Fiscal Policy - A Comprehensive Study


Ajit Kumar AJIT KUMARWISDOM IAS, New Delhi.

Fiscal policy is a change in government spending or taxing designed to influence economic activity.
These changes are designed to control the level of aggregate demand in the economy.
Governments usually bring about changes in taxation, volume of spending, and size of the budget deficit or surplus to affect public expenditure.

Fiscal policy is said to be tight or contractionary when revenue is higher than spending (i.e., the government budget is in surplus) and loose or expansionary when spending is higher than revenue (i.e., the budget is in deficit).

Often, the focus is not on the level of the deficit, but on the change in the deficit. Thus, a reduction of the deficit from $200 billion to $100 billion is said to be contractionary fiscal policy, even though the budget is still in deficit.

Let us Illustrate

To illustrate how the government could try to use fiscal policy to affect the economy, consider an economy that’s experiencing a recession. The government might lower tax rates to try to fuel economic growth. If people are paying less in taxes, they have more money to spend or invest. Increased consumer spending or investment could improve economic growth. Regulators don’t want to see too great of a spending increase though, as this could increase inflation.

Another possibility is that the government might decide to increase its own spending – say, by building more highways. The idea is that the additional government spending creates jobs and lowers the unemployment rate. Some economists, however, dispute the notion that governments can create jobs, because government obtains all of its money from taxation – in other words, from the productive activities of the private sector.

One of the many problems with fiscal policy is that it tends to affect particular groups disproportionately. A tax decrease might not be applied to taxpayers at all income levels, or some groups might see larger decreases than others. Likewise, an increase in government spending will have the biggest influence on the group that is receiving that spending, which in the case of highway spending would be construction workers.

Fiscal policy and monetary policy are two major drivers of a nation’s economic performance. Through monetary policy, a country’s central bank influences the money supply. Regulators use both policies to try to boost a flagging (waning) economy, maintain a strong economy or cool off an overheated economy.

What are Effects of Fiscal Policy?

(i) The most immediate effect of fiscal policy is to change the aggregate demand for goods and services.
A fiscal expansion, for example, raises aggregate demand through one of two channels. First, if the government increases its purchases but keeps taxes constant, it increases demand directly. Second, if the government cuts taxes or increases transfer payments, households’ disposable income rises, and they will spend more on consumption. This rise in consumption will in turn raise aggregate demand.

(ii) Fiscal policy changes the composition of aggregate demand. When the government runs a deficit, it meets some of its expenses by issuing bonds. In doing so, it competes with private borrowers for money loaned by savers. Holding other things constant, a fiscal expansion will raise interest rates and “crowd out” some private investment, thus reducing the fraction of output composed of private investment.

(iii) In an open economy like US, fiscal policy also affects the exchange rate and the trade balance. In the case of a fiscal expansion, the rise in interest rates due to government borrowing attracts foreign capital. In their attempt to get more dollars to invest, foreigners bid up the price of the dollar, causing an exchange-rate appreciation in the short run.

(iv) Fiscal policy is an important tool for managing the economy because of its ability to affect the total amount of output produced—that is, gross domestic product. The first impact of a fiscal expansion is to raise the demand for goods and services. This greater demand leads to increases in both output and prices. The degree to which higher demand increases output and prices depends, in turn, on the state of the business cycle.

If the economy is in recession, with unused productive capacity and unemployed workers, then increases in demand will lead mostly to more output without changing the price level.
 If the economy is at full employment, by contrast, a fiscal expansion will have more effect on prices and less impact on total output.

This ability of fiscal policy to affect output by affecting aggregate demand makes it a potential tool for economic stabilization. In a recession, the government can run an expansionary fiscal policy, thus helping to restore output to its normal level and to put unemployed workers back to work.
During a boom, when inflation is perceived to be a greater problem than unemployment, the government can run a budget surplus, helping to slow down the economy. Such a countercyclical policy would lead to a budget that was balanced on average.

(v) Automatic stabilizers—programs that automatically expand fiscal policy during recessions and contract it during booms—are one form of countercyclical fiscal policy. Unemployment insurance, on which the government spends more during recessions (when the unemployment rate is high), is an example of an automatic stabilizer. Similarly, because taxes are roughly proportional to wages and profits, the amount of taxes collected is higher during a boom than during a recession. Thus, the tax code also acts as an automatic stabilizer.

But fiscal policy need not be automatic in order to play a stabilizing role in business cycles. Some economists recommend changes in fiscal policy in response to economic conditions—so-called discretionary fiscal policy—as a way to moderate business cycle swings. These suggestions are most frequently heard during recessions, when there are calls for tax cuts or new spending programs to “get the economy going again.

Unfortunately, discretionary fiscal policy is rarely able to deliver on its promise. Fiscal policy is especially difficult to use for stabilization because of the “inside lag”—the gap between the time when the need for fiscal policy arises and when the governments  implement it.
The case for using discretionary fiscal policy to stabilize business cycles is further weakened by the fact that another tool, monetary policy, is far more agile than fiscal policy.
Whether for good or for ill, fiscal policy’s ability to affect the level of output via aggregate demand wears off over time. Higher aggregate demand due to a fiscal stimulus, for example, eventually shows up only in higher prices and does not increase output at all.

Expansionary fiscal policy will lead to higher output today, but will lower the natural rate of output below what it would have been in the future. Similarly, contractionary fiscal policy, though dampening the output level in the short run, will lead to higher output in the future.

A fiscal expansion affects the output level in the long run because it affects the country’s saving rate.

(vi) Fiscal policy also changes the burden of future taxes. When the government runs an expansionary fiscal policy, it adds to its stock of debt. Because the government will have to pay interest on this debt (or repay it) in future years, expansionary fiscal policy today imposes an additional burden on future taxpayers. Just as the government can use taxes to transfer income between different classes, it can run surpluses or deficits in order to transfer income between different generations.

Some economists have argued that this effect of fiscal policy on future taxes will lead consumers to change their saving.

(vii) In addition to its effect on aggregate demand and saving, fiscal policy also affects the economy by changing incentives. Taxing an activity tends to discourage that activity. A high marginal tax rate on income reduces people’s incentive to earn income. By reducing the level of taxation, or even by keeping the level the same but reducing marginal tax ratesand reducing allowed deductions, the government can increase output. “Supply-side” economists argue that reductions in tax rates have a large effect on the amount of labor supplied, and thus on output (see supply-side economics). Incentive effects of taxes also play a role on the demand side. Policies such as investment tax credits, for example, can greatly influence the demand for capital goods.

The greatest obstacle to proper use of fiscal policy—both for its ability to stabilize fluctuations in the short run and for its long-run effect on the natural rate of output—is that changes in fiscal policy are necessarily bundled with other changes that please or displease various constituencies.


Friday, 29th Jan 2016, 09:31:16 PM

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