FISCAL POLICY

What Is Fiscal Policy?

Fiscal Policy is a demand side policy. It involves decisions about

government spending and taxation. A budget deficit is the excess of
government expenditures over tax revenues for a particular time period,
while a budget surplus arises when tax revenues exceed government
expenditures. Fiscal policy involves the use of government spending,
taxation and borrowing to influence both the pattern of economic activity
and also the level and growth of aggregate demand, output and
employment. It is important to realize that changes in fiscal policy affect
both aggregate demand (AD) and aggregate supply (AS). Fiscal policy is
applied by the federal government.

Two Dimensions Of Fiscal Policy:

 Deals with government revenues/ expenditures

 Debt management

Fiscal Policy and Aggregate Demand:

Traditionally fiscal policy has been seen as an instrument of demand

management. This means that changes in government spending, direct
and indirect taxation and the budget balance can be used to help smooth
out some of the volatility of real national output particularly when the
economy has experienced an external shock.

 The Keynesian school argues that fiscal policy can have powerful
effects on aggregate demand, output and employment when the
economy is operating well below full capacity national output, and
where there is a need to provide a demand-stimulus to the economy.
Keynesians believe that there is a clear and justified role for the
government to make active use of fiscal policy measures to manage
the level of aggregate demand.
  Monetarist economists on the other hand believe that government
spending and tax changes can only have a temporary effect on
aggregate demand, output and jobs and that monetary policy is a
more effective instrument for controlling demand and inflationary
pressure. They are much more skeptical about the wisdom of relying
on fiscal policy as a means of demand management.

Fiscal Policy and Aggregate Supply:

Changes to fiscal policy can affect the supply-side capacity of the economy
and therefore contribute to long term economic growth. The effects tend to
be longer term in nature.

 Labor market incentives: Cuts in income tax might be used to

improve incentives for people to actively seek work and also as a
strategy to boost labor productivity. Some economists argue that
welfare benefit reforms are more important than tax cuts in
improving incentives – in particular to create a “wedge” or gap
between the incomes of those people in work and those who are in
voluntary unemployment.

 Capital spending. Government capital spending on the national

infrastructure (e.g. improvements to our motorway network or an
increase in the building programmed for new schools and hospitals)
contributes to an increase in investment across the whole economy.
Lower rates of corporation tax and other business taxes might also be
used as a policy to stimulate a higher level of business investment
and attract inward investment from overseas
 Entrepreneurship and new business creation: Government
spending might be used to fund an expansion in the rate of new small
business start-ups
 Research and development and innovation: Government
spending, tax credits and other tax allowances could be used to
encourage an increase in private business sector research and
development – designed to improve the international competitiveness
of domestic businesses and contribute to a faster pace of innovation
and invention
  Human capital of the workforce: Higher government spending on
education and training (designed to boost the human capital of the
workforce) and increased investment in health and transport can also
have important supply-side economic effects in the long run. An
enhanced transport infrastructure is seen by many business
organizations as absolutely essential if the UK is to remain
competitive within the European and global economy

Free market economists are normally skeptical of the effects of

government spending in improving the supply-side of the economy. They
argue that lower taxation and tight control of government spending and
borrowing is required to allow the private sector of the economy to flourish.
They believe in a smaller sized state sector so that in the long run, the
overall burden of taxation can come down and thus allow the private sector
of the economy to grow and flourish.

However targeted government spending and tax decisions can have a

positive impact even though fiscal policy reforms take a long time to feed
through. The key is to help provide the right incentives for individuals and
businesses – for example the incentives to find work and incentives for
businesses to increase employment and investment.

Types Of Fiscal Policy:

 Expansionary Fiscal Policy(loose fiscal policy)

 Contractionary Fiscal Policy(tight fiscal policy)

Expansionary Fiscal Policy: In this policy the government expenditures

exceed earnings from tax revenues hence leading towards budget deficit.
To finance this deficit government will either borrow internally from
commercial banks or externally.

It follows a cyclic process:

Government Expenditures Employment Level Aggregate

Demand Income Level (Real Domestic Output)
Thus expansionary fiscal policy increases aggregate demand and real
domestic output level.

The goal of expansionary fiscal policy is to reduce unemployment.

