Concepts in Fiscal Policy

8/19/2019 Concepts in Fiscal Policy

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Concepts in Fiscal Policy

Fiscal policy deals with the government policy concerning changes in the taxation and expenditure

overheads and components, while Monetary policy, deals with the changes in the factors and

instruments that aect the supply of money in the economy and the rate of interest. These are

routinely used by governments world over in various policy mix or combinations to have desired

eects and to steer the broader aspects of the economy. In case of India as with most other

economies, the government of India deals with ဴscal policy (through Annual Budget and other timelyinterventions), while there is central bank (Reserve bank of India), that is responsible for execution of

monetary policy.

‘Fiscal policy is result of several component policies or mix of policy instruments. These include, policy

on taxation, subsidy, welfare expenditure, etc; investment or disinvestment strategies; and debt or

surplus management. Fiscal policy is an important constituent of the overall economic framework of

a country and is therefore intimately linked with its general economic policy strategy.’

Types of Fiscal Policy

Neutral Fiscal Policy: This implies a balanced budget where (Government spending = Tax revenue).

It f urther means that government spending is fully funded by tax revenue and overall the budget

outcome has a neutral eect on the level of economic activity.

Contractionary (restrictive) Fiscal policy: This policy involves raising taxes or cutting government

spending, so that (Government spending < Tax revenue) it cuts up on the aggregate demand (thus,

economic growth) and to reduce the in耀ationary pressures in the economy.

Expansionary Fiscal Policy: It is generally used for giving stimulus to the economy ,i.e., to speed up

the rate of GDP growth or during a recession when growth in national income is not sucient

enough to maintain the present standards of living. A tax cut and/or an increase in governmentspending would be implemented to stimulate economic growth and lower unemployment rates. This

is not a sustainable policy, as it leads to budget deဴcits and thus, should be used with caution.

Various combinations of 䂆scal policies

Reduction in Government Spending and no Change in Tax Rates (Contractionary ဴ scal policy): This

policy is useful in moderate in耀ation, which though is part of government’s priority, is not the

foremost objective. This would aect the growth little and sometimes even boost growth due to cut

in in耀ation.

Reduction in Government Spending and Increase in Tax Rates (Contractionary ဴ scal policy): Thispolicy is useful in high in耀ation, when curbing in耀ation is the foremost objective, even above the

economic growth in the short run.

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economy is overheated (When a prolonged period of good economic growth and activity causes high

levels of in耀ation as producers overproduce and create excess production capacity in an attempt to

capitalize on the high levels of wealth) due to too much excitement on the part of investors. Increase

in taxes and interest rates (through monetary policy) would curb the investments in short-run and

prevent economy from going into recession after over-heating.

Reduction in Government Spending and an Equivalent Reduction in Taxes (Balanced Fiscal Policy):

This, is a balanced budget approach, when a government decides to reduce its size and level of itsintervention in economy, then this policy can be adopted. It simply means government is managing

less money and hence less impact on markets and business.

Increase in government spending and tax rates (Balanced ဴscal policy): This would be opposite to the

previous policy as it would increase the size of government. A government on the path of

socialization would adopt such policy.

Increase in government spending and decrease in tax rates (Expansionary ဴscal policy): This would be

adopted to give economy a stimulus though injection of funds, ဴrst the government decreases taxes

and leaves more income with people to spend and invest, then it also spends more to give further

boost to demand through additional income generated through government work. This is only

possible in short-run as this policy leads to massive deဴcits and thus, should be used when situation

is alarming.

Increase in government spending and no change in tax rates (Expansionary ဴscal policy): This is also

a stimulus policy (through public sector), but a more moderate one, which can be used for a bit

longer compared to previous.

Rigid Government spending and decrease in tax rates (Expansionary ဴ scal policy): This policy is

usually adopted to give incentive to private sector to invest and boost growth. Again, a short-run

stimulus policy like previous two.

Tools of 䂆scal policy

Components of Spending

Maintenance (including sta븧 salaries): This component can’t be altered in short-run and hence is

hardly a part of policy making, however, in long-run, through VRS and reducing new jobs in public

sector or vice versa, this expenditure can be altered.

Loan payments: This again is a component, which can’t be touched in short-run, however,

governments in long-run can reduce these payments or eliminate them by running the budget

surplus.

Subsidies: This component is a major part of policy as it can be altered in short-run, but

unfortunately, subsidies as policy instrument, have been abused in India. These are used by

politicians as poll promise and political instruments to gain more popular support. Ideally only

meritorious subsidies shall be in operation and all the wasteful subsidies must be phased out, for

example, fertilizer subsidy and power subsidy beneဴts the large farm holder and capitalist farmers

instead of the needy ones. Similarly, the recent example of Aam Aadmi Party manifesto is a good

example, how subsidies should not be used. In place of these, subsides for health programs,

renewable energy, public transport shall be encouraged to ensure good health and sustainablegrowth.

Welfare schemes: These are one of the policy options that once introduced can’t be removed due to


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. ,

instrument of social welfare and economic growth. However, it is the implementation part, which is

key, as these schemes generally suer from poor implementation and massive corruptions and

loopholes. Thus, despite being meritorious expenditure in nature, these at time appears as waste.

Wasteful expenses: Needless to say these are the expenditures that must be curbed with

immediate eect; however, no government in world has neither shown the intention to curb them,

though there are eorts to reduce them from time to time under public pressure. For example, full

page government advertisements in newspaper to generate favorable public opinion.

Components of Earning

Tax: single: Single most important source on government revenue is also a very important policy

measure as elaborated in the policy combinations above.

Borrowing: Borrowing is a necessary source of funds, though not a desirable one. Particularly, in

developing countries, as tax/GDP ratio is low due to less per capita income. However, it becomes an

important part of monetary policy as well due to its impact on interest rates and credit creation and

thus, overall money supply.

Proceeds from sale/lease of assets: This is a both a one-time and regular source of income. For

example, lending government buildings for private use, or other assets such as telecom spectrum or

lease of a mine block for certain years, is a regular source of income, whereas sale of PSUs is a

onetime income. These however, are good sources of revenue, as they provide government more

room to spend without increasing taxes.

Pro䂆ts from PSU: Proဴts from PSUs can also be a potential source of revenue, however, since most

of PSUs are generating losses, Indian government usually ends up subsidizing them. At times PSUs

are deliberately kept in losses to keep prices low and ensure wider outreach for social welfare,

example, PSU banks in pre-reform era and post-oces. Similarly, at other times, they are in lossesdue to ineciency and wasteful expenditure. Most striking case in India, is of ministerial corruption

to keep PSUs in loss deliberately to beneဴt private sector, for example, CAG report says that, Indian

Airlines was deliberately kept in losses by avoiding 耀ights on proဴtable routes to beneဴt private

airlines during UPA government’s rule. Similarly, in previous NDA government, BSNL was deliberately

pushed into loss, by increasing taris to provide competitive edge to a newly launched company by

one of the biggest business conglomerate in India.

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