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Published on Feb 15, 2016


Fiscal policy , taking the scope of budgetary policy , refers to government policy that attempts to influence the direction of the economy through changes in government taxes, or through some spending (fiscal allowances).

Fiscal policy can be contrasted with the other main type of macroeconomic policy , monetary policy , which attempts to stabilize the economy by controlling interest rates and the supply of money . The two main instruments of fiscal policy are government spending and taxation . Changes in the level and composition of taxation and government spending can impact on the following variables in the economy:

Aggregate demand and the level of economic activity

The pattern of resource allocation

The distribution of income.

Fiscal policy therefore refers to the overall effect of the budget outcome on economic activity. The three possible stances of fiscal policy are neutral, expansionary and contractionary:

A neutral stance of fiscal policy implies a balanced budget where G = T (Government spending = Tax revenue). Government spending is fully funded by tax revenue and overall the budget outcome has a neutral effect on the level of economic activity.

An expansionary stance of fiscal policy involves a net increase in government spending (G > T) through a rise in government spending or a fall in taxation revenue or a combination of the two. This will lead to a larger budget deficit or a smaller budget surplus than the government previously had, or a deficit if the government previously had a balanced budget. Expansionary fiscal policy is usually associated with a budget deficit.

A Contractionary stance fiscal policy (G < T) occurs when net government spending is reduced either through higher taxation revenue or reduced government spending or a combination of the two. This would lead to a lower budget deficit or a larger surplus than the government previously had, or a surplus if the government previously had a balanced budget. Contractionary fiscal policy is usually associated with a surplus.

Among the various tools of fiscal policy, the following are the most important:

Reflationary Fiscal Policy: It may be used to boost the level of economic activity during periods of recession or deceleration in economic activity. This is done by lowering taxes or increasing government expenditure.

Deflationary Fiscal Policy: During a boom, i.e., when the economy is growing beyond its capacity, inflation and balance of payment problems might result. This can be achieved by increasing taxes or by reducing government expenditure.

The Limitations of Fiscal Policy

Fiscal policy has been a great success in developed countries but only partially so in developing countries. The tax structure in the developing countries is rigid and narrow. Thus, conditions conducive to the growth of well-knit and integrated tax policies are absent and sorely missed. Following are some of the reasons that are hindrances for its implementation in developing countries:

1. A sizeable portion of most developing economies is non-monetized, rendering fiscal measures of the government ineffective and self-defeating.

2. Lack of statistical information as regards the income, expenditure, savings, investment, employment etc. makes it difficult for the public authorities to formulate a rational and effective fiscal policy.

3. Fiscal policy cannot succeed unless people understand its implications and cooperate with the government in its implication. This is due to the fact that, in developing countries, majorities of the people are illiterate.

4. Large-scale tax evasion, by people who are not conscious of their roles in development, has an impact on fiscal policy.

5. Fiscal policy requires efficient administrative machinery to be successful. Most developing economies have corrupt and inefficient administrations that fail to implement the requisite measures vis-à-vis the implementation of fiscal policy.

The role of public expenditure in the fiscal policy goals of growth, equity and stability , has varied across different phases of economic development in India. The historical importance of public expenditure lies in the mixed economy model adopted after Independence in India whereby the government assumed the primary responsibility of building the capital and infrastructure base to promote economic growth . The concerns regarding equity and poverty alleviation after two decades of Independence added another important dimension to public expenditure in terms of redistribution of resources. The inadequate returns on capital outlays and the macroeconomic crisis of early Nineties arising out of high fiscal deficit shifted the focus of public expenditure to efficiency in its management for facilitating adequate returns and restoring macroeconomic stability. While the fiscal policy goal of stability could be achieved, the modus operandi of public expenditure management through curtailing capital expenditure raised concerns about infrastructure investment and its impact on the long-term growth potential of the economy. Furthermore, stagnating revenue mobilization in particular and some upward movements in expenditures led to a reversal of the fiscal stabilization process since the second half of the Nineties.