LECTURE 11

FISCAL POLICY
Meaning
►Fiscal policy is one of the key tools that governments attempt to
regulate and influence the economy to achieve Macroeconomics Goals.

►In simple words, Fiscal policy refers the use of government spending
and tax policy to influence the path of the economy over time. It means
the use of taxation and public expenditure by the government for
stabilisation or growth of the economy.

►In other words, Fiscal policy refers to the budgetary policy of the
government, which involves the government controlling its level of
spending and taxation within the economy. It is the sister strategy to
monetary policy.

Types of Fiscal policy

There are two main types of fiscal policy. They are:

1. Neutral Fiscal policy: Fiscal policy is said to be neutral when the

level of government spending in relation to tax revenue is stable over
time. This type of policy is usually undertaken when an economy is in
equilibrium- neither rapidly expanding nor contracting. In this
instance, government spending is fully funded by tax revenue, which
has a neutral effect on the level of economic activity.

2. Discretionary fiscal policy: Discretionary fiscal policy refers to

government fiscal policy that alters government spending or taxes. Its
purpose is to expand or shrink the economy as needed. It has two sub-
types as:

(i) Expansionary Fiscal Policy: Discretionary fiscal policy is said to be

Expansionary when the government spends more money than its revenue
collected through taxes. This type of fiscal policy is usually undertaken
during recessions to increase the level of economic activity.

(ii) Contractionary Fiscal Policy: Discretionary fiscal policy is said to

be Contractionary when government spending is lower than tax revenue.
This type of Fiscal policy is undertaken to pay down government debt
and to curb inflation.

Objectives of Fiscal policy:

1. Full employment: The first and foremost objective of fiscal policy in
a developing economy is to achieve and maintain full employment in an
economy. In such countries, even if full employment is not achieved, the
main motto is to avoid unemployment and to achieve a state of near full
employment. Therefore, to reduce unemployment and under-
employment, the state should spend sufficiently on social and economic
overheads. These expenditures would help to create more employment
opportunities and increase the productive efficiency of the economy

2. Price stability: Various classes of society such as consumers,

labourers and employees, agriculturists, producers, traders, etc. are
affected by fluctuation in prices. The general public is adversely affected
by increasing prices. Fiscal policy endeavors to bring stability in prices
by removing demerits of increase/decrease in prices. The impact of the
price increase can be reduced by providing subsidy or decreasing taxes
3. Accelerating the rate of economic development: Primarily, fiscal
policy in a developing economy, should aim at achieving an accelerated
rate of economic growth. Therefore, fiscal measures such as taxation,
public borrowing and deficit financing etc. should be used properly so
that production, consumption and distribution may not be adversely
affected. It should promote the economy as a whole which in turn helps
to raise national income and per capita income.

4. Optimum allocation of resources: Fiscal measures like taxation and

public expenditure can greatly affect the allocation of resources in
various occupations and sectors. Public expenditure in the form of
subsidies and incentives can favorably influence the allocation of
resources in the desired channels. For example, tax exemptions and tax
concessions may help a lot in attracting resources towards the favored
industries. On the contrary, high taxation may draw away resources in a
specific sector.

5. Equitable distribution of income and wealth: A welfare state

should provide social justice by giving equitable distribution of income
and wealth. Fiscal policy can serve as an effective means of achieving
this much desired goal of socialism in developed as well as developing
countries. Progressive tax system can be of much use in realizing this
objective. Moreover, public expenditure helps in redistributing income
from the rich to the poor section of the society

6. Economic stability: Economic stability is another prime aim of a

sound fiscal policy. This goal implies maintenance of full employment
with relative price stabilization. Inflation should be curbed and deflation
should be avoided.

►In short, economic growth and stability are the twin objectives jointly
pursued by a developing country’s fiscal policy. The forces stimulating
growth process should be given a boost at a time while inflationary
pressures are to be curbed. Fiscal measures promote economic stability
in the face of short-run international cyclical fluctuations. These
fluctuations cause variations in terms of trade, making them most
favorable to the developed and unfavorable to the developing
economies. Therefore, fiscal policy plays a leading role in maintaining
economic stability in the face of internal and external forces.
7. Capital formation: The fiscal policy also aims at increasing the rate
of investment in the private and public sector. The rate of capital
formation in developing countries is very low due to unemployment and
low per capita income. The vicious circle of poverty is main the problem
of these countries. Therefore, fiscal policy is adopted in such a way that
it reduces consumption and encourages savings is used to reduce
undesirable consumption in developed countries

From the above discussion, it follows that the objectives of fiscal policy
are not conflicting but complementary to each other.

Components of Fiscal policy

All the decisions taken by government in terms of taxation, resource
mobilization and expenditure comprise Fiscal Policy. There are four
key components of Fiscal Policy:

1. Taxation Policy: The government tries to keep the taxes in tune and
with the help of direct and indirect taxes controls, the government
generates its revenue by imposing both indirect taxes and direct taxes and
at the same time maintain Price stability. Thus, it is important for the
government to follow a judicial system for taxation and impose correct
tax rates such as progressive tax. This is because of two reasons:
(a)The higher the tax, lower the purchasing power of the people. This
will lead to a decrease in investment and production.
(b) The lower tax will leave more money with people that lead to high
spending and thus higher inflation.

