In this article we will discuss about the meaning and instruments of fiscal policy.
Meaning of Fiscal Policy:
Fiscal policy is a powerful instrument of stabilisation. “By fiscal policy we refer to government actions affecting its receipts and expenditures which we ordinarily take as measured by the government’s net receipts, its surplus or deficit.” The government may offset undesirable variations in private consumption and investment by anti-cyclical variations of public expenditures and taxes.
Arthur Smithies defines fiscal policy as “a policy under which the government uses its expenditure and revenue programmes to produce desirable effects and avoid undesirable effects on the national income, production and employment.”
Though the ultimate aim of fiscal policy is the long-run stabilisation of the economy, yet it can be only achieved by moderating short-run economic fluctuations. In this context Otto Eckstein defines fiscal policy as “changes in taxes and expenditures which aim at short-run goals of full employment and price-level stability”.
Instruments of Fiscal Policy:
Fiscal policy, through variations in government expenditure and taxation, profoundly affects national income, employment, output and prices. An increase in public expenditure during depression adds to the aggregate demand for goods and services and leads to a large increase in income via the multiplier process; while a reduction in taxes has the’ effect of raising disposable income thereby increasing consumption and investment expenditures of the people.
On the other hand, a reduction of public expenditure during inflation reduces aggregate demand, national income, employment, output and prices; while an increase in taxes tends to reduce disposable income thereby reducing consumption and investment expenditures. Thus the government can control deflationary and inflationary pressures in the economy by a judicious combination of expenditure and taxation programmes. We discuss below the various instruments of fiscal policy.
1. Budgetary Policyâ€”Contra-cyclical Fiscal Policy:
The budget is the principal instrument of fiscal policy. Budgetary policy exercises control over size and relationship of government receipts and expenditures. We discuss below the common budget policies that can be adopted for stabilising the economy.
(a) Budget Deficitâ€”Fiscal Policy during Depression:
Deficit budgeting is an important method of overcoming depression. When government expenditures exceed receipts, larger amounts are put into the stream of national income than they are withdrawn. The deficit represents the net expenditure of the government which increases national income by the multiplier times the increase in net expenditure.
If the MPC is 2/3, the multiplier will be 3; and if the net increase in government expenditure is Rs.100crores it will increase national income to Rs.300crores (= 100 x 3). Thus the budget deficit has an expansionary effect on aggregate demand whether the fiscal process leaves marginal propensities unchanged or whether a redistribution of disposable receipts occurs.
The expansionary effect of a budget deficit is shown diagrammatically in Fig. 1. C is the consumption function. C+I+G represents consumption, investment and government expenditure (the total spendings function) before that budget is introduced. Suppose government expenditure of AG is injected into the economy.
As a result, the total spendings function shifts upward to C+I+G’. Income increases from OY to OY1 when the equilibrium position moves from E to E1 .The increase in income YY, (= EA = E1 A) is greater than the increase in government expenditure E1 B (= Î”G).
BA (E1A-E1B) represents increase in consumption. Thus the budget deficit is always expansionary, the rise in national income being (YY1) greater than the actual amount of government spending (Î” G=E1B). In this method of budget deficit taxes are kept intact.
Budget deficit may also be secured by reduction in taxes and without government spending. Reduction in taxes tends to leave larger disposable income in the hands of the people and thus stimulates increased consumption expenditure. This, in turn, would lead to increase in aggregate demand, output, income and employment. This is illustrated in Fig. 2, where C is the original consumption function. Suppose tax is reduced by ET, it will shift the consumption upward to C’. Income will increases from OY to OY1.
However, reduction in taxes is not so expansionary via increased consumption expenditure because the tax relief may be saved and not spent on consumption. Businessmen may not also invest more if the business expectations are low.
Therefore, to safeguard against such eventualities the government should follow the policy of reduction in taxes with increased government spending and its multiplier effect will be much higher in case we also assume that some consumption and investment expenditures increase due to tax relief.
