Fiscal Policy

The fiscal policy is concerned with the raising of government revenue and incurring of
government expenditure. To generate revenue and to incur expenditure, the government frames a
policy called budgetary policy or fiscal policy. So, the fiscal policy is concerned with government
expenditure and government revenue.
Fiscal policy has to decide on the size and pattern of flow of expenditure from the
government to the economy and from the economy back to the government. So, in broad term
fiscal policy refers to "that segment of national economic policy which is primarily concerned
with the receipts and expenditure of central government." In other words, fiscal policy refers to
the policy of the government with regard to taxation, public expenditure and public borrowings.
The importance of fiscal policy is high in underdeveloped countries. The state has to play active
and important role. In a democratic society direct methods are not approved. So, the government
has to depend on indirect methods of regulations. In this way, fiscal policy is a powerful weapon
in the hands of government by means of which it can achieve the objectives of development.

Main Objectives of Fiscal Policy In India

1. Development by effective Mobilisation of Resources
The principal objective of fiscal policy is to ensure rapid economic growth and development. This
objective of economic growth and development can be achieved by Mobilisation of Financial
Resources.
The central and the state governments in India have used fiscal policy to mobilise resources.
The financial resources can be mobilised by :1.
Taxation : Through effective fiscal policies, the government aims to mobilise resources by
way of direct taxes as well as indirect taxes because most important source of resource
mobilisation in India is taxation.
2.
Public Savings : The resources can be mobilised through public savings by reducing
government expenditure and increasing surpluses of public sector enterprises.
3.
Private Savings : Through effective fiscal measures such as tax benefits, the government
can raise resources from private sector and households. Resources can be mobilised through
government borrowings by ways of treasury bills, issue of government bonds, etc., loans from
domestic and foreign parties and by deficit financing.
2. Efficient allocation of Financial Resources
The central and state governments have tried to make efficient allocation of financial
resources. These resources are allocated for Development Activities which includes expenditure
on railways, infrastructure, etc. While Non-development Activities includes expenditure on
defence, interest payments, subsidies, etc.
But generally the fiscal policy should ensure that the resources are allocated for generation
of goods and services which are socially desirable. Therefore, India's fiscal policy is designed in
such a manner so as to encourage production of desirable goods and discourage those goods
which are socially undesirable.

3. Reduction in inequalities of Income and Wealth

Fiscal policy aims at achieving equity or social justice by reducing income inequalities
among different sections of the society. The direct taxes such as income tax are charged more on
the rich people as compared to lower income groups. Indirect taxes are also more in the case of
semi-luxury and luxury items, which are mostly consumed by the upper middle class and the
upper class. The government invests a significant proportion of its tax revenue in the
implementation of Poverty Alleviation Programmes to improve the conditions of poor people in
society.
4. Price Stability and Control of Inflation
One of the main objective of fiscal policy is to control inflation and stabilize price.
Therefore, the government always aims to control the inflation by Reducing fiscal deficits,
introducing tax savings schemes, Productive use of financial resources, etc.
5. Employment Generation
The government is making every possible effort to increase employment in the country
through effective fiscal measure. Investment in infrastructure has resulted in direct and indirect
employment. Lower taxes and duties on small-scale industrial (SSI) units encourage more
investment and consequently generates more employment. Various rural employment
programmes have been undertaken by the Government of India to solve problems in rural areas.
Similarly, self employment scheme is taken to provide employment to technically qualified
persons in the urban areas.
6. Balanced Regional Development
Another main objective of the fiscal policy is to bring about a balanced regional
development. There are various incentives from the government for setting up projects in
backward areas such as Cash subsidy, Concession in taxes and duties in the form of tax holidays,
Finance at concessional interest rates, etc.
7. Reducing the Deficit in the Balance of Payment
Fiscal policy attempts to encourage more exports by way of fiscal measures like
Exemption of income tax on export earnings, Exemption of central excise duties and customs,
Exemption of sales tax and octroi, etc.
The foreign exchange is also conserved by Providing fiscal benefits to import substitute
industries, Imposing customs duties on imports, etc.
The foreign exchange earned by way of exports and saved by way of import substitutes
helps to solve balance of payments problem. In this way adverse balance of payment can be
corrected either by imposing duties on imports or by giving subsidies to export.
8. Capital Formation
The objective of fiscal policy in India is also to increase the rate of capital formation so as
to accelerate the rate of economic growth. An underdeveloped country is trapped in vicious
(danger) circle of poverty mainly on account of capital deficiency. In order to increase the rate of
capital formation, the fiscal policy must be efficiently designed to encourage savings and
discourage and reduce spending.
9. Increasing National Income
The fiscal policy aims to increase the national income of a country. This is because fiscal
policy facilitates the capital formation. This results in economic growth, which in turn increases
the GDP, per capita income and national income of the country.
10. Development of Infrastructure
Government has placed emphasis on the infrastructure development for the purpose of
achieving economic growth. The fiscal policy measure such as taxation generates revenue to the

government. A part of the government's revenue is invested in the infrastructure development.

