Fiscal policy

The discussion
Meaning and scope of fiscal policy Working of fiscal policy Use of fiscal measures for achieving the macroeconomic goals such as of economic growth, employment, stability, income equality, and BOP equity Limitations of fiscal policy

Meaning of fiscal policy

Meaning and scope of fiscal policy

Word fisc- the treasury of a kingdom or state Government programme - discretionary changes in pattern and level of its expenditure, taxation and borrowing (magnitude and composition of inflows and outflows) to achieve intended macroeconomic goals by changing magnitudes of macroeconomic aggregates. Also called budgetary policy
Receipts tax, non-tax revenue and borrowing (including deficit financing)- inflows from private sector Expenditure- payment for goods and services, interest and loan repayment, subsidies, pensions and grants-in-aid outflows towards private sector

The scope of fiscal policy

Fiscal instruments and target variables

Fiscal instruments
Budgetary balance policy- balance-budget, deficit-budget, surplus-budget policy

Government expenditure- on goods and services, payment of wages, public investment, transfer payments etc.- an injection, effect depend on how it is financed Taxation- direct income, corporate, wealth, property, and indirect Public borrowing- internal and external to finance their budget deficits.
Borrowing from public by means of government bonds and treasury bills transfer of purchasing power from public to govt. Borrowing from central bank monetized deficit financing injection External borrowing- from foreign government, international organizations such as IMF, World Bank, market borrowing - injection

Target variables
Change in aggregate demand
Private disposable income through direct taxation Private consumption expenditure through indirect taxation Saving and investment through tax incentives and disincentives Exports and imports through tariffs Level and structure of prices What about the aggregate supply

Kinds of fiscal policy

Automatic stabilization fiscal policy Compensatory fiscal policy and Discretionary fiscal policy

The frequency of fiscal change

Once for all Once a year Or, more at different stages (India 1. prices of essential goods announced such as diesel, petrol, cooking gas, 2. railway budget, 3. annual budget, 4. States budgets)

Automatic stabilization policy

Adopting a fiscal system with built in flexibility of revenue and expenditure due to rise and fall in national income GNP rises and unemployment falls> tax revenue rises and expenditure falls automatically GNP declines and unemployment increases > tax revenue falls and expenditure rises automatically

Automatic changes
Y = C + I + G C = a + bYd, Yd = Y T C = a + b (Y T) Y = a + b (Y T) +I + G Net tax function- TN = t0 + t1y (t0<0 and t1>0) means that below certain level of income govt goes for negative taxation (tr payment), t1 is MPT TN takes care of tax and expenditure linked to income and works as automatic stabilizer

Automatic changes
C = a + b (Y TN) = a + b { Y (t0 + t1y) } C = a - bt0 + b (1 - t1)Y Substituting this in Y equation Y = a - bt0 + b (1 - t1)Y + I + G Y { 1 b (1 - t1) } = a - bt0 + I + G Y = 1/ 1 b (1 - t1) . a - bt0 + I + G This gives the equilibrium level of income with fiscal stabilizer 1/ 1 b (1 - t1) is the automatic stabilizer multiplier

 The tax multiplier is Tm = Y/ T = -b/1-b Gm = Y/ G = 1/1 - b On comparing we find that 1/ 1 b (1 - t1) < 1/1 - b 1/1 0.75 (1 0.20) < 1/1 0.75 1/0.4 < 1/0.25 2.5 < 5 Multiplier effect of automatic stabilization policy is lower than deliberate govt spending

Working of automatic stabilizers

Increase in tax and reduction in public expenditure restrain effective demand preventing excessive rise in the price level during inflation Fall in tax due to fall in taxable incomes and increase in govt expenditure on unemployment compensation, insurance etc adds to aggregate demand preventing the economy going into deep depression

Limitations
Works well in closed economy With external shocks automatic stabilizers fail to smoothen ups and downs Real economic system much more complex

Compensatory fiscal policy

Deliberate budgetary action taken to compensate for deficiency in or excess of aggregate demand
Surplus budgeting Deficit budgeting Policy has more flexibility and freedom for revision

 Depression boost AD through tax reduction and govt spending

rise in AD > rise in P > rise in producers profit with a lag in increase in costs > optimistic env > increasing opportunity and incentives to invest

Inflation surplus budgeting by increasing rate of

taxation and cut in expenditure > fall in AD

Discretionary fiscal policy

When following ad hoc changes are made in the tax and revenue at the discretion of the policy makers to achieve certain goals
The level and pattern of taxation The size and pattern of its expenditure The size and composition of public debt

