FISCAL POLICY

INTRODUCTION

• In the previous unit, we have studied the nature of governments’ intervention in markets to provide public goods, remedy externalities, ensure efficient allocation and to enable redistribution of income. We have also looked into how taxes and subsidies influence the incentives for private economic activity. We have been doing this from the microeconomic point of view.
•  From the macroeconomic perspective, the focus is on the aggregate economic activity of governments, say, aggregate expenditure, taxes, transfers and issues of government debts and deficits and their effects on aggregate economic variables such as total output, total employment, inflation, overall economic growth etc . These, in fact, form the subject matter of fiscal policy.
• The significance of fiscal policy as a strategy for achieving certain socio economic objectives was not recognized or widely acknowledged before 1930 due to the faith in the limited role of government advocated by the then prevailing laissez-faire approach. Great Depression and the consequent instabilities made policymakers support a more proactive role for governments in the economy. 
• However, later on, markets started demonstrating an enhanced role in the allocation of goods and services in the economy. In the previous unit, we have seen situations under which markets fail to achieve optimal outcomes and the need for government intervention to combat those market failures. 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.
• Governments of all countries pursue innumerable policies to accomplish their economic goals such as rapid economic growth, equitable distribution of wealth and income, reduction of poverty, price stability, exchange rate stability, full- employment, balanced regional development etc. Government budget is one among the most powerful instruments of economic policy. The important tools in the budgetary policy could be broadly classified into public revenue including taxation, public expenditure, public debt and finally deficit financing to bridge the gap between public receipts and payments. 
• When all these tools are used for achieving certain goals of economic policy, public finance is transformed into what is called fiscal policy. In other words, through the use of these instruments governments intend to favourably influence the level of economic activity of a country.
• Fiscal policy involves the use of government spending, taxation and borrowing to influence both the pattern of economic activity and level of growth of aggregate demand, output and employment. It includes any design on the part of the government to change the price level, composition or timing of government expenditure or to alter the burden, structure or frequency of tax payment.
•  In other words, fiscal policy is designed to influence the pattern and level of economic activity in a country. 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.

OBJECTIVES OF FISCAL POLICY

The objectives of fiscal policy, like those of other economic policies of the government, are derived from the aspirations and goals of the society. 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,
• 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. Also, these objectives are not always compatible; for instance the objective of achieving equitable distribution of income may conflict with the objective of economic growth and efficiency.

Before we go into the details of fiscal policy, we need to know the difference between discretionary fiscal policy and non-discretionary fiscal policy of automatic stabilizers.

AUTOMATIC STABILIZERS VERSUS DISCRETIONARY FISCAL POLICY

• Non-discretionary fiscal policy or automatic stabilizers are part of the structure of the economy and are ‘built-in’ fiscal mechanisms that operate automatically to reduce the expansions and contractions of the business cycle. Changes in fiscal policy do not always require explicit action by government.
•  In most economies, changes in the level of taxation and level of government spending tend to occur automatically. These are dependent on and are determined by the level of aggregate production and income, such that the instability caused by business cycle is automatically dampened without any need for discretionary policy action.
• Any government programme that automatically tends to reduce fluctuations in GDP is called an automatic stabilizer. Automatic stabilizers have a tendency for increasing GDP when it is falling and reducing GDP when it is rising. In automatic or non discretionary fiscal policy, the tax policy and expenditure pattern are so framed that taxes and government expenditure automatically change with the change in national income.
•  It involves built- in- tax or expenditure mechanism that automatically increases aggregate demand when recession is there and reduces aggregate demand when there is inflation in the economy. Personal income taxes, corporate income taxes and transfer payments (unemployment compensation, welfare benefits) are prominent automatic stabilizers.
• Automatic stabilisation occurs through automatic adjustments in government expenditures and taxes without any deliberate governmental action. These automatic adjustments work towards stimulating aggregate spending during the recessionary phase and reducing aggregate spending during economic expansion. 
• As we know, during recession incomes are reduced; with progressive tax structure, there will be a decline in the proportion of income that is taxed. This would result in lower tax payments as well as some tax refunds. Simultaneously, government expenditures increase due to increased transfer payments like unemployment benefits. 
• These two together provide proportionately more disposable income available for consumption spending to households. In the absence of such automatic responses, household spending would tend to decrease more sharply and the economy would in all probability fall into a deeper recession.
• On the contrary, when an economy expands, employment increases, with progressive system of taxes people have to pay higher taxes as their income rises. This leaves them with lower disposable income and thus causes a decline in their consumption and therefore aggregate demand. Similarly, corporate profits tend to be higher during an expansionary phase attracting higher corporate tax payments.
•  With higher income taxes, firms are left with lower surplus causing a decline in their consumption and investments and thus in the aggregate demand. Again, during expansion unemployment falls, therefore government expenditure by way of transfer payments falls and with lower government expenditure inflation gets controlled to a certain extent. 
• Briefly put, during an expansionary phase, all types of incomes rise and the amount of transfer payments decline resulting in proportionately less disposable income available for consumption expenditure. The built-in stabilisers automatically remove spending from the economy to reduce demand-pull inflationary pressures and further expansionary stimulation.
•  In brief, automatic stabilizers work through limiting the increase in disposable income during an expansionary phase and limiting the decrease in disposable income during the contraction phase of the business cycle. Since automatic stabilizers affect disposable personal income directly, and because changes in disposable personal income are closely linked to changes in consumption, these stabilizers act swiftly to reduce the extent of changes in real GDP.
• However, automatic stabilizers that depend on the level of economic activity alone would not be sufficient to correct instabilities. The government needs to resort to discretionary fiscal policies. 
• Discretionary fiscal policy for stabilization refers to deliberate policy actions on the part of government to change the levels of expenditure, taxes to influence the level of national output, employment and prices. Governments influence the economy by changing the level and types of taxes, the extent and composition of spending, and the quantity and form of borrowing.
• Governments may directly as well as indirectly influence the way resources are used in an economy. We shall now see how this happens by investigating into the fundamental equation of national income accounting that measures the output of an economy, or gross domestic product (GDP), according to expenditures.

