Fiscal policy

Fiscal policy has been defined as ‘the policy of the government with regard to the level of government
purchases, the level of transfers, and the tax structure’—probably the best and the most acclaimed
defnition among experts. Later, the impact of fiscal policy on macro-economy was beautifully analysed.
As the policy has a deep impact on the overall performance of the economy, fiscal policy is also defined
as the policy which handles public expenditure and tax to direct and stimulate the level of economic
activity (numerically denoted by the Gross Domestic Product). It was J. M. Keynes, the first economist
who developed a theory linking fiscal policy and economic performance.

Fiscal policy is also defined as ‘changes in government expenditures and taxes that are designed to
achieve macroeconomic policy goals’ (such as growth, employment, investment, etc.).

Therefore, we say that ‘fiscal policy denotes the use of taxes and government expenditures’.

How the taxes and the government expenditures influence the overall economy, has been explained in a
brief discussion here.

Let us first discuss the taxes and their impact on the economy:

(i) Taxes have a direct bearing on people’s income affecting their levels of disposable incomes,
purchase of goods and services, consumption and ultimately their standard of living;
(ii) (ii) Taxes directly affect the savings of individuals, families and firms which affect investment
in the economy—as investment affects the output (GDP) thereby influencing the per capita
income;
(iii) (iii) Taxes affect the prices of goods and services as factor cost (production cost) is afected
thereby affecting incentives and behaviour of economic activities, etc.

Government expenditures affect/influence the economy in two ways:

(i) There are some expenditure on government purchases of goods and services, for
example construction of roads, railways, ports, foodgrains, etc., in the goods category and
salary payments to government employees in the services category; and
(II) There are some expenditure due to government’s income support, to the poor,
unemployed and old-age people (known as government transfer payments)

IndIan fiscal situation: a summary In December 1985, the Government of India presented a
discussion paper in the Parliament titled ‘Long-Term Fiscal Policy’. It was for the first time in
the fiscal history of India that we see a long-term perspective coming on the fiscal issue from
the government. Tis also included the policy of government expenditure. The paper was
bold enough to recoganise the deterioration in India’s fiscal position and accepted it among
the most important challenges of the eighties—the paper set specific targets and policies to
set the things right. Tis paper was followed by a country-wide debate on the issue and it was
 in 1987 that the government came ahead with two bold steps in the direction— (i) a virtual
freeze was announced on government expenditure, and
(ii) a ceiling on the budgetary defcit. Te above steps had a positive impact on the situation
but it was temporary as since mid1988 the situation again started deteriorating. The BoP
crisis at the end of 1990 was generated partly by the alarmingly high fiscal deficit.

The three stances of fiscal policy are the following:

 Neutral fiscal policy is usually undertaken when an economy is in neither a recession nor

an expansion. The amount of government deficit spending (the excess not financed
by tax revenue) is roughly the same as it has been on average over time, so no changes to it are
occurring that would have an effect on the level of economic activity.
 Expansionary fiscal policy is used by the government when trying to balance the contraction
phase in the business cycle. It involves government spending exceeding tax revenue by more
than it has tended to, and is usually undertaken during recessions. Examples of expansionary
fiscal policy measures include increased government spending on public works (e.g., building
schools) and providing the residents of the economy with tax cuts to increase their purchasing
power (in order to fix a decrease in the demand).
 Contractionary fiscal policy, on the other hand, is a measure to increase tax rates and
decrease government spending. It occurs when government deficit spending is lower than usual.
This has the potential to slow economic growth if inflation, which was caused by a significant
increase in aggregate demand and the supply of money, is excessive. By reducing the
economy's amount of aggregate income, the available amount for consumers to spend is also
reduced. So, contractionary fiscal policy measures are employed when unsustainable growth
takes place, leading to inflation, high prices of investment, recession and unemployment above
the "healthy" level of 3%–4%.

Methods of fiscal policy funding

Governments spend money on a wide variety of things, from the military and police to services such
as education and health care, as well as transfer payments such as welfare benefits. This
expenditure can be funded in a number of different ways:

 Taxation
 Seigniorage, the benefit from printing money
 Borrowing money from the population or from abroad
 Dipping into fiscal reserves
 Sale of fixed assets (e.g., land)
 Selling equity to the population