Due to this, all sectors of the economy get a boost.
11. Foreign Exchange Earnings
Fiscal policy attempts to encourage more exports by way of Fiscal Measures like,
exemption of income tax on export earnings, exemption of sales tax and octroi, etc. Foreign
exchange provides fiscal benefits to import substitute industries. The foreign exchange earned by
way of exports and saved by way of import substitutes helps to solve balance of payments
problem.
Conclusion On Fiscal Policy
The objectives of fiscal policy such as economic development, price stability, social
justice, etc. can be achieved only if the tools of policy like Public Expenditure, Taxation,
Borrowing and deficit financing are effectively used.
Though there are gaps in India's fiscal policy, there is also an urgent need for making
India's fiscal policy a rationalised and growth oriented one.
The success of fiscal policy depends upon taking timely measures and their effective
administration during implementation.

Fiscal Policy and Objectives of Indian Government

The budgetary provisions made in the budgets when read together, bring out the guiding
philosophy of the new fiscal policy and the objectives that the government intends to achieve.
(i) Restoring Fiscal Equilibrium:
A very important feature of the governments efforts is to attain a match between the
revenue receipts and revenue expenditure with the ultimate aim of securing surpluses on revenue
account for capital expenditure.
Towards this end, three types of measures have been taken. The first concerns expenditure.
This has been to slow-down the growth-rate in it despite increase in the absolute amounts. Second
concerns tax-revenues.
The aim is to increase it, but unlike in the past when high taxes prevailed the policy now is
to seek larger tax receipts through moderately low rates of taxes on a wider base. Third the
government has made efforts to raise profits of the public sector undertakings.
(ii) Reforming Tax-structure:
The approach towards the tax system is to design it in such a manner that it becomes
growth elastic and gets in line with the tax-systems of other fast-growing and developed
countries. To ensure better compliance and less incentive for tax-evasion, the government has
lowered the tax rates both in respect of direct taxes and indirect taxes.

At the same time schemes have been introduced to widen the base of the tax. These
together with lower tax and a wider base are very likely to raise the yield of taxes. And with
growth in the activities and income of the economy, the tax receipts will increase.
This approach is totally different from the one pursued so far on the premise of a high taxrate on a narrow base. The new tax-regime will reduce and if pursued further eliminate the
difference between the domestic tax-rates and the tax rates in the foreign country.
This will help in integrating the Indian economy with the world economy. The benefits to
the country will be an increase in exports and a larger inflow of foreign direct investment. The
competitive strength and efficiency of the Indian economy will also improve.
(iii) Promoting Socially Desirable Activities:
The Government in the new fiscal policy has also provided larger expenditure, tax
concessions and other incentives for the expansion of socially important sectors. These are the
sectors which are normally the responsibility of the government. The development of
infrastructure is one such field of key significance for the economy.
While most of it is to be undertaken by the Government, several incentives have been
extended to seek private sectors involvement in some areas like power to ensure that the supply
of infrastructural services becomes adequate.
Tax concessions in the form of tax holiday have been given to encourage the private sector
to set up industries in the backward regions. Similar incentives have also been given to industries
producing pollution-control equipment.
Provision has also been made for the development of R&D (Research and Development)
to upgrade the technological base of the economy. Besides public expenditure, tax concessions
have been given to the private sector for this purpose.
(iv) Market-Oriented Development:
The new fiscal policy in line with the new economic policy aims at promoting allocation of
resources largely in terms of the market prices. The government has already dismantled a
significant part of state- intervention and enlarged the field for the private sector. The fiscal policy
has carried this process further by offering money incentives through lower tax-rates and taxconcession to the private sector.
Supply constraints in the market have also been caused by several fiscal measures.
Reduction in custom duties on the import of capital goods to modernise domestic production is
one such measure to step-up the supply of goods and services.

