Unit 4: Fiscal Policy Chapter Notes | Business Economics for CA Foundation PDF Download

Introduction

Governments worldwide implement various policies to achieve economic objectives such as rapid growth, fair wealth and income distribution, poverty reduction, price and exchange rate stability, full employment, and balanced regional development. Among these, the government budget is a crucial tool for economic policy.

The key components of budgetary policy include:

• Public Revenue and Taxation
• Public Expenditure
• Public Debt
• Deficit Financing

When these tools are used to achieve specific economic goals, public finance becomes fiscal policy. Fiscal policy aims to influence the level of economic activity using these instruments.

Definition of Fiscal Policy

• Fiscal policy involves the government deliberately using taxation, public spending, and borrowing to impact economic activity, aggregate demand, output, and employment.
• It is primarily a demand-side policy.
• In situations where the economy is at full employment, fiscal policy is not necessary.

Classical Economists ' View

• Classical economists believed that government intervention was unnecessary because the market could self-regulate, maintaining the economy near its natural GDP level.
• They argued that the economy would naturally achieve stable prices and full employment, utilizing resources efficiently without unemployment.
• They advocated for a balanced government budget, viewing deliberate fiscal policies as unnecessary.

Shift in Perspective on Fiscal Policy

• Before 1930, fiscal policy was not widely recognized as a means to achieve socio-economic objectives due to the prevailing laissez-faire belief in limited government intervention.
• The Great Depression highlighted the inadequacy of classical economics in addressing low aggregate demand and high unemployment.
• In response, John Maynard Keynes, in his 1936 work "The General Theory of Employment, Interest, and Money," advocated for increased government spending to counteract recessionary forces and reduce unemployment.
• In recent times, particularly after the global financial crisis, many countries have adopted more active fiscal policies.

Objectives of Fiscal Policy

The objectives of fiscal policy are based on the goals and aspirations of society, similar to other economic policies by the government. Fiscal policy aims to correct market failures and ensure social welfare by providing essential goods and services like highways, primary education, and healthcare.

While the specific objectives may vary from country to country, the common objectives include:

• Full Employment: Achieving and maintaining full employment is a key objective.
• Price Stability: Ensuring stable prices is crucial for economic stability.
• Economic Development: Accelerating the rate of economic development is a priority.
• Income and Wealth Distribution: Promoting an equitable distribution of income and wealth is important for social justice.

The priority of these objectives may differ between countries and over time. For example, developed nations may prioritize stability and equality, while developing countries might focus more on economic growth, employment, and equity.

Fiscal policy is a powerful tool for managing the economy because it can influence gross domestic product (GDP) and aggregate demand. The fundamental equation of national income accounting that measures GDP according to expenditures is:

GDP = C + I + G + NX

• C. Private Consumption
• I. Investment
• G. Government Expenditure
• NX. Net Exports (Exports - Imports)

The government can influence economic activity by directly controlling G (government expenditure) and indirectly affecting C (private consumption), I (investment), and NX (net exports) through changes in taxes, transfer payments, and public expenditure.

Types of Fiscal Policy

Fiscal policy aims to adjust government revenues, expenditures, and public debt to address issues like unemployment during recessions and price stability during inflation. There are two main types of fiscal policy: expansionary fiscal policy and contractionary fiscal policy.

(a) Expansionary Fiscal Policy

• Expansionary fiscal policy is intended to boost the economy during the contraction phase of a business cycle or when a contraction is anticipated. A recession occurs when overall economic activity declines, characterized by falling real GDP, low aggregate demand, reduced consumer spending, and rising unemployment. To address such a decline in economic activity, the government can implement expansionary fiscal policies, aiming to close a "recessionary gap."
• The government can achieve this by:
  • Tax Cuts: Reducing all types of taxes, both direct and indirect, increases taxpayers' disposable income, leading to higher consumer spending and demand for goods and services. This, in turn, boosts aggregate demand, output, and employment.
  • Increased Government Expenditure: Raising government spending injects money into the economy, enhancing aggregate demand, output, and employment.
  • Combined Approach:. combination of increased government spending and tax cuts on personal income and/or business taxes.
• Implementing expansionary fiscal policy may lead to budget deficits, as tax cuts reduce government revenue and expenditures exceed tax revenues in a given year.

(b) Contractionary Fiscal Policy

• Contractionary fiscal policy is the opposite of expansionary fiscal policy. It aims to restrain economic activity during an inflationary phase or when a business-cycle expansion is anticipated, which could lead to inflation. This policy involves deliberate actions by the government to curtail aggregate demand and, consequently, the level of economic activity, aiming to eliminate an "inflationary gap."
• Contractionary fiscal policy is used when the economy is growing at an unsustainable rate, causing inflation and asset bubbles. By implementing this policy, the government seeks to bring economic growth back to sustainable levels.

