Unit IV: Fiscal Policy | Financial Management & Economics Finance: CA Intermediate (Old Scheme) PDF Download

 Page 1


2.92 ECONOMICS FOR FINANCE 
LEARNING OUTCOMES 
UNIT IV: FISCAL POLICY 
 
 
At the end of this unit, you will be able to: 
? Define fiscal policy and list out its objectives 
? Distinguish between discretionary and non- discretionary fiscal policy  
? Explain the various instruments of fiscal policy 
? Describe the expansionary and contractionary fiscal policies  
? Illustrate the use of fiscal policy for redistribution and economic growth   
? Elucidate the limitations of fiscal policy 
 
 
Public Finance
Fiscal Policy
Objectives of Objectives of 
Fiscal Policy
Automatic Automatic 
Stabilizers Versus Stabilizers Versus Stabilizers Versus 
Discretionary Discretionary Discretionary 
Fiscal Policy
Instruments of Instruments of 
Fiscal Policy
Types of Fiscal Types of Fiscal 
Policy
UNIT OVERVIEW 
Page 2


2.92 ECONOMICS FOR FINANCE 
LEARNING OUTCOMES 
UNIT IV: FISCAL POLICY 
 
 
At the end of this unit, you will be able to: 
? Define fiscal policy and list out its objectives 
? Distinguish between discretionary and non- discretionary fiscal policy  
? Explain the various instruments of fiscal policy 
? Describe the expansionary and contractionary fiscal policies  
? Illustrate the use of fiscal policy for redistribution and economic growth   
? Elucidate the limitations of fiscal policy 
 
 
Public Finance
Fiscal Policy
Objectives of Objectives of 
Fiscal Policy
Automatic Automatic 
Stabilizers Versus Stabilizers Versus Stabilizers Versus 
Discretionary Discretionary Discretionary 
Fiscal Policy
Instruments of Instruments of 
Fiscal Policy
Types of Fiscal Types of Fiscal 
Policy
UNIT OVERVIEW 
2.93 
 
FISCAL POLICY 
4.1 INTRODUCTION 
In the previous unit, we have studied the nature of governments’ intervention in 
markets to provide public goods, remedy externalities, ensure efficient allocation 
of resources and to enable redistribution of income. We have also looked into 
how taxes and subsidies influence the incentives for private economic activity. We 
have been doing this from the microeconomic point of view.  From the 
macroeconomic perspective, the focus is on the aggregate economic activity of  
governments, say, aggregate expenditure, taxes, transfers and issues of 
government debts and deficits and their effects on aggregate economic variables 
such as total output, total employment, inflation, overall economic growth etc. 
These, in fact, form the subject matter of fiscal policy.  
The significance of fiscal policy as a strategy for achieving certain socio-economic 
objectives was not recognized or widely acknowledged before 1930 due to the 
faith in the limited role of government advocated by the then prevailing laissez-
faire approach. Great Depression and the consequent instabilities made 
policymakers support a more proactive role for governments in the economy. 
However, later on, markets started   demonstrating an enhanced role in the 
allocation of goods and services in the economy. In the previous unit, we have 
seen situations under which markets fail to achieve optimal outcomes and the 
need for government intervention to combat those market failures.  In recent 
times, especially after being threatened by the global financial crisis and 
recession, many countries have preferred to have a more active fiscal policy. 
Governments of all countries pursue innumerable policies to accomplish their 
economic goals such as rapid economic growth, equitable distribution of wealth 
and income, reduction of poverty, price stability, exchange rate stability, full-
employment, balanced regional development etc.   Government budget is one 
among the most powerful instruments of economic policy. The important tools in 
the budgetary policy could be broadly classified into public revenue (including 
taxation), public expenditure, public debt and finally deficit-financing to bridge 
the gap between public receipts and payments. When all these tools are used for 
achieving certain goals of economic policy, public finance is transformed into 
what is called fiscal policy. In other words, through the use of these instruments 
governments intend to favourably influence the level of economic activity of a 
country.  
Fiscal policy involves the use of government spending, taxation and borrowing to 
influence both the pattern of economic activity and level of growth of aggregate 
Page 3


