Paper: 11, Managerial Economics

Module: 35, Fiscal Policy

Principal Investigator Prof. S P Bansal

Vice Chancellor
Maharaja Agrasen University, Baddi

Co-Principal Investigator Prof Yoginder Verma

Pro–Vice Chancellor
Central University of Himachal Pradesh. Kangra. H.P.

Prof. S.K. Garg

Paper Coordinator Former Dean and Director,
HPU, Shimla

Content Writer Dr. Savita

School of Management,
Maharaja Agrasen University, Baddi

Fiscal Policy
Management
Managerial Economics
 Items Description of Module
Subject Name Management
Paper Name Managerial Economics
Module Name/Title Fiscal Policy
Module Id Module no-35
Pre-requisites Basic knowledge about the Fiscal Policy
Objectives *To understand the meaning and concept of Fiscal Policy
*To understand the different instruments of Fiscal Policy
*To understand the objectives and limitations of Fiscal Policy
Keywords Fiscal Policy, Instruments of Fiscal Policy, Role of Fiscal Policy

QUADRANT-I

Module 35: Fiscal Policy

1. Learning Objectives
2. Introduction
3. Instruments of Fiscal Policy
4. Objectives of Fiscal Policy
5. Role of Fiscal Policy
6. Fiscal Policy and Business Environment
7. Limitations of Fiscal Policy
8. Summary

1. Learning Objectives
After completing this module, the students will be able to understand:
 The concept of Fiscal Policy
 Instruments of Fiscal Policy
 Various objectives of Fiscal Policy
 Role of Fiscal Policy
 Limitations of Fiscal Policy

Fiscal Policy
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 FISCAL POLICY
2. Introduction
Fiscal policy refers to the budgetary policy and it works through the government budget. Any type of
fiscal policy move ultimately affects the government budget and hence its impact falls on the economy.
The government of any country collects different types of taxes and also spends on different heads in a
given year. The total revenue collected (both tax and non-tax) by the government and the total
expenditure on different heads is shown in the government budget. In simple words, fiscal policy or
budgetary policy is the policy which deals with the income and expenditure of the government. Fiscal
policy relates to a variety of measures such as:
 Taxes,
 Public borrowing, and
 Public expenditure

It is related to the public finance involves the use of taxation, public borrowing, public expenditure by
government for securing economic stabilization and economic growth. Fiscal policy involves giving
positive and negative incentives to producers and consumers through the expenditure and revenue
polices.
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 According to Arthur Smithies, fiscal policy is a “policy under which the government uses its
expenditure and revenue programmes to produce desirable effects and avoid undesirable effects on the
national income, production and employment”.

So, it can be concluded that a fiscal policy is that policy which avoid undesirable effects on the country
as a whole. It deals with the proper use of revenue resources through public expenditure for attaining
common national development and growth objectives.

3. Instruments of Fiscal Policy

Fiscal policy is based on a fundamental idea that it can influence the total level of aggregate spending
which further influence the income of the economy, corporate bodies and individuals. There are five
major instruments of fiscal policy which are used to maintain stability and economic growth of an
economy. They are given below:

Instruments
of
Fiscal Policy

Public
Budget Taxation Expenditure Public Works Pubic Debts

 Budget: The government budget or the revenue and expenditure process of the government
(either balanced or unbalanced) can be used effectively to maintain stability and economic
growth.
 Taxation: It is also a powerful instrument of fiscal policy by means of which the government
can directly affect disposable income of the people and hence aggregate demand of the
economy. The government can encourage or discourage economic growth and can combat
inflationary and deflationary tendencies of the economy by applying suitable tax policies.