Contractionary fiscal policy is implemented through various measures aimed at reducing aggregate demand in the economy. Here are the key components:

• Decrease in Government Spending: When the government reduces its spending, the total amount of money circulating in the economy decreases. This leads to a reduction in aggregate demand, as there is less money available for consumption and investment.
• Increase in Personal Income Taxes: Raising personal income taxes reduces disposable incomes for households. With less disposable income, consumers cut back on their spending, which in turn lowers aggregate demand.
• Increase in Business Taxes: Increasing taxes on business profits reduces the surplus available to businesses. This leads to a decrease in business investments, as firms have less money to reinvest. Additionally, higher taxes can deter potential new entrants from investing, further shrinking aggregate demand.
• Combination of Measures: Contractionary fiscal policy can also involve a combination of decreased government spending and increased personal income and/or business taxes.

The goal of contractionary fiscal policy is to achieve a smaller government budget deficit or a larger budget surplus. Governments influence the economy through their policies on taxation, expenditure, and borrowing.

Fiscal Policy Objectives:

• During Inflation: When the economy is experiencing inflation or excessive utilization of resources, fiscal policy aims to control excessive aggregate spending. This is done to prevent overheating of the economy.
• During Deflation: In contrast, during periods of deflation or sluggish economic activity where resource utilization is low, fiscal policy seeks to boost aggregate spending. This is necessary to compensate for the deficiency in effective demand and stimulate economic activity.

Tools of Fiscal Policy:

• Taxation: Adjusting tax rates can influence disposable incomes and consumption levels, thereby impacting aggregate demand.
• Government Expenditure: Altering government spending on public services, infrastructure, and other areas can directly affect aggregate demand.
• Borrowing: Governments can also borrow to finance spending, impacting the overall fiscal balance and aggregate demand.

Instruments of Fiscal Policy

The tools of fiscal policy are taxes, government expenditure, public debt and the government budget. We shall discuss each of them in the following paragraphs.

Government Expenditure as an Instrument of Fiscal Policy
Government expenditure is a crucial tool of fiscal policy. It encompasses government spending on consumption, investment, and transfer payments. Since government expenditure makes up a significant portion of the total expenditure in the economy, it plays a vital role in determining the balance between what the government spends and what it receives. Changes in government expenditure can lead to substantial variations in the country’s total income. Therefore, it can be instrumental in adjusting consumption and investment levels to achieve full employment.

Types of Government Expenditure

1. Current Expenditures: These are expenses incurred to meet the day-to-day functioning of the government.

2. Capital Expenditures: These involve investments made by the government in capital equipment and infrastructure projects.

3. Transfer Payments: These are government expenditures that do not contribute directly to GDP, as they involve transferring income from one group of people to another without any direct contribution from the receivers.

Role of Government Expenditure

• Government expenditure is necessary for the performance of various functions and for achieving economic stabilization.
• During a recession, the government may initiate public works programs such as the construction of roads, irrigation facilities, sanitation projects, ports, and electrification of new areas.

Direct and Indirect Effects

• Directly generates income for labor and suppliers of materials and services.
• Indirectly stimulates the economy through the multiplier effect, where increased income leads to higher consumption of goods.

Marginal Propensity to Consume (MPC)

• The extent of spending by individuals depends on their marginal propensity to consume (MPC), which measures the proportion of additional income that is spent on consumption.
• During a recession, there is typically surplus capacity in consumer goods industries. An increase in demand for various goods leads to an expansion in production in these industries.

The question arises as to how the government will source the funds necessary for increased expenditure. Increasing taxes would be counterproductive, as it would decrease disposable incomes and, consequently, aggregate demand. In such cases, the government should consider a deficit budget, which can be financed through borrowing or monetization (creating additional money to finance expenditure). However, borrowing carries the risk of crowding out private spending.

Furthermore, a program of public investment would boost the overall confidence of businesses and their willingness to invest. Primary employment generated through public works programs would lead to secondary and tertiary employment, putting the economy on an expansion trajectory.

Public expenditure is also used as a tool to mitigate inflation and reduce prices. This is achieved by decreasing government expenditure when there is a threat of inflationary price increases. Lower incomes resulting from reduced public spending help eliminate excess aggregate demand.

Taxes as an Instrument of Fiscal Policy

• Taxes are a crucial source of revenue for governments and are used to establish economic stability. Tax policies, as an instrument of fiscal policy, involve changes in government revenues or tax rates to encourage or restrict private consumption and investment. Taxes affect the disposable income of the public, which in turn influences aggregate demand and potential inflationary or deflationary gaps. The structure of tax rates is adjusted based on the prevailing economic conditions.
• During periods of recession and depression, tax policies are designed to encourage private consumption and investment. Reducing income taxes increases disposable incomes, leading to higher consumption. Lower corporate taxes enhance profit prospects for businesses, promoting further investment. The extent of tax reduction or increase in government spending depends on the size of the recessionary gap and the magnitude of the multiplier.
• Conversely, during inflation, new taxes can be introduced and existing tax rates can be increased to reduce disposable incomes and eliminate surplus purchasing power. However, excessive taxation can stifle new investments, so the government must be cautious when implementing tax increases.

