Fiscal Policy

What is Fiscal Policy?

• FISCAL policy is the use of government spending and taxation to influence the economy.

• Governments typically use fiscal policy to promote strong and sustainable growth and reduce poverty

Tools of Fiscal Policy:• Taxation• Public Expenditure• Public Debt• Deficit Financing• Budget

Types of Fiscal PolicyAutomatic Stabilizer Policy: • Automatic stabilizers—programs that automatically expand fiscal policy during

recessions and contract it during booms—are one form of countercyclical fiscal policy. It is a structural features of government spending and taxation that smooth fluctuations in disposable income, and hence consumption, over the business cycle.

Examples of Automatic Stabilizers:• Taxes:• Taxes are roughly proportional to wages and profits, the amount of taxes collected is

higher during a boom than during a recession. Thus, the tax code acts as an automatic stabilizer.

• Federal Income Tax system is progressive (fraction of income paid in taxes increases as income increases).

• During Economic Expansion a growing fraction of income goes to taxes and slowing the growth in Disposable Income and Consumption.

• This relieves the inflationary pressure associated with expansions.

Automatic Stabilizer Policy:

• Unemployment Insurance• Unemployment insurance, on which the government spends more during

recessions (when the unemployment rate is high), is another example of an automatic stabilizer.

• During Economic Recession unemployment increases and payments are made from the insurance fund to those who are unemployed

• This increases their disposable income and decreases the impact of the recession.• Because of Automatic Stabilizers• 1. GDP fluctuates less than it otherwise would• 2. Disposable Income varies proportionately less than does real GDP• Stabilizers go into effect as tax revenues and expenditure levels change and do not

depend on specific actions but operate in relation to the business cycle.

Types of Fiscal Policy: Automatic Stabilizer

• Automatic stabilizers are linked to the size of the government, and tend to be larger in advanced economies. Why? In advanced economies stabilizers are larger, there may be less need for stimulus—tax cuts, subsidies, or public works programs since both approaches help to soften the effects of a downturn

• Automatic stabilizers are not subject to implementation lags (for example, design, approval, and implementation of new road projects), and their impacts are automatically withdrawn as conditions improve.

• Stimulus may be difficult to design and implement effectively and difficult to reverse when conditions pick up. In many low-income and emerging market countries, however, institutional limitations and narrow tax bases mean stabilizers are relatively weak.

• Even in countries with larger stabilizers, there may be a pressing need to compensate for the loss of economic activity and compelling reasons to target the government’s crisis response to those most directly in need

Discretionary Fiscal policyDiscretionary Fiscal Policy:• The deliberate manipulation of government purchases,

taxation, and transfers in order to promote macroeconomic goals such as full employment, price stability, and economic growth.

• But fiscal policy need not be automatic in order to play a stabilizing role in business cycles.

• Some economists recommend changes in fiscal policy in response to economic conditions—so-called discretionary fiscal policy—as a way to moderate business cycle swings.

• These suggestions are most frequently implemented during recessions, when there are calls for tax cuts or new spending programs to “get the economy going again.”

Demerits of this policy

• Unfortunately, discretionary fiscal policy is rarely able to deliver on its promise.

• This Fiscal policy is especially difficult to use for stabilization because of the “inside lag”—the gap between the time when the need for fiscal policy arises and when the legislature approves and implement it. If economists forecast well, then the lag would not matter because they could tell legislature the appropriate fiscal policy in advance.

• But economists do not forecast well and effectiveness of this policy to counter business cycle fluctuations reduces.

• The case for using discretionary fiscal policy to stabilize business cycles is further weakened by the fact that another tool, monetary policy, is far more agile than fiscal policy.

Objectives of fiscal policy

1.Lifting economy out of depression:• Fiscal policy can play a major role in lifting the economy out of

depression . When the economy is in depression, it is faced with rising unemployment, falling income, severe declining investment and shrinking of economic activities. The government, by undertaking public works programme, increases its expenditure which helps in raising the level of aggregate demand and employment in the economy.

• Another way to increase aggregate demand:• The government can also induce changes in aggregate

investment by reduction of taxes, tax breaks, abolition of sales tax, reducing excise duties etc.

2. Control over Inflation:

• The main fiscal measures to bring down the excess demand (If this is the cause of inflation) in the economy are: (a) reduction in government expenditure, (b) increase in taxes and (c) creating a budget surplus.

• By adopting contractionary fiscal policy, the

aggregate demand curve shifts downward and the economy starts operating at the desired level of income.

3. Control the excessive business cycle fluctuations

• The fluctuations in the economy which are associated with the business cycles can be controlled (smoothed) by fiscal policy.

• For example, when the aggregate demand rises rapidly in the expansionary phase of the business cycle, it can be brought down by reducing government expenditure or raising taxes. This will help in dampening down the expansionary phase.

• In the recessionary phase, the problem of unemployment and low growth can be covered and remedied by cutting taxes and raising government expenditure.

• If timely counter cyclical fiscal measures are adopted the problems of excess or deficiency of demand will never be severe and the economy operates at the potential level of income which is called fine tuning.

4. Equilibrium in Balance of Payments:

• The level of national income is also affected by the balance of payments position of the country.

• If the country has a favorable balance of payments, it will lead to increase in income.

• The fall in the balance of payments has the opposite effect. The government uses fiscal policy in such a way that the balance of payments remains in equilibrium in the short run

5. Economic Growth

• If the economy is operating below its potential level, the increase in government expenditure and cut in taxes is the perfect medicine to bring the economy back to its full employment level.

• Government encourage investment to increase the rate of capital formation by using timely proper fiscal measures. – The government borrowing for financing schemes of development, – the increase in ratio of savings to national income, – cut in taxes to increase investment spending can accelerate the rate of

capital for nation in the country and lead to economic growth