Fiscal Policy

Fiscal policy
 Fiscal Policy is an important instrument to stabilize the economy. (overcome recession and control inflation in the economy)  Stabilization of economy is achieved on the basis of given tools, as:  Taxation,  Public Debt/Borrowings  Public expenditure.

Objective Of Fiscal Policy in Developing Countries

1. Economic Stability :
 It requires absence of sharp cyclical movements. (Boom & Depression). To ensure such stability counter cycle policy is recommended as:
 If depression exists in the economy appropriate Fiscal Policy, Expansionary Fiscal Policy where Govt.s expenditure will be increased and tax rate will be decreased.

 If Boom exists in the economy appropriate fiscal policy is Contractionary Fiscal Policy where the expenditure of Govt. is reduced and taxes are increased.

2. Increasing Rate of Investment:

 Fiscal policy aims at increasing the rate of capital formation or investment. It can be only possible by pushing up the saving ratio. It is possible by raising the government income through taxation and public borrowing. 

However, in developing countries it is difficult to mobilize resources through taxation because very small number of people come under income tax bracket.

If govt. mobilize resources through indirect tax its incidence mostly falls on relatively poor section of society.  Second measure of raising resource is public borrowing . Although, taxable capacity in developing country is low but people and institution do investment in govt. securities in hope to receive income from these investment act with intact saving.

3. Reducing Inequalities in Income:

 The tax policy is so designed as to make the overall

tax structure highly progressive which would compel rich section of the population to contribute substantially more in the form of higher taxes.

 The indirect tax also imposes on luxury goods at higher side. 

Revenue generated though taxes spends on public works and on welfare schemes.

4. Reducing Unemployment:


Public expenditure programme plays important role as when govt. start constructing hospital, school buildings, dams, irrigation canals large number of rural people remain unemployed during off season can be employed.

Instruments of Fiscal Policy

1. Taxation : It is classified as  Direct and Indirect Taxes:


Direct tax its incidence directly falls upon tax payee.

 Example:
 Income Tax, Annual Wealth Tax, Corporation, Capital gains tax

 Indirect Tax:
 Its burden can be shifted to others. So that those who pay theses taxes to the govt. do not bear the whole burden.

Example:
 Excise duty, VAT, Custom duty, Sales Tax.

 Taxation as instrument of policy can be used in any of the following forms:

 Change in Tax rate  Change in Tax base  Change in taxation mix

Taxation as Counter-Cyclical Device

 An anti-depressing tax policy must increase disposable income during depression by the way of reducing direct and indirect tax rates.  Lower taxation policy promotes investment by reducing corporate tax. private

 An anti-inflationary tax policy must decrease disposable income by the way of imposing high rate of direct and indirect tax rates.

Public Expenditure
 A rise or fall in government expenditure through multiplier effect brings about a multiple change in the level of national income .  Public expenditure is mainly financed by tax, market borrowing and deficit financing.  Public expenditure is a powerful tool for reducing regional economic disparities and income inequalities. The allocative and distributive effects of public expenditure can be understood by following issues:

1.

Establishments of PSUs in areas where private enterprise is weak can reduce regional disparities. Provision of economic infrastructure in industrially backward areas can promote balanced regional developments. Subsides to promote sectoral growth Welfare schemes for weaker sections

2.

3. 4.

Public Expenditure as CounterCyclical Device

 During a business cycle, when an economic slow down heads towards recession, govt. can restore to compensatory spending (spending on public works, social insurance payments, and subsidies) to cover the deficiency in private spending.  In an inflationary situation government spending needs to be reduced to deflate aggregate demand.  Pump Priming expenditure involves injection of a certain amount of spending in the income stream can restore the economy at normal growth path.

Public Debt
 This is important source to finance deficit budget. It can be categorized as:  Public borrowing;  Banking borrowing;  Deficit Financing  International borrowing

Public Debt- as Counter-Cyclical Device

 Public debt immediately affects money and credit supply, resultantly aggregate demand get affected.  Public borrowing transfers money from public to government and repayment of debt shift money from government to back Public.

 During inflationary situation when money transfers from households to govt. consumption falls and in the business sector investment also falls. Consequently, declining demand push down the prices.  During recessionary situation repayment of debt to public increase the consumption and investment level whereby increased demand pull up the prices to equilibrium.

Danger of Deficit Financing

 Deficit financing plays useful role during the phase of depression in developed country because capital equipment and machinery is already existing. Whereby production can increase and inflationary pressure can be offset.  However, in the case of developing countries it leads inflationary pressure because machinery and capital equipments are not existing.  In economy because of printing money purchasing power is increased but production not increased which generates inflationary pressure.

Kind of Fiscal Policy

 There are three forms of Fiscal policy

1. Automatic Stabilizers :
This type of fiscal policy stabilizes economy without involving policymakers on the basis of important stabilizers :  Taxation As GNP of country rises some people did not cover under tax bracket now they cover under tax bracket. Thus tax revenue increase as well as money supply in market also restricted

 Unemployment Compensation:
 In developed countries unemployment compensation is paid to workers who are laid off.

 During recession as more people unemployed unemployment compensation paid by the govt. to the unemployed people automatically wiped off recession.

2. Compensatory Policy
 This type of fiscal policy is a deliberate budgetary action taken by the govt. to compensate for the deficiency or in excess of aggregate demand. This action is of two kind1. Surplus Budgeting During inflation, govt. keeps its expenditure lower than its revenue and increase taxes. 2. Deficit Budgeting During depression, Govt. keeps it budget at deficit side where expenditure is greater than revenue. Whereby public expenditure is high and imposition of taxes is low.

3. Discretionary Policy

 In this case temporary changes are made in the govt. expenditure and taxation system which is at discretion of the Govt. make changes as The level of pattern of taxation, Size and pattern of expenditure and size and composition of public debt

Crowding-Out Effect
 Crowding-out effect is the fall in the private investment due to deficit spending by the government. As:
Deficit

spending through deficit financing results in net injection into the economy, which push up demand and rise in price level.

Increase in aggregate demand leads inflationary pressure in the economy.

To control inflation, the central bank will intervene by adopting tight money with rising rate of interest, which choke-off or Crowd-out the private investment.

Crowding-in Effect

 Crowding-in means rise in the private investment due to deficit spending by the government.

 Deficit spending push up rate of interest, undoubtedly, which discourage private investment but deficit spending leads to rise in aggregate demand which is met by increasing production from the existing capital stock. Therefore, demand for existing capital increase and thus deficit spending stimulates new investments.