2.92 ECONOMICS FOR FINANCE 
LEARNING OUTCOMES 
UNIT IV: FISCAL POLICY 
 
 
At the end of this unit, you will be able to: 
? Define fiscal policy and list out its objectives 
? Distinguish between discretionary and non- discretionary fiscal policy  
? Explain the various instruments of fiscal policy 
? Describe the expansionary and contractionary fiscal policies  
? Illustrate the use of fiscal policy for redistribution and economic growth   
? Elucidate the limitations of fiscal policy 
 
 
Public Finance
Fiscal Policy
Objectives of Objectives of 
Fiscal Policy
Automatic Automatic 
Stabilizers Versus Stabilizers Versus Stabilizers Versus 
Discretionary Discretionary Discretionary 
Fiscal Policy
Instruments of Instruments of 
Fiscal Policy
Types of Fiscal Types of Fiscal 
Policy
UNIT OVERVIEW 
2.93 
 
FISCAL POLICY 
4.1 INTRODUCTION 
In the previous unit, we have studied the nature of governments’ intervention in 
markets to provide public goods, remedy externalities, ensure efficient allocation 
of resources and to enable redistribution of income. We have also looked into 
how taxes and subsidies influence the incentives for private economic activity. We 
have been doing this from the microeconomic point of view.  From the 
macroeconomic perspective, the focus is on the aggregate economic activity of  
governments, say, aggregate expenditure, taxes, transfers and issues of 
government debts and deficits and their effects on aggregate economic variables 
such as total output, total employment, inflation, overall economic growth etc. 
These, in fact, form the subject matter of fiscal policy.  
The significance of fiscal policy as a strategy for achieving certain socio-economic 
objectives was not recognized or widely acknowledged before 1930 due to the 
faith in the limited role of government advocated by the then prevailing laissez-
faire approach. Great Depression and the consequent instabilities made 
policymakers support a more proactive role for governments in the economy. 
However, later on, markets started   demonstrating an enhanced role in the 
allocation of goods and services in the economy. In the previous unit, we have 
seen situations under which markets fail to achieve optimal outcomes and the 
need for government intervention to combat those market failures.  In recent 
times, especially after being threatened by the global financial crisis and 
recession, many countries have preferred to have a more active fiscal policy. 
Governments of all countries pursue innumerable policies to accomplish their 
economic goals such as rapid economic growth, equitable distribution of wealth 
and income, reduction of poverty, price stability, exchange rate stability, full-
employment, balanced regional development etc.   Government budget is one 
among the most powerful instruments of economic policy. The important tools in 
the budgetary policy could be broadly classified into public revenue (including 
taxation), public expenditure, public debt and finally deficit-financing to bridge 
the gap between public receipts and payments. When all these tools are used for 
achieving certain goals of economic policy, public finance is transformed into 
what is called fiscal policy. In other words, through the use of these instruments 
governments intend to favourably influence the level of economic activity of a 
country.  
Fiscal policy involves the use of government spending, taxation and borrowing to 
influence both the pattern of economic activity and level of growth of aggregate 
2.94 ECONOMICS FOR FINANCE 
demand, output and employment.  It includes any design on the part of the 
government to change the price level, composition or timing of government 
expenditure or to alter the burden, structure or frequency of tax payment.   In 
other words, fiscal policy is designed to influence the pattern and level of 
economic activity in a country. Fiscal policy is in the nature of a demand-side 
policy. An economy which is producing at full-employment level does not require 
government action in the form of fiscal policy.  
 4.2 OBJECTIVES OF FISCAL POLICY  
The objectives of fiscal policy, like those of other economic policies of the 
government, are derived from the aspirations and goals of the society. Since 
nations differ in numerous aspects, the objectives of fiscal policy also may vary 
from country to country.   However, the most common objectives of fiscal policy 
are:  
• achievement and maintenance of full employment, 
• maintenance of price stability, 
• acceleration of  the rate of economic development, and 
• equitable distribution of income and wealth.  
The importance as well as order of priority of these objectives may vary from 
country to country and from time to time. For instance, while stability and 
equality may be the priorities of developed nations, economic growth, 
employment and equity may get higher priority in developing countries. Also, 
these objectives are not always compatible; for instance the objective of achieving 
equitable distribution of income may conflict with the objective of economic 
growth and efficiency.   
Before we go into the details of fiscal policy, we need to know the difference 
between discretionary fiscal policy and   non-discretionary fiscal policy or 
automatic stabilizers.  
 4.3 AUTOMATIC STABILIZERS VERSUS 
DISCRETIONARY FISCAL POLICY 
Non-discretionary   fiscal policy or automatic stabilizers are part of the structure 
of the economy and are ‘built-in’ fiscal mechanisms that operate automatically to 
reduce the expansions and contractions of the business cycle. Changes in fiscal 
Page 4


