Essay on: How does the fiscal policy influence economic activity?

Analyse the impact of Indias fiscal policy on the economy since

the beginning of the last decade.
- Akshata Patil(FT153005)

Fiscal Policy
Fiscal policy is a government's decision regarding spending and taxing. If a government wants
to stimulate growth in the economy, it will increase spending for goods and services. This will
increase demand for goods and services. Since demand goes up, production must go up. If
production goes up, companies may need to hire more people. People that were once
unemployed may now have jobs and money to spend on goods and services.
This will further increase the demand and require more production and, hopefully, the cycle
of growth will continue. Barry may even get more business as people have more money to
spend on products at his store. Consequently, government spending tends to speed up
economic growth.
If the government thinks the economy is overheating - or growing too fast - the government
may decrease spending. A decrease in government spending will decrease overall demand in
the economy.
Businesses will slow production, which means profits will decline, resulting in less hiring and
business investments. A cut in government spending may hurt business, because there will
be less money in people's pockets to spend at the store, possibly from being laid off. If one
provides goods or services to the government, he may take a double-hit.
The other side of fiscal policy is taxes. Decreasing taxes tends to stimulate economic growth.
If taxes go down, one will have more money in his pocket. He'll either spend it or save it. If he
spends it, he increases demand and businesses have to produce more. This means they may
have to hire more people. These people will then have more money to save or spend. On the
other hand, if one saves the money, he'll put it in his bank. The bank will loan the money he
deposited, and borrowers will spend it.
Some economists are concerned that government spending and reduction in taxes will create
a crowding out effect. If the government doesn't have enough revenue to support spending,
it will have to borrow money. According to some economists, government borrowing tends
to increase interest rates. And increased interest rates discourage individuals and businesses,
from borrowing money for spending and investment. According to these economists,
government spending may crowd out private investment.
If the government wants to slow down an overheating economy, it may decide to raise taxes.
This means people have less money to spend. Fewer people will be hired because there is less
demand. Unemployed people don't have extra money to spend at the store. Businessmen
may not make as much money, which means he'll have less money to invest in his business
and less money to spend for his personal consumption. The economy will slow down.

Effects of Fiscal Policy on economic Activity

Capital markets are influenced by fiscal policy in two ways:

Government spending and tax policy will generate either a budget surplus or a deficit,
which will in turn mean that the government sector will either contribute towards
financing investment or "crowd out" private investment.

Tax policy will affect the amount saved. Taxes on interest earned will decrease the
incentive to save and create a wedge between the after-tax interest earned by avers
and the interest rate paid by firms.

Effects of tax changes

1. Taxation and work incentives:

Changes in income taxes affect the incentive to work. Consider the impact of a rise in
income tax.
This has the effect of reducing the post-tax income of those in work because for each
hour of work taken the total net income is now lower.
This might encourage the individual to work more hours to maintain his/her target
income.
Conversely, the effect might be less work since the return from each hour worked is
less.
Changes to the tax and benefit system seek to reduce the risk of the poverty trap
where households on low incomes see little financial benefit from supplying extra
hours of their labour

2. Taxation and the Pattern of Demand

Changes to indirect taxes can alter the pattern of demand for goods and services
For example, the rising value of duty on cigarettes and alcohol is designed to cause a
substitution effect and reduce the demand for what are perceived as de-merit
goods.
The use of indirect taxation and subsidies is often justified on the grounds of instances
of market failure. But there might also be a justification based on achieving a
more equitable allocation of resources e.g. providing basic state health care free at
the point of use.

3. Taxation and labour productivity

Some economists argue that taxes can have a significant effect on the intensity with
which people work and productivity. But there is little strong empirical evidence to
support this view. Many factors contribute to improving productivity tax changes
can play a role - but isolating the impact of tax cuts on productivity is extremely
difficult.

The Laffer curve

Created by the US supply-side economist Arthur Laffer, this curve explores a

relationship between tax rates and tax revenue collected by governments
It argues that as tax rates rise, total tax revenues grow at first but at a diminishing rate.
There may be a tax burden which yields the highest tax revenues. Beyond this, further
hikes in taxation serve only to lower revenues
The Laffer curve has been used as a justification for cutting taxes on income and
wealth - the argument being that improved incentives to work and create wealth will
broaden the base of tax-paying businesses and individuals and also reduce the
incentive to avoid and evade paying tax.
A Keynesian view is that lower direct taxes stimulate higher spending within the
circular flow which itself boosts demand, output, profits and employment, all of which
can drive tax revenues higher.
The Laffer curve came back into the news in spring 2009 when the Labour government
announced a rise in the top rate of income tax designed to raise more than 5bn per
year. Laffer curve supporters argue that it might fail to do this, perhaps even cause
revenues to fall.

Fiscal Policy and the Economic Cycle

Fiscal policy is the Governments main demand-management tool.

