MONETARY AND FISCAL POLICY AS

TOOLS FOR
HIGHER GROWTH RATE

By: Dr. Neelam Tandon

 OUTLINE
 Monetary Policy
- Definition
- Changes in the international policy setting
- Targets and Instruments of Monetary Policy
- The link between the money supply and policy
targets
- CONCLUSION – Monetary Policy
 FISCAL POLICY

- Definition of Fiscal Policy

 OUTLINE
-Key fiscal objectives
 GOVERNMENT REVENUE
- Issues on taxation
- Prerequisites for a Good Tax System
- Tax Compliance
1. Tax Compliance Issues
2. Decision to non- comply
3. Measures to improve Tax Compliance
Part I: MONETARY POLICY AS A TOOL
FOR
HIGHER GROWTH
MONETARY AND FISCAL POLICY AS
TOOLS FOR
HIGHER GROWTH
MONETARY POLICY
 Definition
• Monetary policy involves all the deliberate
decisions and actions by the monetary
authorities to influence
·       the monetary aggregates,
·       the availability of credit,
·       interest rates and
·       exchange rate,
• with a view to affecting monetary demand,
income, output, prices and the balance of
payments.
Changes in the international policy setting

World War 2 to 1971: Discipline

• fixed exchange rates
• smooth the business cycle
From 1971 to 1980: Instability
• Large deficits on the balance of payments
• Exchange rate depreciation
• inflation accelerated
From 1980 to 1990: Stability regained
• More market related monetary policy.
• Low inflation by following strict macroeconomic policies.
• Stability regained in spite of the monetary supply targets
generally not being very successful.
• Furthermore the Central Banks’ independence in many
countries was strengthened.
1990 - 2005: transparency and increasing
global integration

• Strict monetary and fiscal policies.

• Increasing world integration raised cross-
border financial flows.
• A reduction in policy freedom in
individual countries.
• Volatile capital flows internationally
brought problems of their own.
Since 2005: More volatility in economic variables
with more pressure on monetary policy

• Rising food prices.

• Rising fuel prices.
• Rising inflationary pressures.
• Increased interest rates.
• More volatility in exchange rates.
• Pressure on Fiscal policy - more
intervention?
Targets and Instruments of Monetary
Policy

Policy targets
• Price stability
• Economic growth
• Exchange rate stability
Monetary policy instruments
• Open market operations
• The setting of the bank/discount/repo rate
• Reserve requirements
• Selective credit controls
• Public debt management
The link between the money supply and
policy targets
• Monetary policy can achieve either a price level
target or an output target, but not both.
• With instruments that directly only affects the
money supply, the central bank can only
achieve one target.
• The flows between monetary policy instruments
and targets can be illustrated as follows:
The link between the money supply and
policy targets

Policy Operating Intermediate

instruments targets targets
 Open market  Repo rate  Money
PPoperations  Borrowed stock
 Accomodation reserves  Interest
policy - Repo  Non- rates
 Reserve Borrowed  Price level
requirements reserves  Nominal
 Public debt GDP
management

Final Targets
 Inflation rate
 Unemployment
rate
 Real GDP
CONCLUSION – Monetary Policy

 Good governance through monetary policy could imply

that certain targets are set for variables such as
inflation, the growth in the money supply, or the
exchange rate.
 In India today the policy target is the inflation rate
through the process of inflation targeting.
 Good governance in this country implies that the
inflation rate as measured by CPIX (i.e. consumer
prices minus bond rates), is set between 3% and 6%.
 This has become important in the globalised world and
the difficulty to compete in international markets.
Part II: FISCAL POLICY AS A TOOL
FOR
GOOD GOVERNANCE

 Revenue and expenditure

policies
Definition of Fiscal Policy
 Fiscal policy entails the ways in which government
intervenes in the economic activity of a country…
 through its expenditure priorities, and also, the way
in which such expenditures are financed through
taxes and borrowing.