2.92 ECONOMICS FOR FINANCE 
LEARNING OUTCOMES 
UNIT IV: FISCAL POLICY 
 
 
At the end of this unit, you will be able to: 
? Define fiscal policy and list out its objectives 
? Distinguish between discretionary and non- discretionary fiscal policy  
? Explain the various instruments of fiscal policy 
? Describe the expansionary and contractionary fiscal policies  
? Illustrate the use of fiscal policy for redistribution and economic growth   
? Elucidate the limitations of fiscal policy 
 
 
Public Finance
Fiscal Policy
Objectives of Objectives of 
Fiscal Policy
Automatic Automatic 
Stabilizers Versus Stabilizers Versus Stabilizers Versus 
Discretionary Discretionary Discretionary 
Fiscal Policy
Instruments of Instruments of 
Fiscal Policy
Types of Fiscal Types of Fiscal 
Policy
UNIT OVERVIEW 
2.93 
 
FISCAL POLICY 
4.1 INTRODUCTION 
In the previous unit, we have studied the nature of governments’ intervention in 
markets to provide public goods, remedy externalities, ensure efficient allocation 
of resources and to enable redistribution of income. We have also looked into 
how taxes and subsidies influence the incentives for private economic activity. We 
have been doing this from the microeconomic point of view.  From the 
macroeconomic perspective, the focus is on the aggregate economic activity of  
governments, say, aggregate expenditure, taxes, transfers and issues of 
government debts and deficits and their effects on aggregate economic variables 
such as total output, total employment, inflation, overall economic growth etc. 
These, in fact, form the subject matter of fiscal policy.  
The significance of fiscal policy as a strategy for achieving certain socio-economic 
objectives was not recognized or widely acknowledged before 1930 due to the 
faith in the limited role of government advocated by the then prevailing laissez-
faire approach. Great Depression and the consequent instabilities made 
policymakers support a more proactive role for governments in the economy. 
However, later on, markets started   demonstrating an enhanced role in the 
allocation of goods and services in the economy. In the previous unit, we have 
seen situations under which markets fail to achieve optimal outcomes and the 
need for government intervention to combat those market failures.  In recent 
times, especially after being threatened by the global financial crisis and 
recession, many countries have preferred to have a more active fiscal policy. 
Governments of all countries pursue innumerable policies to accomplish their 
economic goals such as rapid economic growth, equitable distribution of wealth 
and income, reduction of poverty, price stability, exchange rate stability, full-
employment, balanced regional development etc.   Government budget is one 
among the most powerful instruments of economic policy. The important tools in 
the budgetary policy could be broadly classified into public revenue (including 
taxation), public expenditure, public debt and finally deficit-financing to bridge 
the gap between public receipts and payments. When all these tools are used for 
achieving certain goals of economic policy, public finance is transformed into 
what is called fiscal policy. In other words, through the use of these instruments 
governments intend to favourably influence the level of economic activity of a 
country.  
Fiscal policy involves the use of government spending, taxation and borrowing to 
influence both the pattern of economic activity and level of growth of aggregate 
2.94 ECONOMICS FOR FINANCE 
demand, output and employment.  It includes any design on the part of the 
government to change the price level, composition or timing of government 
expenditure or to alter the burden, structure or frequency of tax payment.   In 
other words, fiscal policy is designed to influence the pattern and level of 
economic activity in a country. Fiscal policy is in the nature of a demand-side 
policy. An economy which is producing at full-employment level does not require 
government action in the form of fiscal policy.  
 4.2 OBJECTIVES OF FISCAL POLICY  
The objectives of fiscal policy, like those of other economic policies of the 
government, are derived from the aspirations and goals of the society. Since 
nations differ in numerous aspects, the objectives of fiscal policy also may vary 
from country to country.   However, the most common objectives of fiscal policy 
are:  
• achievement and maintenance of full employment, 
• maintenance of price stability, 
• acceleration of  the rate of economic development, and 
• equitable distribution of income and wealth.  
The importance as well as order of priority of these objectives may vary from 
country to country and from time to time. For instance, while stability and 
equality may be the priorities of developed nations, economic growth, 
employment and equity may get higher priority in developing countries. Also, 
these objectives are not always compatible; for instance the objective of achieving 
equitable distribution of income may conflict with the objective of economic 
growth and efficiency.   
Before we go into the details of fiscal policy, we need to know the difference 
between discretionary fiscal policy and   non-discretionary fiscal policy or 
automatic stabilizers.  
 4.3 AUTOMATIC STABILIZERS VERSUS 
DISCRETIONARY FISCAL POLICY 
Non-discretionary   fiscal policy or automatic stabilizers are part of the structure 
of the economy and are ‘built-in’ fiscal mechanisms that operate automatically to 
reduce the expansions and contractions of the business cycle. Changes in fiscal 
 