Fiscal Policy
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  Public Expenditure: Public expenditure is that expenditure incurred by the government to
satisfy those common wants which the people in their individual capacity are unable to satisfy
efficiently. It thus tends to satisfy collective social wants. The appropriate variation in public
expenditure can have more direct effect upon the level of economic activity than even taxes. It
will have a multiple effect upon income, employment and output. Hence by increasing or
decreasing public expenditure the fluctuations in economic activities can be checked
effectively.
 Public Works: Keynes in his book “General Theory of Employment, Interest and Money”
highlighted public works program as the most significant anti- depression device. There are
two main forms of expenditure i.e., public works and Transfer payments. Public works include
expansion of roads, rail ways, hospitals, parks, irrigation, transport and communications etc.
Transfer payments include interest on public debt, subsidies, pension, relief payment, social
security benefits etc. All these activities affect the level of income and employment in an
economy.
 Public Debt: Public borrowing or public debt is nothing but loans taken by the government
(both from internal and external sources) when current revenues fall short of public
expenditures. The instruments of public borrowing are in the form of various types of
government bonds and securities. Public debt is a very powerful instrument to fight against
deflation. I t also brings about economic stability and full employment in an economy. By
means of public debt the government can meet unprecedented expenses during War, natural
calamities and associated relief and rehabilitation works. In developing economies it is the
most important source of development finance.

It is thus clear that by using different fiscal instruments (depending upon circumstances) the
fundamental macroeconomic goals like price stability, full employment and economic growth can be
achieved effectively.
4. Objectives of Fiscal Policy

Fiscal Policy
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 There are various objectives of fiscal policy. The major objectives of fiscal policy are as follows:
 Economic Growth: For accelerating rate of economic growth of the developing economies,
fiscal policy can be used as an effective instrument. Economic growth simply means rise in real
national income as well as per capita real income over time. Less developed and poor countries
suffer from the vicious circle of poverty and to break this vicious circle a large dose of
investment (big push) is necessary. Government can directly interfere on economic activities
and design fiscal policy to raise the level of savings and to reduce potential consumption of the
people. Different fiscal measures can induce the process of capital formation and create
favourable environment for rapid economic growth .In addition, the government can redesign
its tax policies to encourage both private and public investment in those economies. A
mounting investment on social overhead capital (development of roads and communications,
generation of electricity etc.) also creates a favourable a favourable environment for rapid
economic growth. All these can be achieved by means of appropriate fiscal policy.

 Economic stabilization: We know that in capitalist countries economic activities fluctuate

over time and these economies suffer from the problem of business cycles. To stabilize the
economy, i.e. to overcome recession (business downswing) and control inflation (business
upswing and over expansion) in the economy fiscal policy may be regarded as an important
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 instrument .At the time of recession the government increases its expenditure or cuts down
taxes or adopts a suitable combination of both .On the other hand to control inflation or
business upswing the government cuts down its expenditure or raises taxes. This type of
budgetary policy is known as contra-cyclical fiscal policy.
 Full Employment: In an economy those who are willing to work at the going wage rate but do
not get job are called involuntarily unemployed. In a situation of full employment all those who
are willing to work get jobs and all are absorbed. If there is unemployment in an economy, the
government may adopt various expansionary measures for increasing income and employment.
There are various ways of achieving this goal. Once full employment level is reached, it has to
be constantly maintained by adopting appropriate fiscal measures from time to time.

 Balance of payment Equilibrium: When a country is engaged in international trade then the
country can get money (foreign currency) by exporting goods and services and the country
spends money for importing goods and services from foreign countries .The difference between
the value of exports and imports is known as balance of trade and if it is added to the capital
account, then it is called balance of payment. If the value of exports is less than value of
imports then there will be a deficit in trade balance and surplus if opposite happens. In
particular if a country has a deficit in trade balance, then to correct such deficit the government
should encourage exports and discourage imports. For doing this, the government can grant
different types of benefits and exemptions to exporters, and impose hardships on imports. In
this way by increasing exports and decreasing imports the problem of deficit in trade balance
can be corrected and equilibrium in balance of payment can be achieved. The government can

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 also import funds in different forms to cover such deficit. Just its opposite mechanism will
come into the picture in the opposite when there is a surplus in trade balance.
 Social Justice or Equality in the Distribution of Income and Wealth: The great motto of
any welfare state is to provide greatest benefits for the greatest number of people. A welfare
state can provide social justice by giving equitable distribution of income and wealth. Fiscal
policy means should be designed in such a manner that the distribution of income and wealth
will move in favours of the poor and against the rich. Thus, fiscal policy insists on the
programmes like free medical care, free education, old age pension scheme, widow pension
scheme and other social security measures to provide social justice to the society. Public
expenditure, particularly grants and subsidies to poor helps in redistributing income from the
rich to the poorer section of the society. Suitable fiscal policy means can also reduce regional
developmental imbalance in an economy.