Public Debt as a Tool of Fiscal Policy

• Internal debt occurs when the government borrows from its own citizens.
• External debt happens when the government borrows from foreign sources.

Public debt can take various forms, including market loans and small savings.

Market Loans

• Treasury Bills and Government Securities: The government issues these instruments in different denominations and durations, which are then traded in debt markets.
• Long-Term Capital Bonds: These are issued to finance capital projects.
• Treasury Bills: These are issued to meet short-term government expenditure.

Small Savings

• Public Borrowings: Small savings represent public borrowings that are not negotiable and cannot be bought or sold in the market.
• Mobilising Small Savings: In India, various schemes such as National Savings Certificates and National Development Certificates are introduced to mobilise small savings.

Impact on Aggregate Demand

• Borrowing from the Public: When the government borrows from the public through the sale of bonds and securities, it curtails aggregate demand in the economy.
• Repayment of Debt: When governments repay debt, it increases the availability of money in the economy, thereby increasing aggregate demand.

Budget as a Tool of Fiscal Policy

• A government’s budget is a crucial policy tool used to either stimulate or contract aggregate demand as needed.
• The budget is essentially a statement outlining the revenues earned by the government from taxes and other sources, as well as the expenditures made by the government within a year.
• The impact of a budget on aggregate demand depends on the budget balance.

Types of Budgets

• Balanced Budget:. balanced budget occurs when the government’s expenditures match its tax revenues for the year. In this case, there is no net effect on aggregate demand because the leakages from the system, in the form of taxes collected, are equal to the injections, in the form of expenditures made.
• Budget Surplus:. budget surplus occurs when the government collects more in revenues than it spends. While this may seem positive, it actually has a negative net effect on aggregate demand because the leakages exceed the injections.
• Budget Deficit:. budget deficit occurs when the government’s expenditures exceed its tax revenues. This situation has a positive net effect on aggregate demand since the total injections surpass the leakages from the system.

Impact on National Debt

• Budget Surplus:. budget surplus helps reduce national debt.
• Budget Deficit:. budget deficit contributes to increasing national debt.

Deliberate Changes to Budget Composition

• Governments can deliberately modify the composition of revenue and expenditure components within the budget to achieve specific economic objectives.

Fiscal Policy for Long-run Economic Growth

Fiscal policy is a means by which the government can influence economic growth, inflation, unemployment, and external stability. While fiscal policy is effective for managing aggregate demand in the short run, it is essential to combine it with policies that stimulate aggregate supply for long-term economic growth.

Fiscal policies influence economic growth by affecting the incentives of individuals and firms. For instance:

• Infrastructure Spending: Fiscal policies that involve infrastructure spending have positive supply-side effects. When the government invests in modern infrastructure, it provides the private sector with the necessary overheads, facilitating business operations.
• Public Goods: Government provision of public goods such as education, healthcare, nutrition, and research contributes to long-run economic growth through human capital formation. Increased human capital enhances the productivity of physical capital.
• Tax Policies: Taxes can either promote or hinder economic growth depending on their impact on saving and investment. A well-designed tax policy that encourages innovation and entrepreneurship without discouraging incentives can stimulate private business investment and economic growth. For example, excessively high corporate taxes may have negative consequences on incentives and output.
• Market Failures: Tax and spending policies, such as subsidies, can be used to correct market failures resulting from externalities. For instance, increasing environmental taxes raises firm costs and reduces output, while subsidies on inputs and support prices to producers, such as farmers, can generate higher output.

Fiscal Policy and Income Inequality

• Fiscal policy is a crucial tool for governments to influence income distribution and reduce inequality. In both developed and developing economies facing rising income and opportunity inequality, fiscal policy plays a significant role in achieving equity and social justice.
• Tax Rates and Structure: Policy makers in developing countries often adjust tax rates, tax structure, and public spending levels to address socioeconomic issues such as illiteracy, poverty, unemployment, and inequality.
• Public Spending: The direction and levels of public spending are deliberately changed to target socioeconomic challenges and reduce inequality.

Fiscal Policy and Income Distribution

Introduction

• Fiscal policy, which involves government revenues and expenditures, plays a crucial role in redistributing income within society.
• Both direct and indirect taxes, along with public spending, can be adjusted to achieve desired distributional effects.

Direct Taxation

• A progressive direct tax system ensures that individuals with a greater ability to pay contribute more to government expenses.
• This system helps distribute the tax burden fairly among the population.