The lowering of the rates of indirect taxes on the consumer goods including luxury items
like electronics goods, cars, etc., will encourage a growth-pattern largely based on the expansion
of consumer goods industries.
The market orientation of development is also sought to be promoted by providing a
demand stimulus to the economy. How direct taxes will mean larger disposable income with the
people. Low indirect taxes will result in lower prices. Both of these will increased demand.

Importance of Fiscal Policy in the Economic Development of India!

The attitude of economists and government regarding the role of fiscal policy has radically
changed owing to the Keynesian impact.
The old conception of neutrality of public finance has yielded place to a new one namely
functional finance, public finance with its fiscal measures has been assigned a positive and
dynamic role for the promotion and acceleration of the rate of economic development.
The Keynesian analysis of fiscal policy is however, applicable to the advanced and well-to-do
countries of Europe and it has little relevance to underdeveloped economies.
The problem of developed countries is to stabilise the rate of economic growth by
maintaining effective demand at a high pitch and for that fiscal policy aims at reducing the
savings of the people and increasing their propensity to consume, The problem of underdeveloped countries is however different.
They need more savings so as to increase the rate of capital formation and thereby achieve
higher rate of economic development. But in these countries the general level of incomes of the
people is low and their propensity to consume is high and hence the rate of savings is small. The
fiscal measures in these countries, therefore, should aim at raising the rate of capital formation by
reducing consumption and encouraging propensity to save.
Our analysis of the problems connected with voluntary savings indicated that the per capita
incomes and savings are extremely low and as such capital formation in underdeveloped
economies cannot be left to voluntary savings.
According to an expert UN study, the annual per capita incomes in the Middle East, in Asia
and in Latin America are less than 200 US dollars or less than one-seventh of the US level and
one-fourth of the Canadian level. It was revealed in the I.M.F. staff papers that in India savings
contributed only 2 percent of the national income for development purpose.

The crucial determinant of economic growth is the rate of savings and, therefore savings
cannot be left to themselves to grow automatically. On the contrary, fiscal measures have to be
adopted to increase the savings of the people and to mobilise them for productive purpose. In the
words of Nurkse, fiscal policy, assumes a new significance in the face of the problem of capital
formation in under-developed countries.
The backward countries are caught in the vicious circle of low income, high consumption,
low savings, and low rate of capital formation and therefore, low incomes. To get out of this
vicious circle of poverty, the fiscal policy can play a constructive and dynamic role for the
economic development of the underdeveloped countries.
To break out of this circle, apart from foreign aid, observes an expert UN study calls for
vigorous taxation and government development programmes. Thus in poor countries, the
importance of fiscal policy lies in raising the rate and volume of savings and to divert them into
the desired channels.
In this connection, the UN report on Taxes and Fiscal Policy says, Fiscal policy is
assigned the central task of wresting from the pitifully low output of under-developed countries
sufficient savings to finance economic development programmes and to set the stage for more
vigorous private and public investment activity.
The limitations and ineffectiveness of monetary policy in securing an accelerated rate of
economic growth has further added to the importance of fiscal policy. Fiscal policy was designed
to supplement monetary policy but now it seems to have supplanted monetary policy altogether.
The role of fiscal policy in economic development cannot be overemphasized. The importance of
fiscal policy as an instrument of economic development was first envisaged by Keynes in his
General Theory wherein he showed that the total national income was an index of economic
activity and brought out the relation of economic activity of total spending.
The direct and indirect effects of fiscal policy on aggregate spending in the community
were clearly established and as a result the budgetary policy of the government as a weapon of
economic control and development came into prominence.
The fiscal policy can affect the rate of economic development in a variety of ways such as
by increasing the rate of saving and investment, affecting the allocation of resources, controlling
inflation, promoting economic stability. We now discuss them in detail.

To Increase the rate of saving and Investment:

Shortage of financial resources is the main obstacle in the way of economic development
of under- developed countries. There are certain forces operating in these countries which
increase consumption and reduce savings. The first among them is the population pressure.
Besides, the high income groups spend much of their income on conspicuous consumption
and their propensity to consume is further reinforced by the demonstration effect. According to
Still-worse, a large part of the meager savings is dissipated in unproductive channelsreal
estate, hoarding, gold, jewellery, speculation etc.
The fiscal policy can be employed effectively to divert savings of the people into
productive channels. It should aim at raising the incremental saving ratio through taxation and
forced loans and make funds available for investment purposes in the public and private sectors of
the economy.
This can be done by checking conspicuous consumption and preventing the flow of funds
for unproductive purposes. For this, high taxes on personal and corporate incomes and
commodity taxation on articles of widest use and conspicuous consumption should be imposed to
check the actual and potential consumption of the people.
In this connection, report of the Taxation Enquiry Commissions, Government of India,
observes, A tax system, which on the whole, promotes capital formation in is two aspects of
saving and investment fulfills an essential desideration.
It should be borne in mind that the purpose of taxation should not be merely to transfer
funds from private to public use but to enlarge the total volume of savings available for
investments. This requires that the general emphasis should be on curtailing and restraining
consumption and thereby increasing the volume of saving in the community.
In Japan, for example, agricultural productivity was doubled between 1885 and 1915 and
the instruments of taxation was used effectively and much of the increase was taken away from
the farmers by imposing on them higher rents and taxes and the resources thus collected were
channelled into productive investments.
Dr. R.N. Tirpathy, in his book, Public Finance in Under-developed Countries has suggested
the following methods which the government may adopt to increase the volume of domestic
savings to meet the financial requirements of economic development:
(i) Direct physical controls.
(ii) Increase in the rate of existing taxes.

(iii) Imposition of new taxes.

(iv) Surplus from public enterprises.
(v) Public borrowing of a non-inflationary nature.
(vi) Deficit financing.
The process of economic development inevitably leads to inflationary pressures in the
economy because it generates additional effective demand without an immediate and
corresponding increase in the production of consumption goods.
Direct physical controls can be used most effectively to curtail consumption and check
socially undesirable investment and thereby releasing resources for economic development.
Though direct physical controls are not compatible with maintenance of democratic freedom and
may be difficult to administer in an underdeveloped economy yet they are a necessary adjunct to a
developmental fiscal policy.
To meet the financial requirements of economic development, the imposition of a new
variety of taxes both direct and indirect becomes indispensable in absence of sufficient voluntary
savings. In some countries profits made in public enterprises bring the government closer to
economic realities and enable it to measure the efficiency and taxpaying capacity of their
counterparts and in the private sector.

Optimum Pattern of Investment:

An underdeveloped country can ill-afford the diversion of her limited resources into
socially undesirable channels. The fiscal measure can be used to secure the pattern of investment
which is in conformity with the criteria of social marginal productivity.
High taxes on land value increments on capital gains and other windfalls should be imposed to
prevent the flow of funds into unproductive channels such as land, buildings, inventories and
other investments of speculative nature.
The tax system can provide positive inducement to productive and socially desirable
investment in the private sector. This can be done by differential rates of taxation and the grant of
tax exemption in selected cases.
Investment in economic and social overheads, viz. transport, power, soil conservation,
education public health, technical training facilities etc., is of vital importance for attaining
optimum pattern of investment because the provision of these basic facilities is essential for
speeding up development.

Such an investment widens the extent of the market; helps reduce cost of production and
raise productivity by creating external economies. Private enterprise cannot be expected to
provide such basic facilities as the investment involved in them is very huge and they are low
yielding and slow yielding projects.
Therefore, Governments of under-developed countries should take upon themselves the
responsibilities to the execution of these basic facilities. However, such projects should be
financed through taxation and not with borrowed funds because they do not yield direct returns
necessary for the repayment of these debts.
The raising of collective compulsory saving through taxation for such development
programmes is now widely recognised. Thus fiscal measures should be directed to secure the
optimum pattern of investment so as to accelerate the pace of economic development of the
underdeveloped countries.

To Counteract Inflation:
The process of economic development in underdeveloped countries inevitably leads to
inflationary pressures as a result of the imbalances between the demand for and supply of real
resources.
The pressure of wages on prices, structural rigidities of their economic systems, market
imperfections and bottle- necks impede the supply of goods and services and prices start rising.
Inflation feeds on itself and if it goes out of control, it ruins the entire economy and all progress
comes to standstill.
That is why economic growth and stability are regarded as joint objectives for underdeveloped
countries to pursue. Today the choice is not between economic growth and stability but only
over the inter-relations ups between them and over the policies necessary to achieve them.
The fiscal measures should be used to counter act the inflationary pressures by reducing over a
effective demand for the attainment of this objective. The tax structure should be so devised that it
mops up a major portion of the rise in money income.
For that, greater reliance should be placed on progressive direct taxes and commodity taxes, the
yield of which changes more than in proportion to changes in tax base. Special anti-inflationary
taxes on excess profits, capital gains and other windfalls including taxes on articles of
conspicuous consumption may be imposed.
Besides, the fiscal policy of the Government should extend to the removal of structural rigidities,
market imperfections and imposition of physical controls including subsidies and protection to