(b) Surplus Budget:
Fiscal Policy during Boom. Surplus in the budget occurs when the government revenues exceed expenditures. The policy of surplus budget is followed to control inflationary pressures within the economy. It may be through increase in taxation or reduction in government expenditure or both. This will tend to reduce income and aggregate demand by the multiplier times the reduction in government or/and private consumption expenditure (as a result of increased taxes).
This is explained with the aid of Fig. 1, where the economy is at the initial equilibrium position E. Suppose the government expenditure is reduced by AG so that the total spending function C+I+G’ shifts downward to C+I+G. Now E is the new equilibrium position which shows that the income has declined to OY from OY, as a result of reduction in government expenditure by E,B. The fall in income Y,Y (=AE)>E1B, the reduction in expenditure because consumption has also been reduced by BA.
There may be budget surplus without government spending when taxes are raised. Enhanced taxes reduce the disposable income with the people and encourage reduction in consumption expenditure. The result is fall in aggregate demand, output, income and employment. This is illustrated in Fig. 3. C is the consumption function before the imposition of tax. Suppose a tax equal to ET is introduced. The consumption function shifts downward to C1 .The new equilibrium position is E1. As a result, income falls from OY to OY1.
(c) Balanced Budget Multiplier:
Another expansionist fiscal policy is the balanced budget. In this policy, the increase in taxes and in government expenditures are of an equal amount. This has the impact of increasing net national income. This is because the reduction in consumption resulting from the tax is not equal to the government expenditure. This is explained in terms of what is known as the balanced budget theorem or multiplier.
2. Compensatory Fiscal Policy:
The compensatory fiscal policy aims at continuously compensating the economy against chronic tendencies towards inflation and deflation by manipulating public expenditures and taxes. It, therefore, necessitates the adoption of fiscal measures over the long-run rather than once-for-all measures at a point of time.
When there are deflationary tendencies in the economy, the government should increase its expenditure through deficit budgeting and reduction in taxes. This is essential to compensate for the lack in private investment and to raise effective demand, employment, output and income within the economy. On the other hand, when there are inflationary tendencies, the government should reduce its expenditure by having a surplus budget and raising taxes in order to stabilise the economy at the full employment level.
The compensatory fiscal policy has two approaches:
(i) Built-in stabilisers and
(ii) Discretionary fiscal policy.
(i) Built-in Stabilisers;
The technique of built-in flexibility or stabilisers involves the automatic adjustment of the expenditures and taxes in relation to cyclical upswings and downswings within the economy without deliberate action on the part of the government. Under this system, changes in the budget are automatic and hence this technique is also known as one of automatic stabilisers.
The various automatic stabilisers are corporate profits tax, income tax, excise taxes, old age, survivors and unemployment insurance and unemployment relief payments. As instruments of automatic stabilisation, taxes and expenditures are related to national income. Given an unchanged structure of tax rates, tax yields vary directly with movements in national income, while government expenditures vary inversely with variations in national income.
In the downward phase of the business cycle when national income is declining, taxes which are based on a percentage of national income automatically decline, thereby reducing the tax yield. At the same time, government expenditures on unemployment relief and social security benefits automatically increase.
Thus there would be an automatic budget deficit which would counteract deflationary tendencies. On the other hand, in the upward phase of the business cycle when national income is rising rapidly, the tax yield would automatically increase with the rise in tax rates.
Simultaneously, government expenditures on unemployment relief and social security benefits automatically decline. These two forces would automatically create a budget surplus and thus inflationary tendencies would be controlled automatically.
Built-in stabilisers have certain advantages as a fiscal device.
First, the built-in stabilisers serve as a cushion for private purchasing power when it falls and lessen the hardships on the people during deflationary period.
Second, they prevent national income and consumption spending from falling at a low level.
Third, there are automatic budgetary changes in this device and the delay in making administrative decisions is avoided.