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 Mobilization of resources: Mobilization of resources is one of the most important objectives
of fiscal policy. It is a great tool in the hand of developing countries like India. It is of utmost
importance to increase the rate of the investment and capital formation so as to accelerate the
rate of economic growth in the country. Fiscal measures like taxation and public expenditure
programme can help in mobilizing resources from unproductive to productive channel.

Fiscal Policy
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 Objectives of fiscal policy, as discussed above are generally consistent but sometimes there
may be some discrepancies among them. Conflict may be as under:

 The objective of attaining an accelerated rate of economic development may come in

conflict with the objective of counter-acting inflation particularly in the initial phases of
economic development.
 Another conflict is as economic development proceeds, wealth gets concentrated in the
hands of a few and if concentration of economic wealth is not checked over a period of
time, then these compound into glaring inequalities in the distribution of income and
wealth.
Thus, in view of this, it is not easily possible to determine the order of priorities of the various
objectives. Priorities will differ from country to country and from time to time, depending
upon the economic, political and social conditions prevailing in the country.

5. Role of Fiscal Policy

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 The seriousness of the fiscal problem facing the country is now so widely recognized that it is useful to
put in some perspective. The attitude of governments and economists toward the role of fiscal policy is
entirely changed. The old conception of neutrality of public finance was given up and the government
adopted a new budgetary philosophy called functional finance. With the adoption of development
planning, public finance has been assigned a positive and dynamic role for the promotion of economic
development. The main objective of fiscal policy in a developing economy is to promote highest
possible rate of capital formation and overcome the vicious circle of poverty. It needs to accelerate
capital formation. Since, private capital is, generally, reluctant in those countries; the government
should fulfill the gap through public investment and public expenditure on building social overhead
expenditure.
Another role of fiscal policy in a developing country is to encourage investment into socially desirable
channels. It would be possible if inducements to make investment are increased by providing various
incentives to private investors such as development rebates, subsidies and tax exemptions etc. fiscal
policy also plays a significant role to reduce income and wealth inequalities in the developing
countries. It can help by imposing taxes on rich people and providing facilities to the weaker section.
Fiscal policy also protects the countries from the ad effect of inflation. Relative price stability
constitutes an important objective of fiscal policy in the developing countries like India
The following important roles to be played by fiscal policy for ensuring rapid economic development
and growth in developing economies:
 To increase the rate of capital formation so that economic growth could be accelerated.
 To encourage saving and investment.
 To check sectoral imbalances so that regional disparities can be removed.
 To check extra- vagent and superfluous consumption.
 To reduce income and wealth inequalities.
 To raise standard of living of the country as a whole and to uplift the poor section of the
community.
The role of fiscal policy in developed differs from that in under-developed countries as mentioned
under:

 In developed countries economic stability is achieved by regulated public expenditure,

but it has no relevance in the under developed countries.
 The fiscal policy in the advance countries aims at maintaining economic stability which
is an essential condition of economic progress in developed countries where as fiscal
policy aims at achieving accelerated economic development. Although, economic
instability accrue in both types of economies but the nature and extent differs.

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  In developing countries, government plays a significant role in generating
infra0structure where as in the advanced countries budget intends to establish balance
between income and expenditure.
 In developing countries, taxation, borrowing and deficit financing are used as a
technique of mobilizing resources whereas in under-developed countries, government
uses other resources.
 In under-developed countries, government receipts are very low from long term loans
but in advanced economy, national debt amounts to even 200% more than national
income.

