FISCAL POLICY

FISCAL POLICYFiscal PolicyFiscal policy is a policy under which the government uses its expenditures and revenue programmes to produce desirable effects and avoid undesirable effects on the national income, production and employment.Scope of Fiscal PolicyBudgetary surplus and deficitGovernment expenditureTaxationPublic debtDeficit financingObjectives of Fiscal PolicyFull employmentEconomic stabilizationEconomic growthEconomic equality social justice or equity in the distribution of income and wealthExternal balanceFiscal Policy for full EmploymentTaxation should be devised to promote and sustain consumption and investment.To raise the level of effective demand and to overcome depressionary forces, budget should be in deficit and it should have deficit financing.Public expenditure has to be compensatory one. It has to be in a planned way to finance public works programmes and provide social security measures.Direct taxes should be lowered to encourage savings and investments directed towards creation of more employment opportunities.Public expenditure should be meant for uplifting the level of aggregate demand, investment and employment.Public borrowing should be on a large scale to finance productive public expenditure.Fiscal Policy and Economic StabilisationThis goal implies maintenance of full employment with relative price stabilisation.Inflation should be curbed and deflation should be avoided.In a growing economy, when huge investment is undertaken to construct social overhead capital, infrastructure of the economy and development of heavy industries is done it leads to demand pull and cost push inflation.Fiscal Policy and Economic GrowthFiscal policy should aim at improving marginal propensity to save and consequent incremental saving which can be done through:Imposition of additional taxesDirect physical controlRevenue of public enterprisesPublic debtDeficit financing.To induce and stimulate private sector investmentTo promote investment into socially desirable channelsFiscal Policy and External BalanceFiscal policy is one of the important measure to reduce the gap between external payment obligations and external earnings.This gap arises mainly due to decreasing trade balance or current account deficits.Measures that are adopted are:Imposition of heavy import duty, especially on the import of consumer goods andSubsidization of exportThis measure will efficiently work only when both imports and exports are price elastic.Fiscal policy in DepressionDuring depression or recession, the govt. must adopt a deficit budget policy, while a surplus budget policy is to be followed to combat inflation.During a depression a deficit budget can be created.The level of public expenditure is kept unchanged, but the taxation rates are reduced. Taxation rates are kept unchanged but public expenditure is increased.The second method is regarded as more significant as an anti- depressionary measure. The excess of expenditure may be financed through public borrowing plus deficit financing i.e. creation of new money.Fiscal policy in DepressionThe public work expenditure has 2 variants: pump- priming and public spending or compensatory spending.Pump-priming refers to that initial public expenditure which helps to initiate and revive economic activity in a depressed economy.Public spending or compensatory spending- refers to government expenditure which is undertaken with the idea of compensating the decline in private investment. During depression private investment declines due to the low marginal efficiency of capital, whose automatic revival is not possible.Deficit FinancingThe term deficit financing means that the government spends more than it collects in taxes, leaving the budget unbalanced. When the government spends more money than it takes away from the public in the form of taxes, there must be a net addition to the money income available for spending by the public. this represents a net addition to the effective demand results in more employment and the creation of a larger real national income.Deficit FinancingIn adopting compensatory financing public progammes as an anti-depression measure, however the following difficulties may be encountered:There has to be a proper timing of public investment. But it is difficult to forecast the advent of depression.The required magnitude of public investment is to be determined in relation to the duration and amplitude for the depression.The advent of depression cannot be checked as soon by the immediate enforcement of compensatory public spending.When compensatory public spending is financed through public loans it adds to the burden of public debt.Any public work project when undertaken has to completed. And if it does not coincide with the contraction phase and if it is prolonged further even when depression is overcome, it will generate inflation.Role of Fiscal Policy in Developing countriesThe main goal of fiscal policy in a newly developing economy is the promotion of the highest possible rate of capital formation.Another objective of fiscal policy, in a poor country is to divert existing resources from unproductive to productive and socially more desirable uses.An important aim of fiscal policy in a developing economy is to create and equitable distribution of income and wealth in the society.Fiscal policy in a poor country has an additional role of protecting the economy from high inflation domestically and unhealthy developments abroad.Role of Fiscal Policy in Developing countriesFor developing countries such as India the following main objectives of the fiscal policy may be restated as: To increase the rate of investment and capital formation, so as to accelerate the rate of economic growth.To increase the rate of savings and discourage actual and potential consumption.To diversify the flow of investment and spending from unproductive uses to socially most desirable channels.To check sectoral imbalances.

Instruments of Fiscal Policya. Taxesb. Public expenditurec. Public borrowing

Taxes a) 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 income 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.On the other hand, deficient demand is caused due to low level of personal disposable income. Therefore, government of a country should reduce the rate of direct taxes such as personal income tax, and corporate tax.

Public expenditure (b) 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. As a result, national income would rise due to the operation of multiplier and aggregate demand for goods would expand.

Public borrowing(c) 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. Rather, government should repay the past loans to the people to increase their disposable income.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.

FISCAL POLICY CHOICES1. Expansionary fiscal policy: used to combat a recession.