essential consumer goods industries. However, if inflationary pressures go on mounting, capital

levy on cash balances and liquid assets may be imposed.
Alternative Fiscal Policies for Curbing Inflation:
The inflationary situation may basically be caused by the condition of excess demand, when the
spending on consumption and investment goods and the foreign spending on the goods of home
country, aggregate together, exceed the full employment output. This implies that true inflation
starts only after full employment. But actually, inflationary pressure are felt even before full
employment on account of the bottle necks and rigidities of factor supply and the pushes of
wages, profits and costs.

The fiscal remedies of inflation are discussed below:

(i) Reduction in Government Spending and no Change in Tax Rates:
Such a fiscal policy will give rise to budget surplus and drain out the purchasing power of
the people. Tins will set a reverse process of government expenditure multiplier in motion and
bring about a contraction in national income and employment and a consequent mitigation of
inflationary phenomenon.
(ii) Reduction in Government Spending and Increase in Tax Rates:
This set of fiscal measures is likely to be made effective than the previous one since an
increase in tax rates coupled with a reduction in government spending will create a larger budget
surplus and consequently a larger reduction will be affected in national income and employment.
(iii) Rigid Government Spending and Increasing Tax Rates:
Sometimes the Government spending is rigid as for instance during the period of war the
reduction in aggregate spending can be affected. In this case, only through an increase in tax rates.
This results, in a reduction in private disposable incomes and hence private consumption
and investment expenditures fall which can check inflation. It was through such a policy that the
United States during the period of Second World War could siphon of purchasing power by a
measure sufficient to finance more than 48 percent of the cost of war out of tax proceeds.
(iv) Reduction in Government Spending and an Equivalent Reduction in Taxes:
Just as an increase in government expenditure and an equivalent increase in tax revenues
raises the national income through the operation of the balanced budget multiplier, similarly a

decrease in government spending and equivalent decrease in tax revenue brings about a reduction
in national income and expenditure on account of its reverse operation.
If these fiscal changes result in a redistribution of income between the beneficiaries of
government expenditure and tax payers in such a way that it results in reduction in government
expenditure. A balanced budget multiplier greater than unity will in this situation have an antiinflationary impact upon the economy.
This discussion clearly brings out the fact that variation in taxes is the most crucial
instrument of an anti-inflationary fiscal policy. There is a controversy about the relative antiinflationary impact of income-tax and consumption tax of an equal yield.
The latter is sometimes conceived as more effective, since it results entirely in reducing
consumption. The income tax, on the contrary, falls partly upon consumption and partly upon
savings, to the extent income-tax reduces savings, if will not help in curtailing inflationary
pressure.
To Promote Economic Stability:
The underdeveloped countries are susceptible to economic instability resulting from
deficiency of effective demand in the short-run and fluctuations in demand for their products in
the world market. Underdeveloped countries mainly export agricultural and mineral products the
demand for which is generally less elastic.
On the other hand these countries import capital goods and finished manufactured articles,
the demand for which is elastic. When the prices of export goods fall in the international markets
the terms of trade becomes unfavourable, foreign exchange earnings decline and national income
falls which produces depression effects on the economy.
The under-developed countries cannot push their, exports to take advantage of the fall in
prices because their capacity to produce more is limited. Similarly, when the prices of the exports
rise due to the boom conditions in the world-markets, the increase in export earnings does not
lead to increased output and employment but instead it is dissipated in conspicuous consumption
and speculative investment which further generate inflationary pressure in the economy.
Fiscal measures can be used to offset the effects of international cyclical fluctuations in the prices
of exports. For example, in booms heavy export and imports duties may be imposed export duties
to neutralise the windfall gains arising from the rise in world market prices and import duties to
discourage conspicuous consumption.
The earnings from such export and import duties should be used for capital formation. In
periods of depression on the other hand, subsidies may be given to encourage exports and

government should directly intervene to maintain the level of effective demand through public
work programmes etc.
Thus, contra-cyclical fiscal policy should be followed to mitigate the effects of
international cyclical movements and all out efforts should be made to develop all sectors of the
economy so as to reduce an excessive dependence on the primary sector alone. Hence a welldevised fiscal policy can go a long way in promoting economic stability.