Fiscal Policy
Fiscal Policy
Fiscal Policy
Fiscal policy is the process of shaping government taxation and government spending
so as to achieve certain objectives. According to Prof. Samuelson, by a positive fiscal
policy we mean the process of shaping public taxation and public expenditure in order
to:
There are two views regarding the policies adopted by the government in order to
operate the economy – Classical View and Keynesian View.
1. Classical View: Classical economics, the prevailing economic theory prior to the
Great Depression, hypothesizes that market economies are inherently stable. In
particular, actual GDP automatically adjusts to the economy's productive capacity,
called potential GDP. Economic capacity is determined by the quantity and quality of
resources available (e.g., labour, capital and natural resources). If resource prices are
flexible, they will adjust until resources are fully employed and the economy is operating
at economic capacity. If resources are under-employed, their prices will fall. Production
becomes more profitable as resource prices fall, encouraging firms to expand output.
GDP expands until under-employment is eliminated. Conversely, prices will increase
for over-employed resources, reducing profits, decreasing production and eliminating
over-employment.
With sufficient resource price flexibility, the economy will adjust to full employment
relatively quickly. In this case, counter-cyclical fiscal policy is unnecessary in the short
run and counterproductive in the long run. If resource price flexibility stabilizes the
economy relatively quickly, fiscal policy is unnecessary in the short run. Furthermore,
the economy cannot accommodate the increased aggregate demand after returning to
full employment, assuming potential GDP is unaffected by expansionary fiscal policy.
Thus, expansionary fiscal policy increases prices in the long run, rather than GDP. As a
result, Classical economists believe that the Federal Government should maintain a
balanced budget; flexible resource prices stabilize the economy at full employment.
2. Keynesian View: John Maynard Keynes formalized a theory linking fiscal policy and
economic performance in his book ‘General Theory of Employment, Interest, and
Money’ in 1036. He believed that Classical economic theory was inconsistent with the
Great Depression that the U.S. and world economies experienced in the 1930s. Even
though the U.S. unemployment rate reached 25% in 1933, flexible resource prices failed
to restore full employment.
Keynes offered two explanations for the Great Depression: sticky prices and
pessimistic expectations. Keynes hypothesized that resource and product prices are
sticky rather than flexible, particularly with respect to price decreases (i.e., a horizontal
AS curve, at least in the short run). Sticky prices are slow to decrease as
unemployment increases. Furthermore, if producers and consumers have pessimistic
expectations, price decreases might not stimulate increased production. Lower
resource prices will only increase output if producers expect to sell the extra output. If
consumers are pessimistic about future economic conditions, they will not consume
more as prices fall; accordingly, business will not increase output. Thus, falling prices
might not stimulate business investment and production.
Keynes believed that prices were sticky and expectations pessimistic during the Great
Depression. Under these conditions, the economy can experience prolonged high
unemployment rates. Keynes advocated counter-cyclical fiscal policy to supplement
private spending and stabilize the economy. He felt that the potentially prolonged
unemployment during an economic contraction imposes unacceptable social and
personal costs. He supported counter-cyclical fiscal policy to minimize these short run
costs.
Keynes was among the first to advocate that federal budget deficits are appropriate in
the short run when the economy is operating below full employment.
Professor Lind Holm in his book ‘Introduction to Fiscal Policy’, laid down the following
four main objectives of fiscal policy
The objectives of fiscal policy differ in different countries according to their economic
conditions and needs. That is why, the fiscal policy is known as the process of shaping
taxation and public spending with a view to achieve certain specific objectives. In
advanced countries, the objectives of fiscal policy is to increase aggregate demand by
stimulating consumption function, whereas in underdeveloped countries, the
consumption of luxurious items has to be discouraged in order to encourage saving for
increasing the rate of economic development. In economically advanced countries, the
goal of fiscal policy may be to reduce the inequality of income in order to check under
consumption; whereas in a backward economy, unequal distribution of wealth may be
allowed rather encouraged for promoting capital formation. Though the objectives are
controversial but they are grouped into three:
2. To dampen the swings of business cycle and promote moderate price stability
in the economy,
1. Full-Employment: An economy can attain the potential rate of growth when the full-
employment rate of capital formation, rate of technological change, the improvement in
levels of skill and education, and increased availability of other factor units are
achieved. Total spending (C + I + G) must at all times keep pace with rising national
income (Y), or otherwise the unemployment will develop.