Therefore the tools would be an increase in government spending and/or a
decrease in taxes. This would shift the AD curve to the right increasing real
GDP and decreasing unemployment, but it may also cause some inflation.

Contractionary Fiscal Policy: In this policy government earnings from tax

revenues exceed government expenditures. Aggregate demand decreases
as a result of this policy. Government goes for a surplus and its savings
increase.

The goal of contractionary fiscal policy is to reduce inflation. Therefore the

tools would be an decrease in government spending and/or an increase in
taxes. This would shift the AD curve to the left decreasing inflation, but it
may also cause some unemployment.
 Tools Of Fiscal Policy:

The government’s main objective is the rapid economic growth and in order
to achieve this goal the, it implies various fiscal policy tools which are:

(1) Discretionary Fiscal Policy.

(2) Non Discretionary Controls.

(1) Discretionary Fiscal Policy: Here the deliberate changes are made in
the government and tax structures by the governmental authorities in order
to offset the cyclic fluctuations in the output and employment levels. The
discretionary fiscal policy has short, as well as long-run objectives.
The short-run counter cyclical fiscal policy aims at eliminating business
fluctuations and maintaining moderate stability. The long-run program of
discretionary fiscal policy is to raise the level of income and employment in
the country. In case of sustained long-run inflationary gap in the economy,
the objective of fiscal policy is to reduce the average level of purchasing'
power.
Short Run and Long Run Counter Cyclical Fiscal Policy: some weapons or
stabilizers of short run and long run discretionary fiscal policy are:
(i) Precautions or Guide map
(ii) Changes in tax rates
(iii) Varying public works expenditure
(iv) Credit aids
(v) Transfer payments.

(i) Guide maps: Entrepreneurs usually lack information regarding each

others’ investment plans. 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 rate of taxes.
Higher tax rates generate lower income levels for people hence they go for
spending less and an inflationary situation is avoided in the economy.

(iii) Varying public works expenditure: Another important factor which

influences economic activity is public expenditure. In times of depression,
the government can contribute directly to the income stream by initiating
public works programs and in boom period, it can withdraw funds from the
income stream by curtailing them. This policy has certain limitations.

(iv) Credit aids: The government can also avert depression by offering long
term credit aids to the needy industrialists for starting or expanding the
business. It can also give financial help to insurance companies and
bankers to prevent their failures.

(v)Transfer payments: business cycle could be moderated by making

certain changes in the issuance of transfer payments. The pressure of
great spending could be controlled to some extent if government refrains
from bonus payments in times of brisk businesses. While in times of
recession more bonuses can be released to activate aggregate effective
demand.

(2) Non Discretionary Control:

Automatic or Built in Stabilizers:
The automatic fiscal stabilizers are those which contribute to keep
economic system in balance without human control. These controls are
built into the economy and so are called built in stabilizers. The main
automatic stabilizer is given below:
Progressive Income Tax:
Personal income taxes are the largest source of revenue to the
government. When the disposable income of the people increases in the
boom period, the higher amount of tax reduces disposable income, reduces
consumption and decreases the aggregate demand which help in curbing
economic boom. A reduction in income tax increases disposable personal
income, increases consumption, increases aggregate demand and thus
helps in curbing recession. The expansionary and contractionary fiscal
policies can be summed up and brought under two approaches.

First: Demand Side Fiscal Policy.

Second: Supply Side Fiscal Policy.

(i) Demand side policy: It was originated as a direct result of Keynesian

belief. According to Keynes, during recession, the goal is to raise
aggregate demand to the full employment level. This objective may be
achieved by (a) an increase in government spending (G), (b) a decrease in
tax revenue (T) brought about by reduction in tax rates.
During a period of rapid inflation, the goal is to lower aggregate demand to
the full employment level. The fiscal policy will be:
(a) A decrease in government expenditure
(b) An increase in taxes brought about by rise in the rates.