Fiscal policy as a tool in good governance has both an

active- and passive element.
 The active element implies that the government
takes a deliberate step to “do something”, for
example to decrease the budget deficit.
 The passive element implies that the government
is “not doing something”, for example, no tax rate
changes are announced in a particular budget.
 Key fiscal objectives

1. Economic growth - synchronize policies

2. Ensure fiscal stability
3. Address the deepening of poverty
4. Progressively raise the ratio of capital formation to GDP
5. Address the saving catastrophe
6. Ensure continuous productivity growth
 Address high costs of power, transport, regulatory
requirements, security and other indirect costs that depress
the productivity of firms
 Upgrade deteriorating infrastructure
7. Promote enterprise development and deregulation – especially
small businesses
8. Eliminate bottlenecks that prevent more effective delivery of
social services
9. Strengthen local and provincial government service delivery
GOVERNMENT REVENUE

 Why do governments use taxes to intervene

in the economy?

 Raise revenue
 Redistribution of income
 Encourage/discourage certain behaviour
GOVERNMENT REVENUE
 Revenue derived from various sources: taxation,
loans and income from property.
 Some of these taxes are visible (for example income
tax); others are less visible to the consumer because
they are levied on the producers of raw materials
and intermediate goods such as VAT.
 Taxes can be classified as being direct or indirect.
 A direct tax is paid directly by the taxpayer to
the Revenue Service – eg. Income tax.
 Indirect tax is paid on goods and services, and
is paid to the Revenue Service by a third party.
Eg. VAT and customs taxes.
Issues on taxation
 Progressive tax
Progressive tax indicates that the percentage of the tax
paid on income will increase as income increases.
Eg. Income taxes
 
 Proportional tax
The taxpayer pays a fixed percentage of tax for different
levels of income. This implies that the average tax rate is
unchanged for all the taxpayers (independent of levels if
income earned.

 Regressive tax
The percentage tax decreases as income increases.
Eg. VAT
Prerequisites for a Good Tax System

 Equity (Fairness)
 Efficiency (Neutrality)
 Administrative feasibility (Simplicity)
 Flexibility
Prerequisites for a Good Tax System

Equity (Fairness)
 An equitable tax system should be in line with
the:
 Benefit principle
 Ability-to-pay principle
 The tax burden should be spread fairly across
the tax base.
 If not it will create incentives for people to avoid
or even evade taxes.   
Prerequisites for a Good Tax System

Equity (Fairness)
 The benefit principle
 People should be taxed if they directly benefit from
the availability of certain goods and services that the
government provides.
 Known as user charges.
 Can be implemented where exclusion is possible.
 Ability to pay principle
 People pay tax according to their economic ability
(may be either income/wealth or both.
 horizontal equity
 vertical equity
Prerequisites for a Good Tax System

Efficiency (Neutrality)
 Taxes may distort prices and therefore distort
the allocation of resources and cause economic
instability.
 Creates “deadweight-losses”.
 Economists always conduct incidence analyses
to determine “true” tax burden.
 High tax percentages may affect the behaviour
of taxpayers in the economy.
 The cost of taxation (i.t.o economy-wide
resource allocation) should be kept as low as
possible.
Prerequisites for a Good Tax System

Efficiency (Neutrality) – Incidence Analysis

 The person who pays the tax to the authorities
may not be same the same person who carries
the eventual tax burden.
 Since taxes impose an additional cost on
people, they will try to shift the burden of tax
onto someone else.
 Tax evasion is a deliberate and deceitful effort
by the taxpayers to avoid their tax obligations.
This is a criminal offence - punishable by law.
 Tax avoidance implies that a taxpayer changes
his/her behaviour so that the personal tax
liability is minimised.
Prerequisites for a Good Tax System

Administrative feasibility (Simplicity)

 The tax system has to be simple enough, so that
every person knows exactly how much tax he/she
has to pay.
 Taxes create costs for the taxpayers. This cost does
not only include the tax payments, but also the cost
of keeping tax records and the expenditures on
financial advisers.
 This type of cost is called compliance cost.
 On the administration’s side there also exists
enforcement costs.
 A good tax system should try to minimise both these
costs.
Tax Evasion Vs Tax
Avoidance
 Tax avoidance has got to do with substitution effect of taxation.
Whenever one activity is taxed more highly than others, people will
switch to the lightly taxed or untaxed activity e.g increase in tax on
labour income results in the following:

 Putting in more hours to compensate

 More leisure (untaxed)

 Home production increases- you keep on working the same hours, but
you divide them between market work and untaxed home-production.

