

In an increasingly global economy and a free market economy, the changes a government can make may be minimal or ineffective. Consumers tend to decide inflation themselves, and government actions may sometimes have the opposite effects intended.