 
2.95 
 
FISCAL POLICY 
policy do not always require explicit action by government. In most economies, 
changes in the level of taxation and level of government spending tend to occur 
automatically. These are dependent on and are determined by the level of 
aggregate production and income, such that the instability caused by business 
cycle is automatically dampened without any need for discretionary policy action.  
Any government programme that automatically tends to reduce fluctuations in 
GDP is called an automatic stabilizer. Automatic stabilizers have a tendency for 
increasing GDP when it is falling and reducing GDP when it is rising.  In automatic 
or non-discretionary fiscal policy, the tax policy and expenditure pattern are so 
framed that taxes and government expenditure automatically change with the 
change in national income. It involves built-in tax or expenditure mechanism that 
automatically increases aggregate demand when recession is  there and reduces 
aggregate demand when there is inflation in the economy. Personal income taxes, 
corporate income taxes and transfer payments (unemployment compensation, 
welfare benefits) are prominent automatic stabilizers. 
Automatic stabilisation occurs through automatic adjustments in government 
expenditures and taxes without any deliberate governmental action.  These 
automatic adjustments work towards stimulating aggregate spending during the 
recessionary phase and reducing aggregate spending during economic 
expansion. As we know, during recession incomes are reduced; with progressive 
tax structure, there will be a decline in the proportion of income that is taxed. This 
would result in lower tax payments as well as some tax refunds. Simultaneously, 
government expenditures increase due to increased transfer payments like 
unemployment benefits. These two together provide proportionately more 
disposable income available for consumption spending to households. In the 
absence of such automatic responses, household spending would tend to 
decrease more sharply and the economy would in all probability fall into a deeper 
recession.   
On the contrary, when an economy expands, employment increases, with 
progressive system of taxes people have to pay higher taxes as their income rises. 
This leaves them with lower disposable income and thus causes a decline in their 
consumption and therefore aggregate demand. Similarly, corporate profits tend 
to be higher during an expansionary phase attracting higher corporate tax 
payments. With higher income taxes, firms are left with lower surplus causing a 
decline in their investments and   thus in the aggregate demand.  Again, during 
expansion unemployment falls, therefore government expenditure by way of 
transfer payments falls and with lower government expenditure inflation gets 
Page 5


2.92 ECONOMICS FOR FINANCE 
LEARNING OUTCOMES 
UNIT IV: FISCAL POLICY 
 
 
At the end of this unit, you will be able to: 
? Define fiscal policy and list out its objectives 
? Distinguish between discretionary and non- discretionary fiscal policy  
? Explain the various instruments of fiscal policy 
? Describe the expansionary and contractionary fiscal policies  
? Illustrate the use of fiscal policy for redistribution and economic growth   
? Elucidate the limitations of fiscal policy 
 
