Fiscal Policy

Fiscal policyFiscal Policy is an important instrument to

stabilize the economy. (overcome recession and control inflation in the economy)

Stabilization of economy is achieved on the basis of given tools, as:

Taxation, Public Debt/Borrowings Public expenditure.

Objective Of Fiscal Policyin Developing Countries

1. Economic Stability : It requires absence of sharp cyclical mov-

ements. (Boom & Depression). To ensure such stability counter cycle policy is recommended as:

If depression exists in the economy appropriate Fiscal Policy, “ Expansionary Fiscal Policy” where Govt.’s expenditure will be increased and tax rate will be decreased.

If Boom exists in the economy appropriate fiscal policy is “ Contractionary Fiscal Policy” where the expenditure of Govt. is reduced and taxes are increased.

2. Increasing Rate of Investment: Fiscal policy aims at increasing the rate of capital

formation or investment. It can be only possible by pushing up the saving ratio. It is possible by raising

the government income through taxation and public borrowing.

However, in developing countries it is difficult to mobilize resources through taxation because very

small number of people come under income tax bracket.

If govt. mobilize resources through indirect tax its

incidence mostly falls on relatively poor section

of society. Second measure of raising resource is public borrowing .

Although, taxable capacity in developing country is low

but people and institution do investment in govt. securities

in hope to receive income from these investment act with intact saving.

3. Reducing Inequalities in Income: The tax policy is so designed as to make the

overall tax structure highly progressive which would compel rich section of the population to contribute substantially more in the form of higher taxes.

The indirect tax also imposes on luxury goods at higher

side.

Revenue generated though taxes spends on public works and on welfare schemes.

4. Reducing Unemployment: Public expenditure programme plays important role as

when govt. start constructing hospital, school buildings, dams, irrigation canals large number of rural people remain unemployed during off season can be employed.

Instruments of Fiscal Policy

1. Taxation : It is classified as –

Direct and Indirect Taxes: Direct tax – its incidence directly falls upon tax payee.

Example: Income Tax, Annual Wealth Tax,

Corporation, Capital gains tax

Indirect Tax:Its burden can be shifted to others. So that those who

pay theses taxes to the govt. do not bear the whole burden.

Example: Excise duty, VAT, Custom duty, Sales Tax.

Taxation as instrument of policy can be used in any of the following forms: Change in Tax rate Change in Tax base Change in taxation mix

Taxation as Counter-Cyclical Device

An anti-depressing tax policy must increase disposable income during depression by the way of reducing direct and indirect tax rates.

Lower taxation policy promotes private investment by reducing corporate tax.

An anti-inflationary tax policy must decrease disposable income by the way of imposing high rate of direct and indirect tax rates.

Public Expenditure

A rise or fall in government expenditure through multiplier effect brings about a multiple change in the level of national income .

Public expenditure is mainly financed by tax, market borrowing and deficit financing.

Public expenditure is a powerful tool for reducing regional economic disparities and income inequalities. The allocative and distributive effects of public expenditure can be understood by following issues:

1. Establishments of PSUs in areas where private ente-rprise is weak can reduce regional disparities.

2. Provision of economic infrastructure in industrially backward areas can promote balanced regional developments.

3. Subsides to promote sectoral growth

4. Welfare schemes for weaker sections

Public Expenditure as Counter-Cyclical Device

During a business cycle, when an economic slow down heads towards recession, govt. can restore

to compensatory spending (spending on public works, social insurance payments, and subsidies) to cover the deficiency in private spending.

In an inflationary situation government spending needs to be reduced to deflate aggregate demand.

Pump Priming expenditure involves injection of a certain amount of spending in the income stream

can restore the economy at normal growth path.

Public Debt This is important source to finance deficit

budget. It can be categorized as:

Public borrowing;Banking borrowing;Deficit FinancingInternational borrowing

Public Debt- as Counter-Cyclical Device

Public debt immediately affects money and credit supply, resultantly aggregate demand get affected.

Public borrowing transfers money from public to government and repayment of debt shift money from government to back

Public.

During inflationary situation when money transfers from households to govt. consumption falls and in the business sector investment also falls. Consequently, declining demand push down the prices.

During recessionary situation repayment of debt to public increase the consumption and investment level whereby increased demand pull up the prices to equilibrium.

Danger of Deficit Financing Deficit financing plays useful role during the phase

of depression in developed country because capital equipment and machinery is already existing. Whereby production can increase and inflationary pressure can be offset.

However, in the case of developing countries it leads inflationary pressure because machinery and capital equipments are not existing.

In economy because of printing money purchasing power is increased but production not increased which generates inflationary pressure.

Kind of Fiscal Policy There are three forms of Fiscal policy –

1. Automatic Stabilizers : This type of fiscal policy stabilizes economy

without involving policymakers on the basis of important stabilizers :

Taxation – As GNP of country rises some people did not cover under tax bracket now they cover under tax bracket. Thus tax revenue increase as well as money supply in market also restricted

Unemployment Compensation:

In developed countries unemployment compensation is paid to workers who are laid off.

During recession as more people unemployed unemployment compensation paid by the govt. to the unemployed people automatically wiped off recession.

2. Compensatory Policy This type of fiscal policy is a deliberate budg-

etary action taken by the govt. to compensate for the deficiency or in excess of aggregate demand. This action is of two kind-

1. Surplus Budgeting – During inflation, govt. keeps its expenditure lower than its revenue and increase taxes.

2. Deficit Budgeting – During depression, Govt. keeps it budget at deficit side where expenditure is greater than revenue. Whereby public expenditure is high and imposition of taxes is low.

3. Discretionary Policy

In this case temporary changes are made in the govt. expenditure and taxation system which is at discretion of the Govt. make changes as-

The level of pattern of taxation, Size

and pattern of expenditure and size and composition of public debt

“Crowding-Out” Effect

Crowding-out effect is the fall in the private investment due to deficit spending by the government. As:

‘Deficit spending through ‘deficit financing’ results in net injection into the economy, which push up demand and rise in price level.

Increase in aggregate demand leads inflationary pressure in the economy.

To control inflation, the central bank will intervene by adopting ‘tight money’ with rising rate of interest, which choke-off or “Crowd-out the private investment.

Crowding-in Effect

Crowding-in means rise in the private investment due to deficit spending by the government.

Deficit spending push up rate of interest, undoubtedly, which discourage private investment but deficit spending leads to rise in aggregate demand which is met by increasing production from the existing capital stock. Therefore, demand for existing capital increase and thus deficit spending stimulates new investments.