2. Price Level Stability: The maintenance of a reasonably stable general price level is
also regarded as a major objective of fiscal policy. A decline in the general price level is
incompatible with the maintenance of full employment and would generate bitter labour
strife, as well as injuring debtors. Inflation – a rising price level – does offer the limited
advantage of aiding investment. However, a continued inflation of any magnitude
produces is undesirable.
Stability in the price level does not require stability of prices of all individual
commodities. Commodities experiencing more than average increases in productivity
will decline in price; and those with little change in productivity will rise as money wages
rise to reflect the higher productivity in the other fields. If money wages keep pace with
productivity in manufacturing, the general price level will rise slowly.
As full employment is approached unions may tend to push money wages up faster
than productivity and prices will rise. Some trade off between the two objectives may be
necessary, that is, society may have to accept some unemployment in order to avoid
inflation. One study concludes that 4% unemployment is necessary if the increase in
the general price level is to be held to 1½ percent; with 3 percent unemployment the
price level increase will be 2½ percent or more.
3. Sustained Economic Growth: The third goal of fiscal policy is to increase the
potential rate of economic growth. A higher rate of economic growth requires a higher
rate of capital formation and a higher S/Y ratio at full employment. But additional saving
requires reduction in consumption. It is a choice between present and future
consumption.
(a) Taxes: Our present tax system automatically operates to eliminate the cyclical
fluctuation in the economy. When a wave of optimistic sentiments prevails in the
business circles and there is a rise in prices, rise in profits and the need is to contract
the inflationary pressure, the progressive tax system comes to rescue and contracts the
surplus purchasing power from the economy. When a country is faced with falling
income and expenditure, the burden of tax automatically lessens. The state has not to
make any conscious effort to counteract deflationary potential. As the graduated rates
apply on income, the burden of the tax is reduced. The consumers are thus left with
more purchasing power to spend on consumption as well as on producer goods. We,
thus, conclude that the progressive tax system contains automatic stabilising properties.
(i) Government receives greater amount of payroll taxes from the employees,
and
Thus, during boom period, the unemployment compensation reserve funds help in
moderating the inflationary pressure by curtailing income and consumption. When the
economy is contracting, unemployment compensation and other welfare payments
augment the income stream and they prove a powerful factor increasing income, output
and employment in the country.
(c) Farm Aid Programme: Farm aid programmes also stabilise against the wave like
cyclical fluctuation. When the prices of the agricultural products are falling and the
economy is threatened with depression, government purchases the surplus products of
the farmers. The income and total spending of the agriculturists thus remain stabilised
and the contraction phase is warded off to some extent.
When the economy is expanding, the government sells these stocks and absorbs the
surplus purchasing power. It thus reduces inflationary potential by increasing the supply
of goods and contracting the pressure of too great spending.
(d) Corporate Savings and Family Savings: The credit of having automatic or built-
in stabiliser does not go to the state alone. The corporations and companies and wise
family members too play an important part to contract cyclical fluctuations. For
instance, the corporations pay a fixed amount every year to the shareholders and
withhold part of the dividends of the boom years to pay in the depression years. Thus
holding back some earnings of good years contracts the purchasing power and
releasing of money in poorer years, expands the purchasing power of the people.
Similarly, wise persons also try to save something during the prosperous days in order
to spend the savings in the rainy days.
(i) Persuasion,
(i) Persuasion: In a capitalistic society, the entrepreneurs are not aware of each other’s
investment plans. They, therefore, in competition with one another over-invest capital in
a particular industry or industries and thus cause overproduction and unemployment in
the economy. Similarly, in depression period, there is no agency to guide them. If
government publishes the total investment plans and marginal efficiency of capital in
various industries, much of the investment can proceed at a moderate speed and there
can be stability to some extent in income, output and employment.