 
Public Finance
Fiscal Policy
Objectives of Objectives of 
Fiscal Policy
Automatic Automatic 
Stabilizers Versus Stabilizers Versus Stabilizers Versus 
Discretionary Discretionary Discretionary 
Fiscal Policy
Instruments of Instruments of 
Fiscal Policy
Types of Fiscal Types of Fiscal 
Policy
UNIT OVERVIEW 
2.93 
 
FISCAL POLICY 
4.1 INTRODUCTION 
In the previous unit, we have studied the nature of governments’ intervention in 
markets to provide public goods, remedy externalities, ensure efficient allocation 
of resources and to enable redistribution of income. We have also looked into 
how taxes and subsidies influence the incentives for private economic activity. We 
have been doing this from the microeconomic point of view.  From the 
macroeconomic perspective, the focus is on the aggregate economic activity of  
governments, say, aggregate expenditure, taxes, transfers and issues of 
government debts and deficits and their effects on aggregate economic variables 
such as total output, total employment, inflation, overall economic growth etc. 
These, in fact, form the subject matter of fiscal policy.  
The significance of fiscal policy as a strategy for achieving certain socio-economic 
objectives was not recognized or widely acknowledged before 1930 due to the 
faith in the limited role of government advocated by the then prevailing laissez-
faire approach. Great Depression and the consequent instabilities made 
policymakers support a more proactive role for governments in the economy. 
However, later on, markets started   demonstrating an enhanced role in the 
allocation of goods and services in the economy. In the previous unit, we have 
seen situations under which markets fail to achieve optimal outcomes and the 
need for government intervention to combat those market failures.  In recent 
times, especially after being threatened by the global financial crisis and 
recession, many countries have preferred to have a more active fiscal policy. 
Governments of all countries pursue innumerable policies to accomplish their 
economic goals such as rapid economic growth, equitable distribution of wealth 
and income, reduction of poverty, price stability, exchange rate stability, full-
employment, balanced regional development etc.   Government budget is one 
among the most powerful instruments of economic policy. The important tools in 
the budgetary policy could be broadly classified into public revenue (including 
taxation), public expenditure, public debt and finally deficit-financing to bridge 
the gap between public receipts and payments. When all these tools are used for 
achieving certain goals of economic policy, public finance is transformed into 
what is called fiscal policy. In other words, through the use of these instruments 
governments intend to favourably influence the level of economic activity of a 
country.  
Fiscal policy involves the use of government spending, taxation and borrowing to 
influence both the pattern of economic activity and level of growth of aggregate 
2.94 ECONOMICS FOR FINANCE 
demand, output and employment.  It includes any design on the part of the 
government to change the price level, composition or timing of government 
expenditure or to alter the burden, structure or frequency of tax payment.   In 
other words, fiscal policy is designed to influence the pattern and level of 
economic activity in a country. Fiscal policy is in the nature of a demand-side 
policy. An economy which is producing at full-employment level does not require 
government action in the form of fiscal policy.  
 4.2 OBJECTIVES OF FISCAL POLICY  
The objectives of fiscal policy, like those of other economic policies of the 
government, are derived from the aspirations and goals of the society. Since 
nations differ in numerous aspects, the objectives of fiscal policy also may vary 
from country to country.   However, the most common objectives of fiscal policy 
are:  
• achievement and maintenance of full employment, 
• maintenance of price stability, 
• acceleration of  the rate of economic development, and 
• equitable distribution of income and wealth.  
The importance as well as order of priority of these objectives may vary from 
country to country and from time to time. For instance, while stability and 
equality may be the priorities of developed nations, economic growth, 
employment and equity may get higher priority in developing countries. Also, 
these objectives are not always compatible; for instance the objective of achieving 
equitable distribution of income may conflict with the objective of economic 
growth and efficiency.   
Before we go into the details of fiscal policy, we need to know the difference 
between discretionary fiscal policy and   non-discretionary fiscal policy or 
automatic stabilizers.  
 4.3 AUTOMATIC STABILIZERS VERSUS 
DISCRETIONARY FISCAL POLICY 
Non-discretionary   fiscal policy or automatic stabilizers are part of the structure 
of the economy and are ‘built-in’ fiscal mechanisms that operate automatically to 
reduce the expansions and contractions of the business cycle. Changes in fiscal 
 