2. Expenditure Policy: Expenditure policy of the government deals

with revenue and capital expenditures. Capital Expenditures of the
government include acquisition of long-term assets, such as facilities or
manufacturing equipment etc, which will generate business or additional
profits to government. Revenue Expenditures are those expenditures
which don’t create any productive assets such as interest paid by the
Government of Zambia on all the internal and external loans or pension
and salaries of government employees.

3. Investment and Disinvestment Policy: Investment and

Disinvestment Policy refers to investment in the form of FDI or FII in an
economy from outside the country or disinvestment of government
holding to public or private shares.

4. Debt / Surplus Management: If the government received more than

it spends, it is called surplus. If government spends more than income,
then it is called deficit. To fund the deficit, the government has to
borrow from domestic or foreign sources. It can also print money for
deficit financing

Role of Fiscal Policy in Developing Economy

The main goal of fiscal policy in a newly developing economy is the
promotion of the highest possible rate of capital formation. The fiscal
policy in developing economy should apparently be conducive to rapid
economic development. Developing Economy, fiscal policy can no
longer remain a compensatory fiscal policy. It has a tough role to play in
a developing economy and has to face the problem of growth-cum-
stability. The Roles of Fiscal Policy in Developing Economy are
discussed as below:

1. Resource Mobilization: Owing to acute poverty, the marginal

propensity to consume is very high in developing economies. As a result
the level of saving is very low in these economies. Therefore fiscal
policy has an important role to play in mobilizing saving for capital
formation through taxation and public borrowing. It can also influence
capital formation and savings in the private sector through granting of
various tax concessions and subsidies.

2. Development of Private Sector: In a developing economy the

private sector forms an important constituent of the economy. The
production and productivity of the private sector can be influenced by
fiscal policy. Tax relief, rebates, subsides may be granted to boost up the
productive activity in the private sector. Fiscal tools and measures can
be used to activate capital market to ensure availability of adequate
resources for the private sector.

3. Optimization of Resources Allocation: In developing economies,

fiscal tools can be utilized to effect optimum allocation of resources.
Very often resources in private sector are directed towards the
production of goods which cater to the requirement of richer section of
society. Fiscal tools can be employed to allocate the mobilized resources
in desirable channels of investment. Thus, process of reallocation can be
done by various tax incentive measures and subsidy programmes.

4. Creation of Social and Economic Overheads: In developing

economies, there is the lack of proper development of basic
infrastructures which are vital requirements for economic development.
Provision of social overheads like education and health service will
directly enhance the productive capacity of the people. Expenditure
incurred for the provision of economic overheads like transport
facilities, power generation and telecommunication facilities which will
speed up the process of industrialization. Hence, government has to
provide investments on Building of social and economic overheads
through fiscal measures of taxation and expenditure programmes.

5. Balanced Regional Development: Developing economies face the

problem of regional imbalance in the matter of economic development.
Fiscal tools like tax concession, tax holiday, subsidies, concessions in
infrastructure utilization etc., can be given to private investors to attract
private investment in these backward geographical areas as part of the
strategies for balanced growth.

6. Economic Stability: Fiscal tools such as taxation and expenditure

programmes can be utilized as an effective tool to control cyclical
fluctuations arising during the process of economic development.
Taxation is an effective instrument to deal with inflationary and
deflationary situations.

7. Reduction of Inequality: Provision of equality in income and wealth

form an integral part of economic development in developing
economics. Fiscal policy has an important role to play in reducing
inequality. Instruments of taxation must be used as a means to bring
about redistribution of income. The various fiscal measures directed
towards reduction of inequality in income, wealth and opportunity are:
progressive taxation of income and property, imposition of heavy
taxation on luxury goods, tax exemption or concession to commodities
of mass consumption, government expenditure on relief programmes,
and provision of essential commodities at subsidized price through fair
price shops to the poor etc.

Differences between Fiscal Policy and Monetary Policy

1. While fiscal policy is concerned with how money is spent and

collected by the government, monetary policy is concerned with the
overall supply of money within the economy.

2. Fiscal policy is usually set by the executive and legislative functions.

Monetary policy is generally determined by central banks.

3. Governments adjust fiscal policy by changing levels of taxation and

spending in order to stimulate (or discourage) consumer spending and
maintain healthy levels of employment and inflation. The key metric
here is aggregate demand.

4. Central banks adjust monetary policy by buying and selling treasury

bonds to expand or contract the amount of currency in circulation, and
by raising or lowering the interest rate and reserve ratio (i.e. the amount
of money banks are required to hold onto at any given time) in order to
stimulate (or discourage) lending by banks

EXERCISE

1. In your own words, discuss the difference between fiscal policy

and monetary policy.
2. Explain the link between fiscal policy and the business cycle.
3. Discuss the difference between neutral and Discretionary fiscal
policy
4. Discuss in detail four objectives of fiscal policy.