(ii) Changes in tax rates: It is an important weapon of fiscal policy for eliminating the
swings of the business cycle. When the government finds that planned investment is
exceeding planned savings and the economy is likely to be threatened with inflationary
gap. It increases the rates of taxes. The higher taxes, other things remaining the same,
reduce the disposable income of the people who then are forced to cut down their
expenditure. The economy is thus, saved from inflationary situation.
If, on the other hand, planned saving is in excess of planned investment and the
economy is likely to be faced with deflationary gap, the taxes are lowered considerably
so that people are left with more disposable income. When purchasing power of the
people increases, the rate of spending on consumption and investment increases. The
economy is thus saved from deflationary situation.
(iii) Varying public works expenditure: Another important factor, which influences
economic activity, is public expenditure. In times of depression, the government can
contribute direct to the income stream by initiating public works programmes and in
boom period it can withdraw funds from the income stream by curtailing them.
(iv) Credit aids: The government can also avert depression by offering long-term credit
aids to the needy industrialists of starting or expanding the business. It can also give
financial help to insurance companies and bankers to prevent their failures.
(v) Transfer Payments: Variation in transfer expenditure programmes can also help in
moderating the business cycle. When the business is brisk, the government can refrain
from giving bonuses to the workers and thus can lessen the pressure of too great
spending to some extent. When the economy is in recession, these payments can be
released and more bonuses can be given to stimulate aggregate effective demand.
(b) Long-Run Fiscal Policy: The objectives of long-run fiscal policy / full fiscal policy
are as below:
Phases of Long-Run or Full Fiscal Policy: The long-run fiscal policy has two phases:
The trend line 3 indicates a state of chronic depression which Professor Hansen calls
secular stagnation. When the economy is having a deflationary gap over decades, the
anti-cyclical fiscal measures alone cannot lift the economy from secular stagnation. The
following long-term fiscal measures are recommended to overcome the situation:
The role of fiscal policy is to remove the inflationary or deflationary gap from the
economy. The government can apply three main fiscal tools, i.e., tax, government
spending, and transfer payments:
In the above diagram, the economy is operating at equilibrium point E1, which is less
than the full employment level of E2, or in other words, the economy is facing
deflationary gap. At point E1, the aggregate demand curve AD1 intersects the aggregate
supply curve AS. When government spending is increased, the aggregate demand
increases from AD1 to AD2. Now the new aggregate demand curve AD2 intersects the
aggregate supply curve AS at a new point of equilibrium, i.e., E2. At this new
equilibrium point E2, the national output is higher than before and the economy is
operating under full employment level.
(b) Decrease taxes: Generally speaking, the tax multiplier for a decrease in taxes is
weaker than the government spending multiplier, because:
In the above diagram, the economy is operating at equilibrium point E1, which is less
than the full employment level of E2, or in other words, the economy is facing
deflationary gap. At point E1, the aggregate demand curve AD1 intersects the aggregate
supply curve AS. When government decreases taxes to give a boost in consumption
and investment expenditure, the aggregate demand increases from AD1 to AD2. Now
the new aggregate demand curve AD2 intersects the aggregate supply curve AS at a
new point of equilibrium, i.e., E2. At this new equilibrium point E2, the national output is
higher than before and the economy is operating under full employment level.
(i) will cause a decrease in aggregate demand more than the change in
government spending through multiplier effect
(ii) is always undertaken when there is a severe inflationary gap in the economy
In the above diagram, the economy is operating at the equilibrium point E1, which is
higher than the full-employment level of EO, or in other words, the economy is facing an
inflationary gap. At point E1, the aggregate demand curve AD1 intersects the aggregate
supply curve AS. When the government reduces its spending, the aggregate demand
curve shifts from AD1 to ADO. Now the new aggregate demand curve ADO intersects the
aggregate supply curve AS at a new point of equilibrium, i.e., EO. At this new
equilibrium point EO, the national output is less than before and the economy is
operating under full employment level.
