Fiscal Policies

of
Developing Economies
What is fiscal policy?

Fiscal policy is the use of government spending and revenue collection to

influence the economy or the overall effect of the budget outcome on
economic activity. The two main instruments of fiscal policy are government
spending(G) and taxation(T).. Changes in the level and composition of
taxation and government spending can impact on the following variables in
the economy:
•Aggregate Demand and the level of economic activity;
•The pattern of resource allocation;
•The distribution of income.

The three possible stances of fiscal policy are:-

•neutral stance: G = T
•expansionary stance: G > T
•Contractionary stance: G < T
Objectives & tools of fiscal policy

In developing countries, fiscal policy is used to create an environment for rapid

economic growth. The various aspects of this are:
1. Mobilization of resources
2. Acceleration of economic growth
3. Minimization of the inequalities of income and wealth
4. Increasing employment opportunities
5. Price stability

Various tools of fiscal policy, the following are the most important:

Reflationary Fiscal Policy

It may be used to boost the level of economic activity during periods of recession
or deceleration in economic activity.
Deflationary Fiscal Policy
During a boom, i.e., when the economy is growing beyond its capacity, inflation
and balance of payment problems might result.
Major issues in fiscal policy of developing
economies

Developing economies two main issues in relation with its fiscal policy. It’s
govt. has to keep in mind these two aspects of fiscal policy while planning
for its budget. These two issues are:-

Creation of fiscal space :-For developing countries, fiscal space may seem
a more immediate issue than in advanced economies because there are
more pressing needs for expenditure today.
Reduction of fiscal deficit :- if fiscal deficit is not reduced then the country
will be struck in a web of further interest payments on its net borrowings and
have a deficiency of funds to allocate towards productive proposals.
What is Fiscal Space?

Fiscal space can be defined as the availability of budgetary room that allows a
government to provide resources for a desired purpose without any prejudice to
the sustainability of a government’s financial position. It must do this without
compromising macroeconomic stability and fiscal sustainability—making sure
that it has the capacity in the short term and the longer term to finance its
desired expenditure programs as well as to service its debt.
Creation of fiscal space

Fiscal space can be created majorly from two methods:

1. Creating Fiscal Space Without New Borrowing
2. Governments can generate fiscal space by increasing their un-utilized
borrowing capacity.

Creating Fiscal Space Without New Borrowing

The most attractive way for countries to create fiscal space is within existing
borrowing parameters. Fiscal space can be created without the issuance of
new debt by
1. improving the efficiency of public expenditure;
2. increasing revenue mobilization;
3. mobilizing grant aid.
Governments can generate fiscal space by increasing their
un utilized borrowing capacity.

Fiscal space can be created by exploiting a government’s unused borrowing

capacity, that is the difference between the maximum level of net debt that it
can sustain and its current level of net debt. The maximum level of debt that a
government can sustain can be increased by:

(i) Enhancing public sector fiscal credibility,

(ii) Enhancing the growth of the revenue base, and/or
(iii) ―locking-in‖ future fiscal resources.
Efficiency and Effectiveness of Fiscal Space

The efficiency and effectiveness of public expenditure or creation of fiscal

space is critical to outcomes in developing economies
•cost-overruns,
•poor project management,
•poor maintenance
•inefficient creation and maintenance of infrastructure assets.
•Leakages increases in health and education spending better
outcomes..

If institutional weaknesses and problems of governance that cause

poor outcomes are not addressed, even spending on potentially high return
programs will have little impact on growth. The net impact will be to erode the
government’s solvency and reduce its fiscal space.
Fiscal Deficit

Fiscal deficit is basically the situation in which govt.’s budgeted expenditure is

more than its revenue. Fiscal deficit can be reduced by taking up two main
measures or by the combination of both. These measures are:
•Reduction of govt. spending
•Increase in govt. revenue

Fiscal policy in developing countries has been broadly successful in

achieving economic stabilization in part through reductions in fiscal
deficits. The median fiscal deficit in developing countries was reduced from 6
percent in the early 1980s to 2 percent in the late 1990s and median inflation
was reduced from 15 to 5 percent over the same period.
Cost of reducing fiscal deficit

The success of fiscal policy in relation to its stabilization objective may

have come at the cost of long-term economic growth.

