Mocktutor 2017

Economic and Social Issues

23rd Sep 2017

Teacher: Mock Tutor Team

Email: bankerstutor@gmail.com

Fiscal Policy
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Notes

Definition: The set of government rules and regulations to control or stimulate the
aggregate indicators of an economy frames the macroeconomic policy. Aggregate
indicators involve national income, money supply, inflation, unemployment rate,
growth rate, interest rate and many more. In short, policies framed to meet the
macro goals.

Description: Two main regulatory macroeconomic policies are fiscal policy and
monetary policy. Fiscal policy is the macroeconomic policy where the government
makes changes in government spending or tax to stimulate growth. Monetary policy
deals with changes in money supply or changes with the parameters that affects the
supply of money in the economy.

Contract laws, debt management policy, income policy are some of the other
macroeconomic policies designed to modify macroeconomic indicators of the
economy.

The word fiscal comes from a French word Fisc, which means treasure of
Government. All the taxation and expenditure decisions of the government
comprise the Fiscal Policy.

Fiscal Policy is different from monetary policy in the sense that monetary policy
deals with the supply of money and rate of interest. The government and RBI use
these two policies to steer the broad aspects of the Indian Economy. While
government is conducts Fiscal Policy, RBI is responsible for monetary policy. RBI
also helps the government in implementing its fiscal policy decisions.

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Conducting fiscal policy is one of the main duties of the government. Via fiscal
policy, the government collects money from different resources and utilizes it for
different expenditures. Since all welfare projects are carried out under public
expenditures, fiscal policy is closely related to the development policy.

Objectives of Fiscal Policy

The objectives of the fiscal policy of the government are as follows:

Resource Mobilization

Fiscal policy allows the government to mobilize resources for public expenditure and
development. There are three ways of resource mobilization viz. taxation, public
savings and private savings through issue of bonds and securities.

Resource Allocation

The funds mobilized under fiscal policy are further allocated for development of
social and physical infrastructure. For example, the government collected tax
revenues are allocated to various ministries to carry out their schemes for
development.

Redistribution of Income

The taxes collected from rich people are spent on social upliftment of the poor and
this fiscal policy in a welfare state tried to reduce inequalities of income using
resource allocation.

Price stability, control of Inflation, Employment generation

Government uses fiscal measures such as taxation and public expenditure to

stabilize the prices and control inflation. Government also generates employment by
speeding infrastructure development.

Balanced Regional Development

A large part of the government tax revenues are given out to less developed states as
statutory and discretionary grant. This helps in the balanced regional development
of the country.

Balance of Payments

Using fiscal policy measures government tries to promote exports to earn foreign
exchange. This helps in maintaining favourable balance of trade and balance of
payments.
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Capital Formation and National Income

Fiscal policy measures help in increasing the capital formation and economic
growth. Increased capital formation leads to increase in national income al

Components of Fiscal Policy

There are four key components of Fiscal Policy are as follows:

Taxation Policy

Expenditure Policy

Investment & Disinvestment policy

Debt / surplus management.

Taxation Policy

We have already discussed in detail about the taxation policy in previous module.
The government gets revenue from direct and indirect taxes. Via its fiscal policy,
government aims to keep the taxes as much progressive as possible. Further,
judicious taxation decisions are very important for economy because of two reasons:

Higher than usual tax rate will reduce the purchasing power of people and will lead
to an decrease in investment and production.

Lower than usual tax rates would leave more money with people to spend and this
would lead to inflation.

Thus, the government has to make a balance and impose correct tax rate for the
economy.

Expenditure Policy

Expenditure policy of the government deals with revenue and capital expenditures.
These expenditures are done on areas of development like education, health,
infrastructure etc. and to pay internal and external debt and interest on those debts.
Government budget is the most important instrument embodying expenditure
policy of the government. The budget is also used for deficit financing i.e. filling the
gap between Government spending and income.

Investment and Disinvestment Policy

Optimum levels of domestic as well as foreign investment are needed to maintain

the economic growth. In recent years, the importance of FDI has increased
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dramatically and has become an instrument of integrating the domestic economies

with global economy.

Debt / Surplus Management

If the government received more than it spends, it is called surplus. If government

spends more than income, then it is called deficit. To fund the deficit, the
government has to borrow from domestic or foreign sources. It can also print money
for deficit financing.

How Fiscal Policy Works

Fiscal policy is based on the theories of British economist John Maynard Keynes.
Also known as Keynesian economics, this theory basically states that governments
can influence macroeconomic productivity levels by increasing or decreasing tax
levels and public spending. This influence, in turn, curbs inflation (generally
considered to be healthy when between 2-3%), increases employment and maintains
a healthy value of money. Fiscal policy is very important to the economy. For
example, in 2012 many worried that the fiscal cliff, a simultaneous increase in tax
rates and cuts in government spending set to occur in January 2013, would send the
U.S. economy back to recession. The U.S. Congress avoided this problem by passing
the American Taxpayer Relief Act of 2012 on Jan. 1, 2013.