(b) Increase taxes: If the economy is operating at a level above full employment
level, the government can remove this inflationary gap through excessive taxation. The
removal of inflationary gap will depend on the multiplier effect of increase in tax or tax
multiplier. These fiscal measures will bring the following changes in the economy:
(iii) finally a decrease in national output cutting the extra inflationary pressure in
the economy
In the above diagram, the economy is operating at the equilibrium point E1, which is
higher than the full-employment level of EO, or in other words, the economy is facing an
inflationary gap. At point E1, the aggregate demand curve AD1 intersects the aggregate
supply curve AS. When the government increases taxes, the aggregate demand curve
shifts from AD1 to ADO. Now the new aggregate demand curve ADO intersects the
aggregate supply curve AS at a new point of equilibrium, i.e., EO. At this new
equilibrium point EO, the national output is less than before and the economy is
operating under full employment level.
(c) Decrease transfer payments: Decrease in transfer payments can improve the
inflationary situation in the economy, but decreases in pensions, unemployment
compensations, allowances, can be very controversial and socially apathetic. However,
a decrease in transfer payments can remove the inflationary gap from the economy.
Fiscal Policy with Reference to Under-Developed Countries
The role of fiscal policy in less-developed countries differs from that in developed
countries. In developed countries, the role of fiscal policy is to promote full employment
without inflation through its spending and taxing powers. Whereas the position of
developing nations is entirely different. The LDCs or economically backward countries
are caught up in vicious circle of poverty. The vicious circle of low income, low
consumption, low savings, low rate of capital formation and low income has to be
broken by suitable fiscal measures. Fiscal policy in developing countries is thus used
to achieve which are different from advanced countries. The principle objectives of
fiscal policy in a developing economy are as under:
(a) Taxation: Taxation is an important instrument for fiscal policy. It is widely used to
mobilise the available resources for capital formation in the economy. The moping up of
surplus resources through taxation is an effective mean of raising resources for capital
formation. There are two types of taxes which are levied to transfer funds from private
to public use:
(i) Direct taxes: are levied on the income, profits and wealth of the people who
have potential economic surplus.
(ii) Indirect taxes: are the taxes such as excise duty, sales tax, etc, imposed
mostly on good which have higher income elasticity of demand.
(b) Tax on farm income: Agriculture sector is another important source of revenue
which can be tapped for capital formation. Agriculture is the largest sector of under-
developed countries and should be subject to progressive taxation. The government
can raise a substantial amount of tax revenue from agriculture sector.
(a) Income from government saving schemes be exempted from taxation, in order to
boost up private saving,
(b) Rates of return on voluntary contribution to provident fund, insurance premium,
etc., be raised for incentive to save,
(c) Retained profits of the public companies should be taxed at preferential rates or
exempted from taxation, in order to boost private investment, and
(d) Rebates and liberal depreciation allowances can also be granted to encourage
investment in the private sector.
(a) Indirect crowding out: is the tendency of expansionary fiscal policy through
deficit spending increases interest rate which in turn reduces investment and
consumption. The interest rate declines because government finances budget deficit by
government borrowing and this will compete with the private sector in terms of
borrowing money. Because of this, aggregate demand increases by less than the
amount of the increase in government spending.
(b) Direct Crowding out: refers to the situation when expenditure offsets directly.
Actions taken by the private sector will offset government spending actions. That is the
way private sector will spend their money cancel out government actions.
3. Time lags:
(a) Recognition time lag: the time lag required to get information about the economy
(recession or inflation)
(b) Administrative time lag or action time lag: the time required between
recognizing the economic problem and applying fiscal policy into effective. It is too short
for both monetary and fiscal policy.
(c) Operational lag or effect time lag: the time that elapses between the onset of the
policy and the results of that policy.
4. Supply side economics: Both traditional fiscal policy and Supply Side economists
suggest tax cuts to stimulate GDP. Fiscal policy emphasizes the short run effects of tax
cuts on aggregate demand. Supply side economics emphasizes the long run effects of
tax cuts on economic capacity. In the supply side model, economic capacity is largely
determined by the quantity of available resources. Reducing marginal tax rates can
increase the supply of resources and expand productive capacity (e.g., by reducing
taxes on personal income, corporate profits, capital gains, savings and capital
investment).
