What is Fiscal Policy?
- Prior to the Great Depression of the 1930s, government operations were small, and so the influence of fiscal policy was extremely limited.
- During the Great Depression of the 1930s, it was Keynes who popularized this powerful tool of macroeconomic policy. Prior to the introduction of Keynes in economic literature, classicists felt that the government should engage in as little economic activity as possible, and hence that a modest and balanced budget was ideal.
- All of the classical ideas were shattered by Keynes’ General Theory. To treat the economic problems that many European capitalist economies were suffering from at the time, Keynes recommended state involvement and a balanced budget. His policy prescription produced remarkable benefits, and fiscal policy has since become an essential tool in macroeconomic policy.
- Fiscal policy is an important component or organ of government finance. Fiscal policy, in simple terms, is a policy that impacts macroeconomic variables such as national income, employment, savings, investment, price level, and so on.
- “A fiscal policy is one in which the government uses its expenditure and revenue programs to generate desirable results while avoiding unwanted impacts on national income, production, and employment,”.
- A change in fiscal policy that is prompted by the situation of the economy is known as automatic fiscal policy. It’s worth noting that this type of fiscal policy adjusts on its own, with no government intervention.
- Automatic fiscal policy stabilizers modify tax receipts and spending automatically in response to variations in income. During a depression, income drops as unemployment grows. As a result, the government’s tax revenue decreases. Government spending, on the other hand, is increasing.
- As a result, tax receipts and expenditures are subject to automatic stabilizing factors. There is no evidence of the government taking any purposeful action to influence aggregate demand. Receipts and expenditures are automatically adjusted when economic activity changes.
Discretionary Fiscal Policy
- Discretionary fiscal policy, on the other hand, is a policy decision made by the authority. The government may choose to implement this form of fiscal policy on purpose.
- Discretionary fiscal policy refers to deliberate policy adjustments aimed at influencing the level of economic activity. A modification in the government budget is required for discretionary fiscal policy. The government adjusts tax schedules and various spending programs on purpose.
Types of Fiscal Policy
The fiscal policies include several key components, and they are as follows:
Expensionary Fiscal Policy
Capital and revenue expenditures are two types of government spending. Furthermore, the government budget is the most significant mechanism for expressing government spending policies. In addition, the budget is used to cover the deficit. As a result, it bridges the gap between personal income and government spending.
Contractionary Fiscal Policy
Both indirect and direct taxes are used by the government to produce money. As a result, it is critical for the government to adopt a judicial taxation system and levy appropriate tax rates. This is due to two factors. The higher the tax, the lower the people’s purchasing power becomes.
This will result in a drop in investment and output. Furthermore, the lower tax will leave more money in the hands of individuals, resulting in increased expenditure and, as a result, higher inflation.
Management of Surplus and Debt
A surplus occurs when the government gets more money than it spends. A deficit is also defined as when spending exceeds income. The government must borrow money from domestic and international sources to cover its deficits.
Objectives of Fiscal Policy
Fiscal policy refers to government programs that make both automatic and discretionary changes in taxation, public spending, and borrowing in order to achieve the stated goals of economic growth, full employment, income equality, and economic stabilization.
The basic aims of fiscal policy are stated, with a focus on developing countries:
(i) Economic Development:
Since these countries are in a state of permanent poverty, one of the most significant long-term aims of fiscal policy for mostly impoverished countries is economic growth. In other words, fiscal policy attempts to maintain long-term equilibrium and control long-term disequilibrium.
Capital formation is a major determinant of economic growth. Capital formation must be increased in order to boost economic growth. Fiscal policy is a tool that can be used to boost investment. To ensure that economic growth is not impeded, the government must ensure that public investment is increased sufficiently to provide a high multiplier impact.
Fiscal policy should stimulate more savings and investment while discouraging consumption through its tax tool. A government’s prudent tax-expenditure policy will tend to encourage investments in socially beneficial areas of production.
Borrowing by the government may be justified on the basis of increasing income levels. It also allows for the flow of funds for development. To ensure that output growth is not inhibited, the government must ensure that enough public investment is increased, resulting in a positive multiplier effect on the economy.
(ii) Full-Time Employment
Full employment is a major short-term objective of fiscal policy. Government fiscal policy—changes in government spending and tax receipts—has a significant impact on unemployment, output, and other factors. An increase in government spending leads to an increase in the number of people employed.
In fact, government transfer expenditures, particularly public works programs, are more effective at stimulating effective demand and, as a result, employment volume. Indeed, the Government of India’s year-round employment-oriented public expenditure programs aid in the creation of more jobs and incomes.
Not just government spending, but also tax policy, contributes to achieving full employment. A tax cut boosts disposable income in the economy, boosting demand to the level required to absorb the unemployed workforce. Tax policy must be constructed in such a way as to encourage investment and consumption.
This will boost aggregate demand (C + I + G) and, as a result, employment levels. Taxation policy, on the other hand, frequently fails to reach the desired result due to political considerations. As a result, a larger emphasis is placed on various public expenditure programs aimed at lowering the unemployment rate.
(iii) Price Stability
The achievement of the goal of price stability is another short-term fiscal policy goal. Instability in the price level, whether in the form of inflation or deflation, has a number of negative repercussions. As a result, the government builds its budget in such a way that inflation and deflation are kept under control.
A surplus budget is created during times of prosperity or boom, whereas a deficit budget is created during times of depression. To put it another way, raising tax rates and cutting government spending is recommended for controlling inflation, while cutting tax rates and increasing government spending is recommended for deflation.
It is important to remember that inflation will inevitably occur as a result of economic expansion. Fiscal policy should be crafted so that relative price stability, rather than absolute price stability, is the goal.