Indirect Taxation

• Indirect taxes can be differentiated based on the consumption patterns of different income groups.
• For instance, luxury goods consumed by the wealthy can be taxed heavily, while necessities that form a larger portion of the lower-income group’s expenditures can be taxed lightly or not at all.

Public Expenditure

• Public spending can be targeted to redistribute income from the rich to the poorer sections of society.
• Government expenditure can be directed towards welfare programs aimed at disadvantaged groups, such as:
• Poverty alleviation programs
• Free or subsidized services (e.g., medical care, education, housing, essential commodities)
• Infrastructure development in underserved areas (e.g., rural roads, water supply for tribal communities)
• Social security schemes (e.g., old-age pensions, unemployment relief, sickness allowances)
• Subsidized production of mass-consumed products
• Public production and subsidies to ensure the supply of essential goods
• Human capital development to enhance employability

Considerations for Fiscal Policy

• While a progressive tax system with high marginal rates can promote income redistribution, it may also discourage work, saving, and investment.
• Therefore, the tax structure needs to be carefully designed to avoid negative impacts on production and efficiency.
• Additionally, overly generous social programs can reduce incentives to work and save, highlighting the need for a balanced approach.

Limitations of Fiscal Policy

• Fiscal policy, which involves the deliberate adjustment of government spending and taxation to influence economic conditions, has its limitations in terms of selection and execution.
• One major constraint is the potential for crowding out, where increased government borrowing leads to higher interest rates, making it more expensive for the private sector to invest. This can offset the intended stimulative effects of fiscal policy.
• Additionally, the effectiveness of fiscal measures can be hindered by time lags in implementation and impact, as well as by political considerations that may affect decision-making.

Challenges of Fiscal Policy in Addressing Economic Fluctuations

Fiscal policy faces significant challenges due to various types of lags involved in its implementation. These lags can impact the effectiveness and timing of fiscal measures aimed at counteracting economic fluctuations.

• Recognition Lag: The economy is complex, and understanding the current state of macroeconomic variables is not easy. There are difficulties in collecting accurate and timely data, leading to delays in recognizing the need for a policy change.
• Decision Lag: Once the need for intervention is identified, the government must evaluate different policy alternatives. This decision-making process can take time, causing further delays in implementing the necessary measures.
• Implementation Lag: Even after deciding on appropriate policy measures, there can be delays in legislation and implementation due to bureaucratic processes, especially in democratic setups.
• Impact Lag: This lag refers to the time it takes for the effects of a policy to become visible. There may be a delay before the outcomes of fiscal measures are apparent.

These lags can lead to poorly timed fiscal policy changes, such as initiating expansionary measures when the economy is already recovering or vice versa. Additionally, there are practical difficulties in swiftly altering government spending and taxation policies.

• Reducing government spending on items like defense, social security, and ongoing capital projects is challenging.
• Public works projects, such as highways and dams, have long gestation periods and cannot be easily adjusted with the fluctuations of the trade cycle. Some urgent public projects also cannot be postponed due to the need for expenditure cuts to correct business cycle fluctuations.

Supply-side economists argue that certain fiscal measures can create disincentives. For instance, increasing profits tax may deter firms from investing, while raising social security benefits may reduce incentives to work and save.

• Deficit financing can boost purchasing power, but in underdeveloped countries, the production of goods and services may not keep pace with the increased demand, leading to uncontrolled price spirals.
• Increased government borrowing places a burden on future generations, as debts must be repaid. If borrowed funds are not utilized productively, generating sufficient surpluses for debt servicing becomes challenging. External debt burdens have been persistent issues for countries like India and other developing nations.

Crowding Out

When the government borrows heavily from the credit market to finance its deficit during a recession, it can lead to higher interest rates. This is because substantial government borrowing reduces the amount of available funds in the credit market, pushing interest rates up.
Higher interest rates can have a dampening effect on private sector spending. Specifically:

• Business Investment: Firms may be less willing to invest in new projects and expansion when borrowing costs are higher. This can slow down economic growth.
• Consumer Spending: Individuals may also be reluctant to take out loans for big-ticket items, such as homes and cars, which are sensitive to interest rates. This further reduces aggregate demand.

However, in the context of a deep recession, the crowding-out effect is less pronounced. During such times, private sector investment is already at a low level, and there is minimal private spending to crowd out. Additionally, the government may be able to borrow from the market without significantly increasing interest rates.

Conclusion

Timely and well-designed fiscal responses are crucial for an economy experiencing recession, inflation, or aiming for economic growth and equitable income distribution.

• During Recession: Increasing aggregate demand can lead to higher total output without raising prices, as there is idle productive capacity and unemployed workers.
• At Full Employment: Expansionary fiscal policy can pressure prices to rise without impacting total output.
• Promoting Economic Growth: Fiscal policy is an effective tool for fostering economic growth and addressing income inequality.