 
2.95 
 
FISCAL POLICY 
policy do not always require explicit action by government. In most economies, 
changes in the level of taxation and level of government spending tend to occur 
automatically. These are dependent on and are determined by the level of 
aggregate production and income, such that the instability caused by business 
cycle is automatically dampened without any need for discretionary policy action.  
Any government programme that automatically tends to reduce fluctuations in 
GDP is called an automatic stabilizer. Automatic stabilizers have a tendency for 
increasing GDP when it is falling and reducing GDP when it is rising.  In automatic 
or non-discretionary fiscal policy, the tax policy and expenditure pattern are so 
framed that taxes and government expenditure automatically change with the 
change in national income. It involves built-in tax or expenditure mechanism that 
automatically increases aggregate demand when recession is  there and reduces 
aggregate demand when there is inflation in the economy. Personal income taxes, 
corporate income taxes and transfer payments (unemployment compensation, 
welfare benefits) are prominent automatic stabilizers. 
Automatic stabilisation occurs through automatic adjustments in government 
expenditures and taxes without any deliberate governmental action.  These 
automatic adjustments work towards stimulating aggregate spending during the 
recessionary phase and reducing aggregate spending during economic 
expansion. As we know, during recession incomes are reduced; with progressive 
tax structure, there will be a decline in the proportion of income that is taxed. This 
would result in lower tax payments as well as some tax refunds. Simultaneously, 
government expenditures increase due to increased transfer payments like 
unemployment benefits. These two together provide proportionately more 
disposable income available for consumption spending to households. In the 
absence of such automatic responses, household spending would tend to 
decrease more sharply and the economy would in all probability fall into a deeper 
recession.   
On the contrary, when an economy expands, employment increases, with 
progressive system of taxes people have to pay higher taxes as their income rises. 
This leaves them with lower disposable income and thus causes a decline in their 
consumption and therefore aggregate demand. Similarly, corporate profits tend 
to be higher during an expansionary phase attracting higher corporate tax 
payments. With higher income taxes, firms are left with lower surplus causing a 
decline in their investments and   thus in the aggregate demand.  Again, during 
expansion unemployment falls, therefore government expenditure by way of 
transfer payments falls and with lower government expenditure inflation gets 
  
 
2.96 ECONOMICS FOR FINANCE 
controlled to a certain extent.  Briefly put, during an expansionary phase, all types 
of incomes rise and the amount of transfer payments decline resulting in 
proportionately less disposable income available for consumption expenditure. 
The built-in stabilisers automatically remove spending from the economy to 
reduce demand-pull inflationary pressures and further expansionary stimulation.  
In brief, automatic stabilizers work through limiting the increase in disposable 
income during an expansionary phase and limiting the decrease in disposable 
income during the contraction phase of the business cycle. Since automatic 
stabilizers affect disposable personal income directly, and because changes in 
disposable personal income are closely linked to changes in consumption, these 
stabilizers act swiftly to reduce the extent of changes in real GDP.  
However, automatic stabilizers that depend on the level of economic activity 
alone would not be sufficient to correct instabilities. The government needs to 
resort to discretionary fiscal policies. Discretionary fiscal policy for stabilization 
refers to deliberate policy actions on the part of government to change the levels 
of expenditure, taxes to influence the level of national output, employment and 
prices. Governments influence the economy by changing the level and types of 
taxes, the extent and composition of spending, and the quantity and form of 
borrowing. 
Governments may directly as well as indirectly influence the way resources are 
used in an economy. We shall now see how this happens by investigating into the 
fundamental equation of national income accounting that measures the output of 
an economy, or gross domestic product (GDP), according to expenditures.  
GDP = C + I + G + NX. 
We know that GDP is the value of all final goods and services produced in an 
economy during a given period of time. The right side of the equation shows the 
different sources of aggregate spending  or demand namely, private consumption 
(C), private investment (I), government expenditure i.e.  purchases of goods and 
services by the government (G), and net exports, (exports minus imports) (NX). It 
is evident from the equation that governments can influence economic activity 
(GDP) by controlling G directly and influencing C, I, and NX indirectly, through 
changes in taxes, transfer payments and expenditure.