6. Fiscal Policy and Business Environment

Monetary and fiscal policy, constitute significant components of a country’s business environment as
given under:
 Fiscal policy, as with the monetary policy, is capable of collapsing or rejuvenating an
economy. It was Keynes who advocated public expenditure to retrieve economies from
the great depression.
 Tax system has significant impact on FDI. Lower taxes attract FDI and higher
levies make MNCs think twice before investing in India.
 Growth of an economy, competitive edges of a country, resource mobilization
and their effective utilization, jobs creation, care of needy and poor and other
macro environmental factors are impacted by the fiscal policy.
 Excess spending which is not backed by equal revenue compels the government
to borrow from the Reserve Bank which resulting high prices. Inflation hits the
poor most. While middle class income people somehow balance their money
inflows and outflows and rich people are not worried about it. In such a situation
it is very difficult for people to save their income. So when aggregate savings
decline, investment too will fall.
 Tax system is not always helping much in generating revenue. Much of the
economy remains out of sight of the tax net. A lot of service sector is informal
and cash based. The real estate market is notorious for black money.

7. Limitations of Fiscal Policy

We see that there are three important fiscal means, namely, taxation, public borrowings and deficit
financing which may be used in a harmonious combination so as to produce the best overall effect in

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 realizing the basic macroeconomic goals. Fiscal policy, however, cannot be effective when there are
shortcomings in the taxation laws and the large scale of tax evasion are prevailed in the economy.
Again, if the government is extravagant in spending on non-developmental items, then deficit
financing must strengthen the inflationary problem in an economy. Existence of market imperfections,
bottlenecks, insufficiency of raw materials and lack of entrepreneurial skills obviously reduce the
effectiveness of fiscal policy in an economy. Rapid population growth is another problem in densely
populated UDCs and fiscal policy alone cannot be very much effective in reaching the goal of rapid
economic growth with stability. The following are the basic weaknesses of fiscal policy responsible for
reducing its effectiveness:
1) Fiscal policy actually operates through the multiplier process. The contractionary as well as
expansionary mechanisms explained in theory are based on restrictive and over simplifying
assumptions. But in reality the multiplier effect may be weakened on account of various types
of leakages.
2) The efficiency of the fiscal policy ultimately depends on strict financial discipline on the part of
government and its correct value judgment. But in reality most of the developing countries
lacking such administrations and hence reduces the effectiveness of fiscal policy.
3) As a result of fiscal policy in connection with full employment wage rate increases. Increase in
wage rate results into increase in prices instead of increase in production. Employment
multiplier decreases and desired increase in employment does not take place. Structural
unemployment is also a challenge for the fiscal policy.
4) As an increase in public expenditure on non-development heads and deficit financing demand
pull inflation has taken place. High rate of indirect taxes has also resulted in cost push inflation.
High rate of direct taxes and increase of black money in the country has given rise to parallel
economy and increase in inflation.
5) Fiscal policy is inappropriate to deal with the problems that require structural adjustments.
6) This policy cannot adjust the distribution of money flows.
7) It has operational limitation due to the involvement of time lags.
8) It is also difficult to decide the magnitude of fiscal action and the optimum size of government
budget.
9) Fiscal policy cannot work effectively without the assistance of adequate monetary policy as it is
both complementary and supplementary to each other.
10) In underdeveloped countries, complicated tax structure, dominance of unorganized money
market, existence of barter economy, tax evasion, existence of black money, low taxable
capacity are also reduces the impact of fiscal policy.
11) Public expenditure is also an instrument of promoting economic development in the hands of
state. In under-developed countries, there is a lack of basic facilities such as transport, power,

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 irrigation, education etc. and also of basic and key industries. Thus, public expenditure should
aim at creating basic facilities and establishing basic and key industries in the public sector
besides encouraging the development of agriculture and industry by giving adequate loans,
grants and subsidies.

8. Summary: We must conclude by saying that fiscal policy in a developing economy has to be
planned on a long term basis. A simple and stable tax system must be evolved. Public borrowing must
be kept within safe limits. Deficit financing should be the last resort of a finance minister if he is
committed to a policy of economic stability and the most important for obtaining the best effective
results it should be combined with monetary and non-monetary policies. The main instruments of fiscal
policy are public revenue, public expenditure and public debt. Debt and deficits in a nation are closely
integrated fiscal deficit reflects the gap between receipts and expenditure, and is representative od
fiscal health of a nation. Fiscal policy plays a very important role to foster economic development and
stability of a nation.

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