                                              GDP = C + I + G + NX.

We know that GDP is the value of all final goods and services produced in an economy during a given period of time. The right side of the equation shows the different sources of aggregate spending or demand namely, private consumption (C), private investment (I), government expenditure i.e purchases of goods and services by the government (G), and net exports, (exports minus imports) (NX). It is evident from the equation that governments can influence economic activity (GDP) by controlling G directly and influencing C, I, and NX indirectly, through changes in taxes, transfer payments and expenditure.

INSTRUMENTS OF FISCAL POLICY

• Fiscal policy is a vital component of the general economic framework of a country and is therefore closely connected with its overall economic policy strategy. The ability of fiscal policy to influence output by affecting aggregate demand makes it a potential instrument for stabilization of the economy.
•  The Keynesian school is of the opinion that fiscal policy can have very powerful effects in altering aggregate demand, employment and output in an economy when the economy is operating at less than full employment levels and when there is need to offer stimulus to demand.
•  As such, there is a significant and justifiable role for the government to institute relevant fiscal policy measures. In fact the global financial crisis about the year 2008 has caused fiscal policy to be at centre of the public policy debate.

The tools of fiscal policy are taxes, government expenditure, public debt and the government budget. We shall discuss each of them in the following paragraphs.

Government Expenditure as an Instrument of Fiscal Policy

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. Government expenditure is an important instrument of fiscal policy. It includes governments’ expenditure towards consumption, investment, and transfer payments. Government expenditures include:

1. current expenditures to meet the day to day running of the government,
2. capital expenditures which are in the form of investments made by the government in capital equipments and infrastructure, and
3. 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.

Government may spend money on performance of its large and ever-growing functions and also for deliberately bringing in stabilization. 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. Additionally, a programme of public investment will strengthen the general confidence of businessmen and consequently their willingness to invest. Primary employment in public works programmes will induce secondary and tertiary employment, and before long the economy is put on an expansion track.
• A distinction is made between the two concepts of public spending during depression, namely, the concept of ‘pump priming’ and the concept of 'compensatory spending'. Pump priming assumes that when private spending becomes deficient, certain volumes of public spending will help to revive the economy. Compensatory spending is said to be resorted to when the government spending is carried out with the obvious intention to compensate for the deficiency in private investment.
• 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 helps to eliminate excess aggregate demand.

Taxes as an Instrument of Fiscal Policy

• Taxes form the most important source of revenue for governments. Taxation policies are effectively used for establishing stability in an economy.
•  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. 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.
• 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.

Public Debt as an Instrument of Fiscal Policy

• A rational policy of public borrowing and debt repayment is a potent weapon to fight inflation and deflation. 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 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.

Budget as an Instrument of Fiscal Policy

• Government’s budget is widely used as a policy tool to stimulate or contract aggregate demand as required. 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 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 of expenditures made. 
• 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. 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 government sector.
• While a budget surplus reduces national debt, a budget deficit will add to the national debt. A nation’s debt is the difference between its total past deficits and its total past surpluses. If a government has borrowed money over the years to finance its deficits and has not paid it back through accumulated surpluses, then it is said to be in debt. Deliberate changes to the composition of revenue and expenditure components of the budget are extensively used to change macro economic variables such as level of economic growth, inflation, unemployment and external stability. 
• For instance, a budget surplus reduces government debt, increases savings and reduces interest rates. Higher levels of domestic savings decrease international borrowings and lessen the current account deficit.