In developing economies reduction of the fiscal deficit was largely achieved

through expenditure adjustments. They relied on expenditure reductions
rather than revenue enhancement as the principal means of fiscal adjustment
over this period. The largest share of expenditure adjustment in these
countries was accomplished by cuts on infrastructure. There are no clear
trends in the share of public expenditure allocated to education – they appear
to have been protected from cuts - but expenditure on health as a share of
GDP shows a clear and sharp increase post-1990.
Selecting the Apt. Fiscal Policy Design

The developing economies should choose that fiscal policy design that enables
both the short-term stabilization objective as well as longer-term growth and
poverty reduction objectives to be achieved. Fiscal policy is important because
of its impact on

1. Physical and human capital formation and the economy’s long-term potential
growth trajectory

2. The efficiency of expenditures and complementarities among productive

expenditure categories.
 Limitations of Fiscal Policy

Fiscal policy has been a great success in developed countries but only
partially so in developing countries. Following are some of the reasons that
are hindrances for its implementation in developing countries:

1. Lack of statistical information as regards the income, expenditure, savings,

investment, employment etc. makes it difficult for the public authorities to
formulate a rational and effective fiscal policy.
2. Fiscal policy cannot succeed unless people understand its implications and
cooperate with the government in its implication. This is due to the fact that,
in developing countries, a majority of the people are illiterate.
3. Large-scale tax evasion, by people who are not conscious of their roles in
development, has an impact on fiscal policy.
4. Fiscal policy requires efficient administrative machinery to be
successful. Most developing economies have corrupt and
inefficient administrations that fail to implement the requisite
measures vis-à-vis the implementation of fiscal policy.

5. The resources available with the government are meager since tax
bases are small and tax administration weak.

6. Much of tax revenue comes from inefficient and distortionary

indirect taxes such as excise duties. International trade is heavily
taxed. Effective personal income taxes are low and easily evaded
and corporate taxes are high.
China
Challenges

1) Unemployment, poverty, and social unrest

2) Negative economic effects of corruption

3) HIV-AIDS and epidemic disease

4) Water resources and pollution

5) Increasing energy consumption and prices;

6) Fragility of the financial system and state-owned enterprises

7) Possible shrinkage of foreign direct investment

8) Potential conflict with Taiwan.

 Fiscal policy

 2002 and 2009 Chinese government continued to pursue a proactive

fiscal policy to boost domestic demand.

 Lowering the securities stamp tax rate

 Customs tariffs were reduced

 The banking and insurance business tax was further lowered

 The increase in expenditures is caused by the following factors:

 Continued investment in projects funded by government bonds,

western region development and technical innovation;

 Increased investment in agriculture, science and education.

  A several million dollar fund for having the top innovators of the world

 VAT—which represents more than 40 percent of total tax revenue—the

government has been piloting a reform to allow credits for the tax paid on
capital inputs, with a view to progressively moving from a production-type to
a consumption-type VAT

 Personal income tax is also in need of reform, in particular: (i) the top rate
should be aligned to the EIT rate; and (ii) the number of tax schedules and
the number of rates within each schedule should be reduced.

 Therefore, the budget deficit

 China’s medium-term fiscal sustainability is strongly underpinned by sustained

economic growth and a steady increase in revenue as well as the people’s
confidence in the government.
Russia
 Russia’s fiscal policy was prudently conservative, but the future fiscal
risks are significant.

 Reduce spending volatility by diverting a stable flow of oil revenues to the

budget and allocating the rest to a stabilization fund impact on the
domestic economy and its competitiveness.

 Three fiscal challenges—uncertain revenues, rising expenditures, and

the specter of renewed debt Oil revenues, booming today, could become
a drag on economic performance.

Issue 1- Uncertain Revenues

 The share of oil revenue in total fiscal revenue increased substantially—

from 10 percent of GDP to about 30 percent.