Fourth, automatic stabilisers minimise the errors of wrong forecasting and timing of fiscal measures.
Lastly, they integrate short-run and long-run fiscal policy.
However, the effectiveness of built-in stabilisers as an automatic compensatory device depends on the elasticity of tax receipt, the level of taxes and flexibility of public expenditure. The greater the elasticity of tax receipts the greater will be the effectiveness of automatic stabilisers in controlling inflationary and deflationary tendencies. But the elasticity of tax receipts is not so high as to act as an automatic stabilizer even in advanced countries like America.
Second, with low level of taxes even a high elasticity of tax receipts would not be very significant as an automatic stabiliser during a downswing.
Third, the built-in stabilisers do not consider the secondary effects of stabilisers on after-tax business incomes and of consumption spending on business expectations.
Fourth, this device keeps silent about the stabilising influence of local bodies, state governments and of the private sector economy.
Fifth, they cannot eliminate the business cycle. At the most, they can reduce its severity. Sixth, their effects during recovery from recession are unfavourable. Economists, therefore, suggest that built-in stabilisers should be supplemented by discretionary fiscal policy.
(ii) Discretionary Fiscal Policy:
Discretionary fiscal policy requires deliberate changes in the budget by such actions as changing tax rates or government expenditures or both.
It may generally take three forms:
(i) Changing taxes with government expenditure constant,
(ii) Changing government expenditure with taxes constant, and
(iii) Variations in both expenditures and taxes simultaneously.
First, when taxes are reduced, while keeping government expenditure unchanged, they increase the disposable income of households and businesses. This increases private spending. But the amount of increase will depend on whose taxes are cut, to what extent, and on whether the taxpayers regard the cut temporary or permanent. If the beneficiaries of tax cut are in the higher middle income group, the aggregate demand will increase much.
If they belong to the lower income group, the aggregate demand will not increase much. If they are businessmen with little incentive to invest, tax reductions will not induce them to invest. Lastly, if the taxpayers regard tax reductions as temporary, this policy will again be less effective. So this policy is more effective in controlling inflation by raising taxes because high rates of taxation will reduce disposable income of individuals and businesses thereby curtailing aggregate demand.
The second method is more useful in controlling deflationary tendencies. When the government increases its expenditure on goods and services, keeping taxes constant, aggregate demand goes up by the full amount of the increase in government spending. On the other hand, reducing government expenditure during inflation is not so effective because of high business expectations in the economy which are not likely to reduce aggregate demand.
The third method is more effective and superior to the other two methods in controlling inflationary and deflationary tendencies. To control inflation, taxes may be increased and government expenditure reduced. On the other hand, taxes may be reduced and government expenditure be raised to fight depression.
The discretionary fiscal policy depends upon proper timing and accurate forecasting.
First, accurate forecasting is essential to judge the stage of cycle through which the economy is passing. It is only then that appropriate fiscal action can be taken. Wrong forecasting may accentuate rather than moderate the cyclical swings. Economics is not an exact science in correct forecasting. As a result, fiscal action always follows after the turning points in the business cycles.
Second, there are delays in proper timing of public spending. In fact, discretionary fiscal policy is subject to two time lags. First, there is the “decision lag,” the time required in studying the problem and taking the decision.
The lag involved in this process may be too long. Second, once the decision is taken, there is an “execution lag.” It involves expenditure which is to be allocated for the execution of the programme. In a country like the USA, it may take two years and less than a year in the UK. Third, certain public works projects are so cumbersome that it is not possible to accelerate or slow them down for the purpose of raising or reducing public spending on them.
Despite the higher multiplier effect of government spending as against changes in tax rates, the latter can be operated more promptly than the former. Emphasis has thus shifted to taxation as the best fiscal device for controlling cyclical fluctuations. Thus when the turning point of a business cycle is already underway, discretionary fiscal action tends to strengthen the built-in stabilisers, as has been the experience of developed countries like the USA.
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