Keynes and the early Keynesian economists believed that counter-cyclical fiscal policy
was more effective than monetary policy for stabilizing the economy. This belief
considers the mechanisms through which monetary policy affects macroeconomics
performance and experience during the Great Depression. Specifically, an increase in
the money supply stimulates the economy both directly and indirectly. (See Monetary
Policy.) As the money supply increases, and supply exceeds demand, individuals will
reduce their money holdings by increasing both consumption and savings. Increases in
consumption increase aggregate demand. Increases in savings reduce interest rates.
As interest rates fall, investment demand increases and consumption demand increases
further (as savings rates fall). Thus, expansionary monetary policy stimulates GDP in
the short run through a direct increase in consumption demand and indirectly through a
decrease in interest rates. As with expansionary fiscal policy, expansionary monetary
policy is inflationary in the long run, after prices adjust to restore full employment.
Keynesians felt that pessimistic expectations during a recession would negate the short
run effects of expansionary monetary policy. In particular, as the money supply
increases, pessimistic individuals won't use the excess money supply to increase
consumption. Thus, there is no direct effect on GDP. Furthermore, investment and
consumption demand will not increase as interest rates fall. Pessimistic individuals
won't increase consumption as interest rates fall and pessimistic firms will not invest.
Thus, there is no indirect effect on GDP. Pessimism renders monetary policy ineffective
in the Keynesian model. Keynes referred to this situation as a "liquidity trap."
Therefore, early Keynesians relied on counter-cyclical fiscal policy to stabilize GDP.
Most modern Keynesian economists recognize that monetary policy has a short run
impact on GDP (Keynes’ liquidity trap is no longer relevant). Furthermore, the policy
implementation lags are significantly shorter for monetary policy than they are for
discretionary fiscal policy. Discretionary fiscal policy requires parliamentary approval;
monetary policy can be implemented autonomously by the central bank. Thus,
Keynesians increasingly support automatic fiscal stabilizers and monetary policy;
discretionary fiscal policy plays a smaller role.
Monetary Policy
Increasing the money supply relative to its demand creates an excess supply of money.
Individuals will spend some of this money on consumption goods and save the rest in
either savings accounts or by investing in stocks, bonds and other interest bearing
assets. An increase in savings reduces interest rates. Capital market competition and
arbitrage spreads the lower interest rates across all short run financial markets. As
interest rates fall, investment demand and consumer durable purchases increase.
Finally, lower interest rates affect exchange rates. As domestic interest rates fall
relative to international interest rates, domestic investment shifts to foreign markets;
foreign investment in domestic capital markets also decreases. This increases the
supply of rupees relative to demand in the international currency markets, lowering the
price of a rupee. Lower exchange rates stimulate exports and reduce imports. Thus,
increasing the money supply increases aggregate demand for consumption, investment
and net exports.
Demand side macroeconomics policies are often used to offset business cycles and
stabilize economic performance, particularly prices and unemployment. If the economy
is operating below full employment, monetary and fiscal policies can be used to
increase aggregate demand. Presumably, businesses will increase output to satisfy the
increase in aggregate demand. If there are unemployed resources, including human,
capital and natural resources, output can increase without significantly increasing
prices. As the economy approaches full employment, and there are few slack
resources, increases in aggregate demand primarily affect wages and prices.
Businesses must compete against one another for the limited supply of resources;
product prices increase with wages and input prices. Given these responses,
expansionary monetary and fiscal policy can stimulate employment during an economic
downturn; contractionary monetary and fiscal policy can alleviate inflationary pressures
when the economy is over heated.
Macroeconomic stabilization is generally considered a short run policy. In the long run,
market prices for capital, labour and other inputs adjust to full employment. The
economy automatically converges to full employment in the long run. In contrast,
supply side economics addresses long run economic performance. Supply side
economics emphasizes aggregate supply. Supply side economics hypothesizes that
long run economic growth requires expanding productive capacity. In the supply side
model, reducing marginal tax rates increases productive capacity by increasing the
labour supply and capital investment. Increasing economic capacity enables the
economy to accommodate growth while reducing inflationary pressures.