 Instead of diversifying, Russia has specialized in oil, which now accounts

for about 60 percent of exports This has not been a problem in the face
of high oil prices, but it could become a major vulnerability if oil prices
begin a rapid descent.
 Issue 2: Russia will confront major public spending

 Aging population - higher pension health services,

 Changing demand structure for education
 Social expenditures are likely to increase by 3.5 percentage points of GDP

Issue 3- Increasing Debt

 Gross debt increasing, oil funds shrinking, budget transfers will exceed oil
revenues transfers from the National Welfare Fund are not enough to cover the
non oil primary (non interest) fiscal deficit.
 Unless the government undertakes fiscal measures to ensure sustainability,
Russia will once again become a net debtor in the long term.
 Oil fund assets and its other foreign exchange assets by the end of the planning
horizon in 2040, reaching zero net debt. After that, Russia could again fall into
debt
 India
 FRBMA Mandated annual targets for reduction in fiscal deficit

 Although changed situation now, because of changing global economic

environment

 Ways

 Improvement in tax-GDP ratio

 Decrease in non-developmental expenditure,
 Moderate growth in non-tax revenue
 Government’s Strategy to Pursue Fiscal Consolidation till last year

 Taxation

 Direct

 Focus
 Moderate rates and a broad base
 Removal of exemptions and improvement in tax administration
 Examples - Property tax, Income Tax, Service tax
 Indirect taxes

 Unlike Direct Taxes, Indirect Taxes are not levied on individuals, but
on goods and services. Customers indirectly pay this tax in the form of
higher prices.

 Examples - VAT (Value Added Tax), Sales tax, Excise tax, Stamp duties
and Expenditure tax.

 Goods and services tax (GST) from April 1 2010. Converge almost all
indirect taxes at the Centre and states level.

 Minimum Alternate Tax (MAT) applied low or no taxable income, however the
books of accounts reflect accounting profits abolished

 Fringe Benefit Tax (FBT) on ESOPs abolished

New Tax Code
Upto 160 Nil Nil
 Replace 1961 indirect tax laws, become a law 000
only in 2011
1 60 001 to 10% 10% of the
3 00 000 amount
 Securities Transaction Tax (STT) abolition
exceeding
lower limit
 Long term and short-term definition by the
period of holding of a capital asset will be 3 00 001 to 20 % 10% of the
removed. 5 00 000 amount
exceeding
 All capital gain income has to be aggregated lower limit
with other income and taxed as per slab rates
applicable to the taxpayer 5 00 001 to 30% 10% of the
10 00 000 amount
 However the cost of acquisition and cost of exceeding
improvement will be adjusted on the basis of 1 60 000
cost inflation index to reduce the inflationary
gains? 10 00 001 30% 84 000 +20
to 25 00 % of the
 The base date for calculation of cost of 000 amount
acquisition of a capital asset has been proposed exceeding
to be shifted from 01-01-1981 to 01-04-2000.
This would be a big disadvantage to people who 10 000`
had brought the assets very long ago. Above 25 30% 3 84 000 +
00 001 30% of the
 The reason is that you would have brought it for amount
very low prices but the capital gains will be
calculated based on the price of the asset on exceeding
01-04-2000. 25 00 000
 Example For ease of understanding

 Suppose you have bought some shares on March 20, 1995 for Rs 60,000 and their value
as on April 1, 2000 was Rs 1 lakh. Now if you sell these shares anytime on or after April 1,
2011 for say, Rs 2.5 lakh, your cost of acquisition for the purpose of indexation will be
taken as Rs 1 lakh and not Rs 60,000
.
 Consequently, the gain of Rs 40,000 (Rs 1,00,000 - 60,000) from 1995 till 2000 escapes
the tax net.

 In the above example, the amount that will be taxable will be Rs 1.5 lakh (Rs 2.50 lakh sale
price less Rs 1 lakh which is the value on the base date).

 It is possible to legally avoid even this tax by selling these shares a little before a April 1,
2011 (say, on March 25, 2011). Since the sale on March 25, 2011 will be governed by the
provisions of ITA61, the entire long-term capital gains will be tax-free.

 Few concern that it would lead to stock market crash when it would be applied and
moreover the rules are same for both Indian and foreign investors this would increase the
severity

 Capital losses will be allowed to be set-off only against capital gains

 Would also effect the further investments in India

 Maximize direct tax collections

 Deficit reduction
Current Policies

 Prudent mix of fiscal and monetary policy.

 Government Bonds

 Ways & Means Advances

 Inflation

 Debt management Office(DMO)

 Common Minimum Programme

 National Rural Employment Guarantee Scheme

 Sarva Shiksha Abhiyan

 National Rural Health Mission

 Backward Regions Grants Fund (BRGF)

 National Investment Fund (NIF)

 Twelfth Finance Commission

Thank
You..

Sri guru gobind singh college of

commerce.
BBE dept.
3rd year