Government spending, direct and indirect taxation and the budget balance can be
used counter-cyclically to help smooth out some of the volatility of real national
output particularly when the economy has experienced an external shock.
Discretionary fiscal changes are deliberate changes in taxation and govt spending
for example a decision by the government to increase total capital spending on road
building.
Automatic fiscal changes (also known as automatic stabilisers) are changes in tax
revenues and state spending arising automatically as the economy moves through the
trade cycle.

Impact of Indias fiscal policy on the economy

In response to the largest economic downturn since the 1930s, several countries around the
world implemented large fiscal stimulus to cushion the blow from the financial crisis and jump
start the economic recovery. During the initial phases of the crisis, policy makers concerns
about the effectiveness of monetary policy, stemming from very low interest rates to weak
transmission mechanism, led to embark in sizable fiscal stimuli packages to offset falling
private sector demand. India was no exception to this. Despite the much shallower slowdown
in overall economic activity, industrial production growth fell markedly and overall financing
conditions tightened significantly during the acute phase of the crisis. The Indian authorities
undertook several measures to address the economic fallout from the crisis. On the fiscal
front, the Indian government implemented large expansionary measures in 208/09 and
2009/10. As a result of the fiscal expansion, the deficit increased sharply and the contribution
of government consumption to GDP growth in the last two quarters of 2008/09 was sizable.

Even as large fiscal stimuli packages are being implemented around the world, the
effectiveness of fiscal policy to counter falling aggregate demand has been called increasingly
into question. In particular, the evidence on the magnitude of fiscal multipliers has become a
hotly debated issue in academic as well as policy circles. Unfortunately, theoretical models
yield wide ranges of fiscal multipliers depending on assumptions about the functioning of the
economy (e.g., degree of price rigidity) and structural parameters (labor supply elasticity), and
to complicate matters further, empirical estimates of the impacts of fiscal policy also vary
significantly and are highly dependent on the methodology employed (Perotti, 2009).
Nonetheless, as the Indian authorities have started to exit from accommodative stance in a
calibrated way, having estimates of fiscal multipliers is likely to be useful.

Trends And Patterns In Fiscal Variables In India

A look at the trends and patterns over the last three decades (19802010), which span both
the pre- and post-reform period, helps us understand the relationship between fiscal
expansion and growth in the Indian economy. The first surge in Indias economic growth rate
came in the early 1980s, when it increased to above 5% from the average Hindu growth
rate1 of 3.5% in earlier decades. Unfortunately, this spurt was achieved by unsustainable
fiscal expansion financed by domestic credit and external borrowing. Growth accelerated to
5.8% during the 1980s, but in the second half of the decade, fiscal and current account deficits
widened significantly, causing serious macroeconomic imbalances and culminating in the
balance of payment (BOP) crisis of 1991. These triggered the series of economic reforms that

have been introduced, starting in 1991, to bring about macroeconomic stabilization and
implement structural measures to push up growth.
Deficit Indicators :: The 1980s saw a sharp rise in the combined fiscal deficit of the central
and state governments to 8% on average (see Table 3.1). Along with high external borrowings,
a sustained increase in the combined revenue expenditure to stimulate demand, particularly
in the services sector, caused the fiscal deficit to rise during the 1980s. As a result, the
combined public debt became 56% of GDP on average, with interest payments at 14.6% of
revenue expenditure (3% of GDP on average) accounting for a large portion of government
revenue expenditure and creating a debt trap in the 1980s. During the first half of the 1980s,
these revenue expenditures averaged 18.5% of GDP. In the second half, they rose to an
average of 22.4% with the bulk of the expansion coming under the heads of defense, interest
payments, higher salaries (Fourth Pay Commission) and subsidies. Studies by Srinivasan and
Tendulkar (2003), Joshi and Little (1994), and others attribute the spurt in economic growth
during the decade to demand-side factors. The flip side, however, was the spilling over of this
into external balances. By 1990, the current account and fiscal deficits had risen to 3.5% and
9.4% of GDP respectively, leading to the BOP crisis of 1991 (Ahluwalia 2000, Arvind Panagariya
2004a and, 2004b; Balakrishnan and Suresh 2004; Nirvikar Singh and Srinivasan 2004).
Containing this deficit was one of the key structural adjustments undertaken by the Indian
government at the time. Economic reforms helped reduce the fiscal deficit, and the combined
fiscal deficit fell to 6.3% of GDP in 19961997.

A sharp increase in government salaries and pensions in the next year halted the process of
fiscal improvement until 20032004 when the government introduced the Fiscal
Responsibility and Budget Management Act3 3 The FRBM Act was enacted by Parliament in
2003; later, Mr. Chidambaram, the finance minister in the UPA (United Progressive Alliance)
government, notified the act on 2 July 2004. (FRBM) to control the fiscal deficit. The Act
required the Government of India to bring down its revenue deficit by 0.5% of GDP each year
until it touched zero, and to reduce its fiscal deficit by 0.3% each year to a level of 3.0% of
GDP. The targets were to be achieved by 20082009. Further, it set an annual limit of 9.0%
on the union governments total liabilities and capped union government guarantees