It’s also worth remembering that fiscal policy’s two objectives—full employment and price stability—are incompatible. Attaining the aim of full employment may result in price instability, whereas achieving the goal of price stability may result in a high level of unemployment. A. W. Phillips observed this type of disagreement.
He suggested that if a government places too much emphasis on price stability, it may not be able to achieve full employment. To put it another way, full employment is frequently connected with high prices, while price stability is frequently associated with a high level of unemployment. As a result, policymakers are faced with a conflict as well as a conundrum. This type of dispute reduces the effectiveness of fiscal policy to some extent.
(iv) Justice and Equity:
Modern welfare states promote social justice by distributing income and wealth in an equitable manner. Fiscal policy is a key tool for bridging the income and wealth divides amongst people. Government policies on taxation and spending can be used to make income distribution more equal.
It accomplishes this by enacting new taxes and raising tax rates in a progressive manner. On the other hand, it spends money on low-income individuals. Thus, economic imbalances between the rich and the poor can be reduced by taxing the wealthy at a progressive rate and using the proceeds to help the needy.
However, it’s difficult to say how far the effects of progressive taxes would trickle down to the poorest members of society. This is because tax revenue falls short of the target amount owing to corruption, tax evasion, and other factors. Since then, the government’s many tax-expenditure programs have made it possible to achieve the goal of equal transfer of income and wealth.
As a result, it is evident that fiscal policy is a crucial tool for influencing aggregate demand in order to accomplish the goal of increased economic growth and stability. Its contribution to alleviating or lowering unemployment and inequality is also undeniable.
The main of aim of fiscal policy
(I) Increase the rate of investment and capital formation in order to boost economic growth.
(ii) To encourage people to save and reduce their consumption of luxury items.
(iii) Allocating existing resources to desired and prioritised areas in order to achieve quick economic growth
(iii) To reduce income and wealth disparities
(v) Maintaining a sufficient level of price stability
Fiscal Policy in Developing Countries: Fiscal policy in developed countries is primarily aimed to combat cyclical swings. In some countries, fiscal policy is also used to control the rate of income growth. Fiscal policy in emerging countries, on the other hand, plays a slightly different role. This is due to the fact that, while various countries face economic variations, the nature of these fluctuations differs.
To begin with, not only do swings occur at a low level of income, but there is also no room for consistent growth. Second, output and price level variations are more noticeable than output and employment level fluctuations. Because of the agriculture sector’s dominance in these economies, supply becomes relatively inelastic, and unemployment becomes a serious concern.
Income and price oscillations, on the other hand, tend to grow more violent. Finally, because agricultural items account for a large portion of export trade, fluctuations are passed from developed to developing countries.
Because international demand for export fluctuates often, the internal economy cannot be immune to such fluctuations or random oscillations. Finally, the nature of inflation in underdeveloped countries is distinct. Because of these factors, fiscal policy in poor countries plays a unique role.
The poorest countries are caught in a vicious cycle of poverty. A country’s growth rate can be boosted by breaking this impasse. As a result, it appears that the primary purpose of fiscal policy in these countries is rapid economic expansion.
However, because these economies are inflation-sensitive, these economies see price increases as a result of economic expansion. Economic growth and stabilization are inextricably linked, in my opinion.
As a result, the most fundamental goal of fiscal policy in emerging countries is to achieve “development with stability.” The nature of fiscal policy has changed as a result of this. In industrialized countries, fiscal policy is reduced to a purely compensating function. However, it cannot be a compensatory measure in developing countries.
The primary goal of fiscal policy in LDCs should be to stimulate capital formation in order to break the poverty cycle. The acquisition of capital is crucial to a country’s economic prosperity. Underdevelopment is caused by a paucity of capital.
As a result, increasing the rate of capital formation in these countries can result in higher and faster economic growth. However, because private money is hesitant to invest in these poor countries, the government steps in to fill the void. To build physical infrastructure, the government spends a lot of money. LDCs can achieve a greater growth rate through accumulating social overhead capital.
Furthermore, higher-order capital accumulation necessitates an increase in aggregate saving. It is fiscal policy that has the potential to increase community savings.
To put it another way, fiscal policy must be designed in such a way that it not only increases overall savings but also reduces actual and potential consumption. Fiscal policy is thus a tool for increasing saving and capital formation, resulting in increased economic growth.
Fiscal policy must also be used in such a way that scarce resources are directed toward socially useful sectors. In these countries, fiscal policy strives to redirect resources away from unproductive industries and toward socially essential development. In other words, fiscal policy is linked to development planning in order to attain stronger economic growth.
However, fiscal policy is not solely focused on increasing economic growth. Its goal is to achieve a more equitable distribution of income and wealth, which is a feature of all current mixed-poor economies. The existence of such disparities between rich and poor people is a major social problem.
In reality, unless equality is achieved, the benefits of increased economic growth will never translate to an improvement in social welfare. A good fiscal policy can help a society redistribute income and wealth.
At the same time, it must be remembered that achieving higher economic growth and income equality targets is rather paradoxical. To put it another way, if the economy screams out for more growth, income disparity will inevitably deepen. Alternatively, if reducing inequality is the primary goal, rapid economic growth will have to be sacrificed to some extent.
As a result, the paradox exists. However, the logic of this claim is debatable. In truth, what’s needed is a compromise between these two seemingly opposing objectives. It is not difficult to accomplish a satisfactory reconciliation between the two fiscal goals of faster economic growth and income equality, and hence maximum social welfare, if well-balanced fiscal instruments are used.
Finally, in LDCs that are inflation-prone, fiscal policy has an additional role to play. Inflation is unavoidable in these economies as a result of economic growth.