FISCAL POLICY

Fiscal policy is the government policy on spending and taxation to monitor and to stabilize
the nation’s economy. It is often known as a sister strategy to monetary policy. Changes in
the timing, consumption and the level of government expenditure and taxation can have a
substantial effect on the economic growth and economic development of the country.

Laissez-faire was the only government approach to the economy before Great Depression.
During World War II it was decided that the government have to play a vital role to control/
to regulate business cycle, unemployment, wages and inflation. By using various
combinations of these two policies government can create healthy economic growth.

Fiscal Policy aims to stimulate economic growth during recession, keep low rate of
inflation and stabilize economic growth within the economy. It is basically based on the
theory of Keynesian economics that government can play an important role in the
productivity level of the economy by increasing or receding public expenditure and taxes
which in turn, curb inflation, increase employment level and maintain money value.

TOOLS OF FISCAL POLICY

The two main tools of fiscal policy are government spending and taxation.

GOVERNMENT SPENDING: It is spending by public sector i.e. expenditure by central

bank and government on goods and services such as education, health care and defense and
is a major component of Gross Domestic Product (GDP).

It is further divided into four categories briefly discussed below:

Capital Expenditure: It is spending on the social infrastructure like school, roads etc.
Capital expenditure increases capital assets of a nation.
Current Expenditure: It is spending on day to day running of public services.
Transfer Payments: Includes payments to the unemployed, pensioners & subsidies to
producer etc. to increase income and output of specific goods and services.
Debit Interest: Includes payment to government debtors e.g. Government bond etc.

FUNCTIONS OF GOVERNMENT SPENDING: following are the main functions of

government spending:
Provision of social security (pension, child benefit, sickness benefit and income support
etc.).
Regulation of economic activity (Road traffic regulations, town and country planning acts
control trading practices in the business).
Improving the efficiency of the allocation of resources.
Provision of public and merit goods and services.
Influence economic activity like output, employment, prices and the balance of payment.
TAXES: A compulsory contribution to state revenue, levied by the government on its
citizens. It is classified in two types:

Direct Taxes: A compulsory contribution levied on the income and wealth of individual
and profit of a business. These taxes are paid by the person or company.
Indirect Taxes: These taxes are on the spending on goods and services. Collected by custom
and excise department.

AIMS OF TAXATION: Following are the targets of taxation:

Raise revenue and lower private sector revenue.
Reduce demand for demerit goods.
Discourage imports.
Equal distribution of wealth in an economy.

TYPES OF FISCAL POLICY

There are two types of fiscal policies i.e. Expansionary Fiscal Policy and Contractionary
Fiscal Policy.

EXPANSIONARY FISCAL POLICY AND ITS IMPACT:

Defined as, “An Increase in government spending and/or a decrease in taxes, as a result,
budget deficit increase and budget surplus decreases”.

Fig 01: Impact of Expansionary Fiscal Policy

ILLUSTRATION:

The above graph shows that with an increase in aggregate demand (AD) there is an increase
in real GDP (Y) from Y1 to Y2 and prices also increases from P1 to P2.

CONTRACTIONARY FISCAL POLICY AND ITS IMPACT:

Defined as, “Decrease in government spending and/or an increase in taxes, as a result,

budget deficit decrease and budget surplus increases”.

It is opposite to expansionary fiscal policy and its purpose is to slow down economic
growth by increase in inflation rate from expanding money supply or crowding out effect
in capital market. Due to tight fiscal policy GDP might falls down, but end results could be
substantial economic growth and smooth business cycle.
Fig 02: Impact of Contractionary Fiscal Policy

ILLUSTRATION:

The above graph shows that with a decrease in aggregate demand (AD) there is a decrease
in real GDP (Y) from Y1 to Y2 and prices level also decreases from P1 to P2.

FUNCTIONING OF EXPANSIONARY AND CONTRACTIONARY FISCAL POLICY:

Here we will look how expansionary and contractionary fiscal policy works under different
scenarios.

Expansionary Fiscal Policy:

Income Tax: If there is a decrease in income tax, disposable income increases which enable
increase in spending. Due to higher consumption level aggregate demand increases and
shift to right as shown in above diagram from AD1 to AD2 and this leads to economic
growth.

Investment In Public Schemes: If government increases such investment, it will create

more jobs, as a result both income and consumption increases and shifts aggregate demand
curve to right or upward.

Injecting Money: If a person gets a job he will further spend to create more employment.
This final increase in real GDP will be more than the initial investment.
However, this increase in aggregate demand can lead to inflation.

Contractionary fiscal policy:

This policy starts its function when growth is at a rate which is not under control i.e. high
inflation and asset bubbles. It is used to rein it in to more sustainable level. If any nation’s
economy is growing at fast pace for example there is low unemployment and formed
inflationary gap than government may reduce government spending and increase taxes to
eliminate this gap.

Income Tax: If there is an increase in income tax, disposable income decreases which in
turn decrease spending. Due to lower consumption, aggregate demand for goods and
services decreases and shift to left as shown in above diagram from AD1 to AD2 and this
slowdowns economic growth.

Investment In Public Schemes: If government decreases such investment, it will not or

barely generate more employment, as a result both income and consumption decreases and
shifts aggregate demand curve to left or downward.
Injecting Money: If a person does not get a job he will not further spend to generate more
jobs. less jobs, less consumption, aggregate demand shifts downward.

EFFECT OF FISCAL POLICY

Effects of fiscal policy are not the same for everyone in an economy. As tax cut only affects
the largest economic group (middle class). When taxes increases middle class have to pay
more taxes than wealthier class. At the time of adjustment of government spending, fiscal
policy affects only specific group. When government decided to start Metro Project in
Pakistan it benefits only its workers in the form of employment and income.

Fiscal policy effects economy by changing incentives. Lower income tax increase
incentives to work. Higher government spending on education increase long term labor
productivity and long term economic growth. During recession, private saving rate rise
rapidly. Fiscal policy helps to offset these rates and inject money to the circular flow and
does not cause crowding out.

Crowding out: When government spends more by borrowing from private sectors, as a
result private sector reduces investment. Therefore government spending “crowd out”
spending of private sector.