(ii) Supply side fiscal policy: It is a new approach to fiscal policy. The
modern economists are of view that fiscal policies can also influence the
level of economic activity through their impact on aggregate supply. When
the firms experience, an increase in resource costs due to a sharp rise in
the world price of a major raw material say oil, the higher costs causes a
decrease in aggregate supply creating a recessionary gap. Therefore, an
expansionary fiscal policy in the form of reduced corporate taxes and pay
roll tax can help in closing the recessionary gap. Conversely, an increase in
the corporate tax rate and pay roll tax etc., can help in closing the
inflationary a gap.
(iii) Unemployment compensation: In advanced countries of the world,
people receive unemployment compensation and other welfare payments
when they are out of job. As soon as they get employment, these payments
are stopped. When national income is increasing, the unemployment fund
grows due to two main reasons: (a) The government receives greater
amount of payroll taxes from the employees and (b) the unemployment
compensation decreases.
Thus, during boom years, the unemployment compensation reserve funds
help in moderating the inflationary pressure by curtailing income and
consumption. When the economy is contracting, unemployment,
consumption and other welfare payments augment the income stream and
they prove a powerful factor increasing income, output and employment in
the country. In the words of Samuelson:
"During boom years, therefore, the unemployment reserve fund grows and
exerts stabilizing pressure against too great spending. Conversely, during
years of slack employment, the reserve funds are used to pay out income
to sustain consumption and moderate the decline".
(iv) Farm aid programs: Farm aid programs also stabilize against the
wave like cyclical fluctuations. When the prices of the agricultural products
are falling and the economy is threatened with depression, government
purchases the surplus products of the farmers at the set prices. The
income and total spending of the agriculturists thus remain stabilized 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.
(v) Corporate saving and family savings: The credit of having automatic
or built in stabilizer does not go to the state alone. The corporations and
companies and wise family members 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.
Limitation of built in stabilizers: The automatic or built in stabilizers can
no doubt minimize the upward and downward movements of business
cycle to some extent but they cannot help in achieving full employment
without inflation. They can be used as a first line of defense but they cannot
cure the economic ills of the society. So the policy makers have to be
vigilant and adopt other suitable fiscal measures which can counter cyclical
fluctuation in the economy.

Impact Of Fiscal Policy On Different Macroeconomic Variables:

 Aggregate Demand
 Aggregate Output And Price Level
Aggregate Demand:

Aggregate demand experiences direct and indirect impact due to the

implementation of fiscal policy. In direct channel just an increase or
decrease in government expenditures brings a change in aggregate
demand. If government spending increases the aggregate demand
increases and vice versa. While in the indirect channel by increasing or
decreasing the tax rates a change occurs in disposable incomes of the
individuals hence aggregate demand faces a relative change. If tax rates
are lowered the individuals are left with more disposable income to spend
and hence an upward pressure is exerted on the aggregate demand and
vice versa. Government policies are usually a combination of both
channels.

Aggregate Output And Price Level:

Change in output and price levels depends upon the full employment level
of output. At full employment level of output, certain incentives like
decrease in taxes are given hence stimulating the economy to grow beyond
its full capacity hence heavily affecting prices but not a very high increase
in output. If this change in price level exceeds the change in the level of
output, then inflation will occur in the economy. Change in price represents
differences between aggregate demand and aggregate supply.

If economy is at lower levels of employment there is much room available

for economic boost. Hence change in output will exceed change in price
levels.
Impact Of Fiscal Policy On Different Macroeconomic Variables:

 Crowding out effect

 Financial repression
 National savings schemes of government

Crowding Out Effect: if expansionary fiscal policy is implemented, it leads

to a decrease in tax rates and an increase in government spending, hence
budget deficit will occur due to intense borrowing. When deficit occurs the
demand for money increases in the loan able funds market hence the rate
of interest increases which discourages the private investors and some
small investors move out of the market. Magnitude of crowding out
depends upon private sectors responsiveness to interest rate or interest
elasticity of demand.

Financial repression: it is a controlled financial system in which

government sets interest rate ceilings which leads to credit rationing hence
limiting private sector investment to a certain amount.

National savings schemes of government: government in order to

overcome its budget deficit takes certain measures like permanent debts,
floating or short term debts and unfunded debts. Expansionary fiscal policy
ultimately leads to an increase in the interest rates which attracts people
towards saving in the national savings schemes. Hence people will
withdraw money from commercial banks and start investing in these
schemes thus banks will be left with very little amounts of loan able funds
hence private investment would be discouraged.