2. Contractionary fiscal policy: used to combat demand-pull inflation, due to excess spending.EXPANSIONARY FISCAL POLICYExpansionary Policy needed: a decline in investment has decreased AD, so real GDP has fallen, and also employment has declined. A possible fiscal solution may be:a. An increase in government spending, which shifts AD to the right by more than the change in G, due to the multiplier.b. A decrease in taxes (raises income, and consumption rises by MPC times the change in income). AD shifts to the right by a multiple of the change in consumption.c. A combination of increased G spending and reduced taxes.d. If the budget was initially balanced, expansionary fiscal policy creates a budget deficit.CONTRACTIONARY FISCAL POLICYContractionary Policy needed: When demand-pull inflation occurs, a shift of AD to the right in the vertical range of AS, then contractionary policy is the remedy.a. A decrease in G spending shifts AD back left, once the multiplier process is complete. Here price level returns to its pre-inflationary level, but GDP remains at full-employment level.b. An increase in taxes will reduce income, and then consumption at first by the MPC times the decrease in income, and then the multiplier process leads AD to shift leftward still further.c. A combined G spending decrease and tax increase could have the same effect with the right combination.d. If the budget was initially balanced, a contractionary fiscal policy creates a budget surplus.

FISCAL POLICY AND THE AD/AS MODELDiscretionary fiscal policy refers to the deliberate manipulation of taxes and government spending by Congress to alter real domestic output and employment, control inflation, and stimulate economic growth. Discretionary means the changes are at the option of the government.Simplifying assumptions:1. Assume initial government purchases dont depress or stimulate private spending.2. Assume fiscal policy affects only the demand, not supply, side of the economy.FINANCING DEFICITSThe method used to finance deficits or dispose of surpluses influences fiscal policy:Financing deficits can be done 2 ways:1. Borrowing: (crowding out effect) The government competes with private borrowers for funds, and could drive up interest rates; the government may crowd out private borrowing, and this offsets the government expansion.2. Money Creation:When the RBI loans directly to the government by buying bonds, the expansionary effect is greater since private investors are not buying bonds. (Monetarists argue that this is monetary, not fiscal, policy that is having the expansionary effect in this situation).DISPOSING OF SURPLUSESDisposing of surpluses can be done in 2 ways:1. Debt reduction is good, but may cause interest rates to fall and stimulate spending, which could then be inflationary.2. Impounding or letting the surplus funds remain idle would have greater anti-inflationary impact. The government holds surplus tax revenues which keeps these funds from being spent.POLICY OPTIONS: G OR T?Economists have mixed views about whether to use government spending or tax changes to promote stability, depending on their view of the government:If economists are concerned about unmet social needs or infrastructure, they tend to favor higher government spending during recessions and higher taxes during inflationary times.When economists think that government is too large or inefficient, they tend to favor lower taxes for recessions and lower government spending during inflationary periods.EVALUATING FISCAL POLICYTo evaluate the direction of discretionary fiscal policy, adjustments need to be made to the actual budget deficits or surpluses. The standardized budget is a better index than the actual budget in the direction of government fiscal policy because it indicates when the budget deficit or surplus would be feasible if the economy were operating at full employment. In the case of a budget deficit, the standardized budget:Removes the cyclical deficit that is produced by swings in the business cycle, andReveals the size of the standardized deficit, indicating how expansionary the fiscal policy was that year. PROBLEMS, CRITICISMS, AND COMPLICATIONSProblems of timingRecognition lag is the elapsed time between the beginning of recession or inflation and awareness of the occurrence.Administrative lag is the difficulty in changing policy once the problem has been recognized.Operational lag is the time elapsed between change in policy and its impact on the economy.PROBLEMS, CRITICISMS, AND COMPLICATIONSPolitical considerations: Government has other goals besides economic stability, and these may conflict with stabilization policy.1. A political business cycle may destabilize the economy: Election years have been characterized by more expansionary policies regardless of economic conditions.2. State and local finance policies may offset government stabilization policies. They are often procyclical, because balanced-budget requirements cause states and local governments to raise taxes in a recession or cut spending, making the recession possibly worse. In an inflationary period, they may increase spending or cut taxes as their budgets head for surplus.PROBLEMS, CRITICISMS, AND COMPLICATIONS3. The crowding-out effect may be caused by fiscal policy.a. crowding-out may occur with government deficit spending. It may increase the interest rate and reduce private spending which weakens or cancels the stimulus of fiscal policy.b. Some economists argue that little crowding out will occur during a recession.c. Economists agree that government deficits should not occur at Full-Employment. It is also argued that monetary authorities could counteract the crowding-out by increasing the money supply to accommodate fiscal policy.PROBLEMS, CRITICISMS, AND COMPLICATIONSC. With an upward sloping AS curve, some portion of the potential impact of an expansionary fiscal policy on real output may be dissipated in the form of inflation.FISCAL POLICY IN AN OPEN ECONOMYShocks or changes from abroad will cause changes in net exports which can shift aggregate demand leftward or rightward.The net export effect reduces the effectiveness of fiscal policy by offsetting its effects. For example: Expansionary fiscal policy may increase domestic interest rates, which can cause the dollar to appreciate and exports to decline. Contractionary fiscal policy may reduce domestic interest rates, which would cause the dollar to depreciate, and net exports to increase.