CPA COLMAN MIRAJI B4-Public Finance and Taxation Dar Es Salaam CPA Review

FISCAL POLICY

Fiscal policy is the policy under which the government uses its expenditures and revenue
(both taxation and borrowing) to produce desired effects or avoid undesired effects on:

• National Income
• Employment level
• Price stability

Fiscal policy refers to a micro economic policy which involves change in tax an
expenditure to attain some economic objectives. For example

• Controlling of inflation and attain price stability

• Correct unfavorable balance of payment
• Reduce unemployment and achieve full employment
• Achieve economic growth;- encourage consumption, production and distribution
through taxation and expenditure

Tools of Fiscal Policy

1. Government expenditure

Government expenditures incurred in any way results in increase in aggregate demand

because money supply increases thus increase people’s income through wages, salaries
and profit. Therefore, government expenditures have economic effect on national income
(i.e., expenditures multiplier)

Government expenditures Multiplier refers to change national income as the result in

change in government expenditures. It is calculated as follows

𝐶ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑁𝑎𝑡𝑖𝑜𝑛𝑎𝑙𝐼𝑛𝑐𝑜𝑚𝑒
𝐺𝑜𝑣𝑒𝑟𝑛𝑚𝑒𝑛𝑡 𝑒𝑥𝑝𝑒𝑛𝑑𝑖𝑡𝑢𝑟𝑒𝑠 𝑀𝑢𝑙𝑡𝑖𝑝𝑙𝑖𝑒𝑟 =
𝐶ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝐺𝑜𝑣𝑒𝑟𝑛𝑚𝑒𝑛𝑡 𝑒𝑥𝑝𝑒𝑛𝑑𝑖𝑡𝑢𝑟𝑒𝑠

1
𝐺𝑜𝑣𝑒𝑟𝑛𝑚𝑒𝑛𝑡 𝑒𝑥𝑝𝑒𝑛𝑑𝑖𝑡𝑢𝑟𝑒𝑠 𝑀𝑢𝑙𝑡𝑖𝑝𝑙𝑖𝑒𝑟 =
1−𝑏

Where: b – The marginal propensity to consume (MPC)

 CPA COLMAN MIRAJI B4-Public Finance and Taxation Dar Es Salaam CPA Review

The marginal propensity to consume (MPC) is the proportion of an aggregate raise in pay
that a consumer spends on the consumption of goods and services, as opposed to saving
it. Marginal propensity to consume is a component of Keynesian macroeconomic theory
and is calculated as the change in consumption divided by the change in income.

For example; if the marginal propensity to consume (MPC) is 0.75 Government

expenditure multiplier will be 4, implying that, when the government spend extra Tsh.100,
the national income increases by TZS. 400.

2. Taxation

The effect of taxation is different from that of public expenditures, an increase in taxation
reduce people’s income hence reduce the aggregate demand and vice versa. The effect
of taxation in the economy can be demonstrated by tax multiplier effect. It is calculated
as follows

𝐶ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑁𝑎𝑡𝑖𝑜𝑛𝑎𝑙𝐼𝑛𝑐𝑜𝑚𝑒
𝑇𝑎𝑥 𝑀𝑢𝑙𝑡𝑖𝑝𝑙𝑖𝑒𝑟 =
𝐶ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑇𝑎𝑥𝑎𝑡𝑖𝑜𝑛

−𝑏
𝑇𝑎𝑥 𝑀𝑢𝑙𝑡𝑖𝑝𝑙𝑖𝑒𝑟 =
1−𝑏

For example, if the marginal propensity to consume (MPC) is 0.75, tax multipliers will be
-3, implying that, Tshs.100 increase in tax causes a reduction in GDP by TZS. 300.

3. Government borrowing

If the borrowing is domestic borrowing at the time of repayment there is the transfer of
fund from the government to the public which increase purchasing power and hence
increases production.
 CPA COLMAN MIRAJI B4-Public Finance and Taxation Dar Es Salaam CPA Review

Types of Fiscal Policy

i) Expansionary fiscal policy

In this policy, the government increases its expenditures and reduce amount of tax.

The objectives here are;

• To increase the level of GDP

• To lower unemployment level

The problem of this policy is that; it can result to increase in general price level (inflation)

ii) Contractionary Fiscal Policy

In this policy the government attempts to reduce aggregate demand by cutting its
expenditures and increasing tax. With the main objective of controlling the level of
inflation. It can be done by

• Increasing taxes (less money in people's pockets)

• Decreasing transfer payments (less money in people's pockets)
• Decrease government spending (less money in people's pockets

Danger of this policy is;

• The reduction in GDP

• Increase in unemployment level

Forms of Fiscal Policy

a) Discretionary Fiscal policy

This refers to an intentional change in government spending and taxation to achieve an

economic objective.

For example, reduction of unemployment, increasing the level of GDP, price stability
improvements of balance of payments terms etc.
 CPA COLMAN MIRAJI B4-Public Finance and Taxation Dar Es Salaam CPA Review

b) Non-discretionary Fiscal Policy/Automatic/Built in Stabilizers

Refers to the change in government spending and taxation that occur automatically
without deliberate action of the government e.g. As Gross Domestic Product (GDP)
increases, the average tax rate will increase in progressive tax system and thus reduce
aggregate demand

Problems of Fiscal Policy

i) Crowding out effect

This is when the government increases its spending by borrowing that leaves fewer funds
available for firms to borrow for investment and for individual consumptions i.e.
government pull out/crowds out private investment.

ii) Time lag

If the government plans to increase spending or change tax rate, this takes long period
of time as it involves sanction (authorization).i.e. it takes a lot of time for the government
to recognize the need for something, to agree on a policy, to implement the policy, and
for the policy to start affecting the behavior of consumers and firms

iii) Disincentive of tax increase

The increase in Taxes affects saving and investment as well as aggregate demand in
such a way that it:

• Reduce saving and Investment

• Increase the level of unemployment
• Reduce aggregate demand and supply
• Reduce consumer surplus and supplier surplus

iv) Side effects on public spending.

Reduced government spending to decrease inflationary pressure could adversely

affect public services such as public transport and education caused by market failure

v) Inflexibility of government finance

CPA COLMAN MIRAJI B4-Public Finance and Taxation Dar Es Salaam CPA Review

Much government expenditures go to wages and salaries and it is not possible to play
around with these to suit the short run needs of the government