Shivani Mohan

Assistant Professor of Economics

CNLU, Patna
 INTRODUCTION
 One major function of the government is to stabilize
the economy (prevent unemployment or inflation)
 Stabilization can be achieved in part by manipulating
the public budget-government spending and tax
collections-to increase output and employment or to
reduce inflation.
Objectives of Fiscal Policy
 Full employment
 Equitable distribution of income and wealth
 Price Stability
 Economic stabilization
 Economic Growth
 Optimum allocation of resources
 FISCAL POLICY AND THE AD/AS
MODEL
A. Discretionary fiscal
B. Simplifying assumptions:
1. Assume initial government purchases don’t
depress or stimulate private spending.
2. Assume fiscal policy affects only the demand, not
supply, side of the economy.
 FISCAL POLICY CHOICES
1. Expansionary fiscal policy: used to combat a
recession.

2. Contractionary fiscal policy: used to combat

demand-pull inflation, due to excess spending.
EXPANSIONARY FISCAL POLICY
Expansionary Policy needed:
a. An increase in government spending, which shifts AD to
the right by more than the change in G, due to the
multiplier.
b. A decrease in taxes (raises income, and consumption
rises by MPC times the change in income). AD shifts to the
right by a multiple of the change in consumption.
c. A combination of increased G spending and reduced
taxes.
d. If the budget was initially balanced, expansionary fiscal
policy creates a budget deficit.
CONTRACTIONARY FISCAL POLICY
Contractionary Policy needed:
a. A decrease in G spending shifts AD back left, once the
multiplier process is complete. Here price level returns to
its pre-inflationary level, but GDP remains at full-
employment level.
b. An increase in taxes will reduce income, and then
consumption at first by the MPC times the decrease in
income, and then the multiplier process leads AD to shift
leftward still further.
c. A combined G spending decrease and tax increase could
have the same effect with the right combination.
d. If the budget was initially balanced, a contractionary
fiscal policy creates a budget surplus.
 Taxation
Taxation represents the revenue side of the budget
and is regarded as a very important instrument for
the public sector not only for raising income, but
also for achieving some socio-economic objectives,
such as reduction in income inequalities,
correction of external diseconomies, and
restriction of production of some regrettable
necessities
 Taxation
 Public sector economics lays more emphasis on
some specific issues, such as taxation and income
distribution, taxation and efficiency, taxation and
work efforts, problems of optimal taxation, and
some other related issues like tax evasion and tax
avoidance.
 Direct and Indirect Taxes
 Direct taxation is levied on income, wealth and profit.
Direct taxes include income tax, inheritance tax, and
corporation tax.
 Indirect taxes are taxes on spending – such as excise
duties on fuel, cigarettes and alcohol and Value Added
Tax (VAT) on many different goods and services
 Types of Taxes
 With a progressive tax, the marginal rate of tax rises
as income rises. i.e. as people earn more income, the
rate of tax on each extra income goes up. This causes a
rise in the average rate of tax
 With a proportional tax, the marginal rate of tax is
constant
 With a regressive tax, the rate of tax falls as incomes
rise – i.e. the average rate of tax is lower for people of
higher incomes
LAFFER CURVE PRINCIPLE
 Taxes and Aggregate Demand
Changes in tax rates and tax allowances can have a direct
and indirect effect on the level of aggregate demand
 Government spending can be
used to manage the level and
growth of AD to meet
macroeconomic policy
objectives such as low inflation
and higher levels of employment

 When private sector demand for

goods and services is low, the
government needs to find a
compensating source of demand
to rebalance the economy – and
the solution comes from the
government in the form of
higher borrowing or less saving.
 The case for budget deficit
reduction
 High debt threatens stability and recovery
 Government wants credibility in financial markets
 Higher future taxes will squeeze the private sector
 Inequitable to leave future generations with debt
 Doubts about effectiveness of stimulus policies
 FINANCING DEFICITS
The method used to finance deficits or dispose of surpluses
influences fiscal policy:
A. Financing deficits can be done 2 ways:
1. Borrowing: (“crowding out” effect) The government
competes with private borrowers for funds, and could drive up
interest rates; the government may “crowd out” private
borrowing, and this offsets the government expansion.
2. Money Creation: When the Federal Reserve loans
directly to the government by buying bonds, the expansionary
effect is greater since private investors are not buying bonds.
(Monetarists argue that this is monetary, not fiscal, policy that
is having the expansionary effect in this situation).
 PUBLIC DEBT
DISPOSING OF SURPLUSES
B. Disposing of surpluses can be done in 2 ways:
1. Debt reduction is good, but may cause interest rates
to fall and stimulate spending, which could then be
inflationary.
2. Impounding or letting the surplus funds remain
idle would have greater anti-inflationary impact. The
government holds surplus tax revenues which keeps
these funds from being spent.
 BUILT-IN STABILITY
Built-in stability arises because net taxes (taxes minus
transfers and subsidies) change with GDP. Remember that
taxes reduce incomes, and therefore, spending. It is
desirable for spending to rise when the economy is
slumping and to fall when the economy is becoming
inflationary.
1. Taxes automatically rise with GDP because incomes rise
and tax revenues fall when GDP falls.
2. Transfers and subsidies rise when GDP falls; when these
government payments (welfare, unemployment, etc.)
rise, net tax revenues fall along with GDP.
 BUILT-IN STABILITY
The size of automatic stability depends on
responsiveness of changes in taxes to changes in GDP:
The more progressive the tax system, the greater the
economy’s built-in stability.
1. Marginal tax rates on personal income can be
changed, such as in 1993, when it was increased from
31% to 39.6% to prevent demand-pull inflation.
2. Automatic stability reduces instability, but does not
correct this economic instability.
 PROBLEMS, CRITICISMS, AND
COMPLICATIONS
A. Problems of timing
1. Recognition lag is the elapsed time between the
beginning of recession or inflation and awareness of
the occurrence.
2. Administrative lag is the difficulty in changing policy
once the problem has been recognized.
3. Operational lag is the time elapsed between change in
policy and its impact on the economy.
 PROBLEMS, CRITICISMS, AND
COMPLICATIONS
B. Political considerations: Government has other goals
besides economic stability, and these may conflict with
stabilization policy.
1. A political business cycle may destabilize the economy:
Election years have been characterized by more
expansionary policies regardless of economic conditions.
2. State and local finance policies may offset federal
stabilization policies. They are often pro cyclical,
because balanced-budget requirements cause states and
local governments to raise taxes in a recession or cut
spending, making the recession possibly worse. In an
inflationary period, they may increase spending or cut
taxes as their budgets head for surplus.
 PROBLEMS, CRITICISMS, AND
COMPLICATIONS
3. The “crowding-out” effect may be caused by fiscal policy.
a. “crowding-out” may occur with government deficit
spending. It may increase the interest rate and reduce
private spending which weakens or cancels the stimulus of
fiscal policy.
b. Some economists argue that little crowding out will
occur during a recession.
c. Economists agree that government deficits should not
occur at Full-Employment. It is also argued that monetary
authorities could counteract the crowding-out by
increasing the money supply to accommodate fiscal policy.
 FISCAL POLICY IN AN OPEN
ECONOMY
A. Shocks or changes from abroad will cause changes in
net exports which can shift aggregate demand
leftward or rightward.
B. The net export effect reduces the effectiveness of
fiscal policy by offsetting its effects. For example:
1. Expansionary fiscal policy may increase domestic
interest rates, which can cause the dollar to
appreciate and exports to decline.
2. Contractionary fiscal policy may reduce domestic
interest rates, which would cause the dollar to
depreciate, and net exports to increase.
THANK YOU