Economic concepts: Fiscal Policy

It is the policy by which a government earns its revenue and spends it and, in the process influence the economic growth and human development in the country.

The main objectives of the fiscal policy are

• Full employment
• Economic stabilization
• Economic growth
• Social justice or equality in the distribution of income and wealth

The prime objective of the fiscal policy among the above said objectives is to ensure social justice in the distribution of income and wealth because, now most of the modern economies accept that(at least after the recession) it is impossible to secure social justice through market phenomena or corresponding monetary policy. The whole world reverted back to fiscal policy, especially counter cyclical fiscal policy after recession (2007-08) as believed by J.M. Keynes (during Great depression, 1930) after a long stint of Milton Friedman's Monetarist policy.

Lets see what are the major issues in economics and their importance of fiscal policy.

1. Economic Growth always goes with inflation. The increase in the total goods and services produced in the country(aggregate demand) will increase with the rapid economic growth which will in turn will push the price up. So full employment can be attained with the heavy economic growth but only with high inflation.

2. Higher rate of inflation may lead to stagflation, a condition where both inflation and unemployment rates are very high and economic growth is low.
3. Demand pull inflation will push the wage higher hence creating a cost push inflation hence the prospects of recovery becomes bleak
4. Failure in the economic cycle(see Image): Earlier economist believed that, 'the automatic stabilizers will stabilize the economy. These stabilizers are present in the market and in the fiscal policy tools of the government. But all this failed to improve during 1930s. Hence the importance of fiscal policy rose to prominence, thanks to the efforts of economist like J.M. Keynes

The main aim of establishing a government is to secure social justice and peacefully regulated employment. In the market phenomena three things are antithetical to each other, they are

Price stability

Employment

& Growth

That is all cannot achieved at the same time. Something has to be sacrificed for achieving the other.

Through the fiscal policy tools like taxation, public expenditure, government borrowings(public debt) this business cycle could be interrupted to produce full employment with relative price stability and a decent growth.

These objectives cannot be realized by only pursuing monetary policy(policy relating to money supply and interest rate). Even when we ride a camel into a oasis it will drink the water only when its thirsty .Similarly, even when we reduce the interest rates and increase the money supply the businessmen will do business only when he has confidence in the growth and performance of the economy in general. Only when he feels that there is demand for the market for the goods he produces, he will produce goods. When the economy is in recession the consumption will be less as most people will be without money or save money for future use. High inflation might also make the situation worse. Hence, the artificial demand for finished goods has to be created. To make this happen the fiscal policy comes into the picture. There are various types of fiscal tools used in various circumstances.

Expansionary Fiscal Policy: During the contraction phase of business cycle(recession & depression), the government will generally

Do a tax cut

Increase transfer to the poor to increase their purchase power.

Develop infrastructure to Stimulate aggregate demand.

These policies are expansionary in nature as these policies would increase the expenditure of the government and decrease the revenue hence higher fiscal deficit(total expenditure of the government- non debt creating revenues). But still government uses this tool to fight recession. These are also known as stimulus package or fiscal expansion measures. At this outset let us also see what is expansionary monetary policy?

Expansionary Monetary policy: during the time of recession government through the central banks will increase the money supply in the system and there by will try to reduce the interest rates. Low interest rate means less cost for starting business and low yield on deposit. Hence the tools generally used by RBI to increase the money supply are

• Decrease CRR and SLR
• Decrease Repo rate and Bank rate
• Buy back government bonds (open market operation)
• Decrease Reverse repo

Contractionary fiscal policy: During growth with high inflation government will generally uses the following policy tools.

• Increase the tax rate
• Decrease the transfer
• Decrease other government expenditures

These fiscal policy options are contractionary in nature as it decreases the fiscal deficit of the government.

Corresponding contractionary monetary policy is a policy by which the RBI curtails the money supply in our economy. The policy options used by the RBI in this context are

• Increase CRR and SLR
• Increase Repo and Bank rate
• Increase Reverse repo rate

NOTE: Fiscal Consolidation: It is long term plan to reduce deficit and accumulation of debts by making suitable fiscal policy options whenever needed. Generally governments tries to decrease transfers and implement other austerity measures for a longer period to achieve it.

COUNTER CYCLICAL FISCAL POLICY

These are policy options adopted by the government to counter the cyclical tendencies in an economy(business cycle). As suggested by Keynes, government has to use its fiscal tools to cool down the economy when growing rapidly to prevent it from going into depression and achieve price stability and full employment much before it is normally achieved in normal cycle.

The generally policy measures suggested by Keynes were

• Deficit Budgeting: budget in such a way where expenditure is more than income.
• Progressive taxation
• Government spending towards public welfare programs and providing social security measures.
• Cheap money policy should always accompany fiscal measures.
• Discretionary taxation policy to counter cyclical effects.

How it works:

Let us consider the concept of progressive taxation. When the economy grows a person goes to the higher income bracket, more amount of money is taxed which effectively reduces his capacity to buy goods and avail services. If more and more people fall in that bracket, automatically the aggregate demand is checked by the process. Similarly, when the economy is in recession more and more people will come under BPL, which has the potential to dry out the aggregate demand of the country. If the country has social security schemes, these BPL people will come under those schemes which in turn will increase the purchasing power of the people which would not let the aggregate demand to dry out . Thus, a stable demand is maintained in the economy.

The above example is the example of 'automatic stabilizer' used in the counter cyclical fiscal policy. The reduction of indirect taxes when needed, giving subsidies in the first quarter of the economy and waiting for output in the subsequent quarters are the discretionary measures adapted by the governments.