 However, If two neighbours both decide to increase their home

production, and at the same time they exchange goods in kind, they
should be taxed if not, they are said to be operating in the underground
economy.
Reasons for Honesty

 People may tend to overestimate both the probability and

magnitude of penalties;

 The fear of social stigma or damage to their reputation if

they are exposed as cheaters.

 People pay tax because it is linked to governance. In the

words of Friedman (2003:1) “we obey the rules when the
government does its job and ensures that the systems
are in place to force us to comply”
Reasons for Non-
compliance
 Negative attitude of citizens toward the government

 Inadequate services from the Government- taxpayers believe that they

do not receive value for money when comparing the services

 Community standards- when the general level of honesty in the

community is low the compliance level is usually very low

 The level of corruption- high levels of corruption by officials lead to

dishonest taxpayers;

 Inadequate interest/penalty regimes, which encourage taxpayers to

evade filling returns and paying tax or ‘borrow’ from the government.
Reasons for Non-
compliance
 Low risk of discovery-the perception that the tax
administration is weak and the chances of being caught
are low enough to take the risk

 Ignorance and confusion

 Poor service by the tax administration

 High compliance costs

 Defective law
Creating Tax Compliance
Introduce self-assessment

 “Administrative assessment” is not compatible with

modern tax administration

 Self-assessment helps improve effectiveness by focusing

resources on (1) tax services and (2) compliance
enforcement (instead of paperwork)

 Self-assessment helps reduce compliance and

administrative costs

 Self-assessment helps reduce corruption

 Creating Tax Compliance

 Adequate services from the Government- taxpayers should receive value for
money when comparing the services provided by Govt.

 Keep the rates low; fight tax base erosion- in most countries tax base erosion
has led to high marginal (effective) tax rates.
 Focus on the probability of getting caught (ignoring risk seekers)- more effective
than increasing the penalties- increasing only the penalty without increasing the
probability, is inequitable.

 Make sure penalties are quickly applied

Creating Tax Compliance
 Educate citizens- Politicians should set the standard.

 Identify main sources of underground activity and

incorporate them into the tax system

 Reduce compliance cost- simple and transparent

procedures –i.e simplified tax regimes.

 Electronise the economy (making cash transaction

limited)
GOVERNMENT EXPENDITURE

 The government participates in the economy by producing

goods and services.
 Government provides the community with collective goods,
such as education, defence, infrastructure and health services.

 The composition of government spending reflects changes in

the economy, social conditions and the priorities i.e.
 consumer preferences
 political and other shocks
 redistribution of income
 government failure
 population growth and urbanisation
GOVERNMENT EXPENDITURE
 Functional classification of government spending.
 defence and on health services.
 Budget deficit
 expenditures exceed revenues.
 This deficit has to be financed to get the budget
to balance.
 Deficits are usually expressed as a percentage of
the GDP.
 Good governance would imply that the ratio stays
within limits that are acceptable for sustainable
economic growth.
 A rule of thumb is that the ratio in any particular
fiscal year should not exceed the three per cent
(3%) level.
DEFICIT FINANCING

 Affects levels of national saving, investment and

the current account on the balance of
payments.
 Sources of finance:
·       Loans
·       Domestic
·       Foreign
·      Treasury bills
GOVERNMENT DEBT

 Difference between the government debt and

the deficit.
 The goals of debt management are:
 Financial certainty
 Debt service minimisation
 Macroeconomic stabilisation and time consistency
 The significance of public debt can be expressed
as a percentage of GDP.
 According to the Maastricht Treaty this ratio
should not exceed the sixty per cent (60%)
level.
CONCLUSION – Fiscal Policy

 Good governance in fiscal policy implies a

government that is committed to increasing the
level of welfare of all the citizens of the
particular country.
 Welfare levels could be raised by both
government revenue programmes, or direct or
indirect expenditure programmes.
 THANX