Change in taxation
To have contraction effect and reduce inflationary pressure Or to have expansionary effect and reduce recessionary pressure
Direct and/or indirect tax
Increasing or decreasing the tax rates Imposition of new tax or abolition of old tax Imposition of new tax on old tax base

Change in government expenditure

Change in the size, composition and the method of financing the government expenditure

Consumption, Investment, Government Spending (C, I, G)

YB =Net Increase in Income

1 =G(1-b) 1-b

Y C+I+G
C+I+G+G

C+I+G+G-bT C+I+G

=G

B
G(1-b)
-bT

D A
Total Increase in Income due to Increase of G Government Spending

YB=G

450 O
YO Y1 Y2

Total Decrease in Income due to Increase of T In Taxes

Income (Y)

Limitations
Suitable and effective only for the short term corrections not for the long term macroeconomic maladjustments or disequilibrium Difficult to accurately assess the magnitude of problem and forecasting expected results of policy change Time lag
Pre Implementation- decision lag India-for fiscal action- a committee takes more time than stipulated >their recommendations are placed for bureaucratic appraisal > sent for ministerial considerations for approval > placed before the parliament for discussion and debate > proposal finds a place in the finance bill > implementation of the policy (suffers from execution lag) Post implementation due to lagged effect of fiscal action further complicated by other changes before full realisation of previous actions > complicating the assessment of policy further

Fiscal policy (FP) and macroeconomic goals

Economic growth
The role of FP recognized in the growth models during 1950s and 1960s Use of FP for breaking the vicious circle of poverty in backward economies and accelerating the pace of growth in growing economies FP to increase S and I to increase S, Income tax rate to be increased and tax incentives on savings Corporate sector is given concessions and promotions for private investments such as tax holidays, high depreciation allowances, investment subsidies, exemption of import duties on capital imports Govt as prime mover for public investment 1. progressive taxation, 2. widespread taxation on all kinds of consumer goods, 3. high duties on imports

Employment
Sustaining full employment and creating employment in developed and developing countries Fiscal measures for growth promote employment but not always
Focus more on capital intensive technology- promote labour-absorbing technology through heavy taxation and duty on capital intensive goods, subsidy and relaxed duty on labour intensive goods Run labour-intensive public programmes like construction of roads, canal, dams, bridges and schemes like Jawahar Rozgar Yojana additional employment > rise in Y > rise in AD These programmes may have long gestation period and low productivity, money income increases faster than real income > AD AS > inflationary pressure more when deficit financing

Stabilization
Increase in govt spending (pump priming) and cutting down tax rates revert depression trends and bringing expansionary effect on the economy termed as contra-cyclical fiscal policy beside Pump priming is ad hoc (boost up dose once) measure aimed at utilizing of available resources When economy overheats, tax rates to be hiked, cut in expenditure The effect of this will depend on the size of the public sector, size of govt spending and the level of taxation in relation to GNP

Economic equality
Progressive income taxation Imposition of property and wealth tax Progressive taxation of high priced and luxury goods Expenditure on projects enhancing earning capacity of low income people Free utilities education, medical Reallocating capital expenditure to enhance employment opportunities for unemployed and underemployed Financial aid for self employment Provision for insurance Excessive use of these measures may be counter-productive 1973-74 tax rate was raised to 98% resulted in large scale tax evasion and corruption of tax collection machinery, and emergence of parallel economy- income gaps widened instead of reducing Laffer curve

External balance
External imbalance gap between the foreign payment obligations and foreign earnings Imposition of heavy duties on imports particularly consumer goods Subsidization of exports They work when import and export are price elastic

Limitations of fiscal policy

Formulation of appropriate fiscal policy requires reliable forecasting of the target variables- Q, C, I, S, N and their determinants The overall effects of FP determined by the rate of dynamic multiplier, difficult to forecast, time consuming process necessitates subsequent changes Decision and execution lags The effectiveness of FP limited by 1. low levels of income , 2. small proportion of population in taxable income group, 3. existence of large non-monetized sector, 4.corruption and inefficiency Excessive borrowing may lead to debt trap Deficit financing beyond the absorption capacity of the economy lead to inflation

 If above are inadequate-borrow to finance the growth projects- does it always lead to economic growth? Not necessarily Deficit spending crowds out private investment Internal borrowing imposes excessive burden on the govt Borrowing reduces private investment for reasons other than crowding-out effect