Types of Fiscal Policy

Neutral Fiscal Policy: This implies a balanced budget where (Government
spending = Tax revenue). It further means that government spending is fully funded
by tax revenue and overall the budget outcome has a neutral effect on the level of
economic activity.
Contractionary (restrictive) Fiscal policy: This policy involves raising taxes or
cutting government spending, so that (Government spending < Tax revenue) it cuts
up on the aggregate demand (thus, economic growth) and to reduce the inflationary
pressures in the economy.
Expansionary Fiscal Policy: It is generally used for giving stimulus to the
economy ,i.e., to speed up the rate of GDP growth or during a recession when growth
in national income is not sufficient enough to maintain the present standards of
living. A tax cut and/or an increase in government spending would be implemented
to stimulate economic growth and lower unemployment rates. This is not a
sustainable policy, as it leads to budget deficits and thus, should be used with
caution.
Various combinations of fiscal policies
Reduction in Government Spending and no Change in Tax Rates (Contractionary
fiscal policy): This policy is useful in moderate inflation, which though is part of
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government’s priority, is not the foremost objective. This would affect the growth
little and sometimes even boost growth due to cut in inflation.
Reduction in Government Spending and Increase in Tax Rates (Contractionary fiscal
policy): This policy is useful in high inflation, when curbing inflation is the foremost
objective, even above the economic growth in the short run.
Rigid Government Spending and Increasing Tax Rates (Contractionary fiscal policy):
This is used when economy is overheated (When a prolonged period of good
economic growth and activity causes high levels of inflation as producers
overproduce and create excess production capacity in an attempt to capitalize on the
high levels of wealth) due to too much excitement on the part of investors. Increase
in taxes and interest rates (through monetary policy) would curb the investments in
short-run and prevent economy from going into recession after over-heating.
Reduction in Government Spending and an Equivalent Reduction in Taxes
(Balanced Fiscal Policy): This, is a balanced budget approach, when a government
decides to reduce its size and level of its intervention in economy, then this policy
can be adopted. It simply means government is managing less money and hence less
impact on markets and business.
Increase in government spending and tax rates (Balanced fiscal policy): This would
be opposite to the previous policy as it would increase the size of government. A
government on the path of socialization would adopt such policy.
Increase in government spending and decrease in tax rates (Expansionary fiscal
policy): This would be adopted to give economy a stimulus though injection of funds,
first the government decreases taxes and leaves more income with people to spend
and invest, then it also spends more to give further boost to demand through
additional income generated through government work. This is only possible in
short-run as this policy leads to massive deficits and thus, should be used when
situation is alarming.
Increase in government spending and no change in tax rates (Expansionary fiscal
policy): This is also a stimulus policy (through public sector), but a more moderate
one, which can be used for a bit longer compared to previous.
Rigid Government spending and decrease in tax rates (Expansionary fiscal policy):
This policy is usually adopted to give incentive to private sector to invest and boost
growth. Again, a short-run stimulus policy like previous two.
Tools of fiscal policy
Components of Spending

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Maintenance (including staff salaries): This component can’t be altered in

short-run and hence is hardly a part of policy making, however, in long-run, through
VRS and reducing new jobs in public sector or vice versa, this expenditure can be
altered.
Loan payments: This again is a component, which can’t be touched in short-run,
however, governments in long-run can reduce these payments or eliminate them by
running the budget surplus.
Subsidies: This component is a major part of policy as it can be altered in short-
run, but unfortunately, subsidies as policy instrument, have been abused in India.
These are used by politicians as poll promise and political instruments to gain more
popular support. Ideally only meritorious subsidies shall be in operation and all the
wasteful subsidies must be phased out, for example, fertilizer subsidy and power
subsidy benefits the large farm holder and capitalist farmers instead of the needy
ones. Similarly, the recent example of Aam Aadmi Party manifesto is a good
example, how subsidies should not be used. In place of these, subsides for health
programs, renewable energy, public transport shall be encouraged to ensure good
health and sustainable growth.
Welfare schemes: These are one of the policy options that once introduced can’t
be removed due to their populist nature. Similarly, in most of the cases these are
necessary too and important instrument of social welfare and economic growth.
However, it is the implementation part, which is key, as these schemes generally
suffer from poor implementation and massive corruptions and loopholes. Thus,
despite being meritorious expenditure in nature, these at time appears as waste.
Wasteful expenses: Needless to say these are the expenditures that must be
curbed with immediate effect; however, no government in world has neither shown
the intention to curb them, though there are efforts to reduce them from time to
time under public pressure. For example, full page government advertisements in
newspaper to generate favorable public opinion.
Components of Earning
Tax: single: Single most important source on government revenue is also a very
important policy measure as elaborated in the policy combinations above.
Borrowing: Borrowing is a necessary source of funds, though not a desirable one.
Particularly, in developing countries, as tax/GDP ratio is low due to less per capita
income. However, it becomes an important part of monetary policy as well due to its
impact on interest rates and credit creation and thus, overall money supply.

Proceeds from sale/lease of assets: This is a both a one-time and regular

source of income. For example, lending government buildings for private use, or
other assets such as telecom spectrum or lease of a mine block for certain years, is a
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regular source of income, whereas sale of PSUs is a onetime income. These however,
are good sources of revenue, as they provide government more room to spend
without increasing taxes.
Profits from PSU: Profits from PSUs can also be a potential source of revenue,
however, since most of PSUs are generating losses, Indian government usually ends
up subsidizing them. At times PSUs are deliberately kept in losses to keep prices low
and ensure wider outreach for social welfare, example, PSU banks in pre-reform era
and post-offices. Similarly, at other times, they are in losses due to inefficiency and
wasteful expenditure. Most striking case in India, is of ministerial corruption to keep
PSUs in loss deliberately to benefit private sector, for example, CAG report says that,
Indian Airlines was deliberately kept in losses by avoiding flights on profitable
routes to benefit private airlines during UPA government’s rule. Similarly, in
previous NDA government, BSNL was deliberately pushed into loss, by increasing
tariffs to provide competitive edge to a newly launched company by one of the
biggest business conglomerate in India.

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