Fiscal Policy

Fiscal policy refers to the government’s use of taxation and spending to influence the economy. It is one of the primary tools governments employ to manage economic activities and achieve specific macroeconomic objectives such as economic growth, price stability, and full employment. Through fiscal policy, governments can manipulate aggregate demand in the economy, which comprises consumption, investment, government spending, and net exports.

By adjusting tax rates, government expenditure levels, and borrowing, fiscal policy aims to stabilise the economy during economic downturns or inflationary pressures. Fiscal policy works with monetary policy, which regulates the money supply and interest rates to maintain overall economic stability and promote sustainable growth.

What is Fiscal Policy

Fiscal Policy concerns the government’s strategies regarding revenue generation and expenditure. The term “fiscal” originates from “fisk,” denoting the public treasury or government funds. Fiscal policy entails the government’s utilisation of taxation, public spending, and borrowing to achieve various economic objectives. It involves government spending and taxation policies to foster sustainable growth. Fiscal policy is often juxtaposed with monetary policy, overseen by the central bank.

It draws significant influence from the theories of British economist John Maynard Keynes, particularly developed in response to the Great Depression. Keynesian principles heavily influenced initiatives like the New Deal in the U.S., emphasising extensive spending on public projects and social welfare development.

How Fiscal Policy Works

Government taxation and expenditure, serve as the principal mechanisms for implementing fiscal policy. Adjusting tax rates, for instance, can influence consumer spending and business investments. Lowering taxes may stimulate consumption and encourage greater business investment, fostering economic growth. Additionally, government spending on public infrastructure projects can contribute to economic expansion by creating job opportunities and improving productivity.

However, if the government opts to raise taxes to bolster revenue or decrease expenditure, these actions can dampen economic growth. Higher taxation may reduce disposable income, leading to a decrease in consumer spending and business investments. Similarly, cuts in government spending can result in reduced economic activity, potentially leading to a slowdown or recessionary conditions.

Objectives of Fiscal Policy

Fiscal policy is the government’s tool for overseeing taxation and expenditure, with three primary functions: stabilisation, distribution, and allocation. Below are several fiscal policy objectives:

• Inflation Control: One of fiscal policy’s core aims is to uphold price stability and manage inflation. The government strives to curb inflation by minimising fiscal deficits, implementing tax-saving schemes, and utilising financial resources effectively.
• Fiscal Discipline: A crucial objective of effective public financial management involves maintaining fiscal discipline. This necessitates a robust expenditure control framework to prevent the accumulation of payment arrears.
• Debt and Deficit Management: Fiscal policy emphasises slowing down the rate of debt accumulation and controlling budget deficits. This facilitates the preservation of spending programs and fosters confidence in the economy.
• Economic Stability: A significant goal of fiscal policy is to attain economic stability, which have the creation of employment opportunities and oversight of unnecessary expenditures.
• Promotion of Economic Growth: Fiscal policy can be employed through various combinations to support the nation in achieving economic objectives. Its purpose is to stimulate economic growth, particularly during times of recession.
• Redistribution of Wealth and Income: Fiscal policy aims to redistribute wealth and income by enhancing the real income of the masses and reducing disparities in income levels among the affluent.

Types of Fiscal Policies

There are three main types of fiscal policy, each aiming to achieve different economic goals:

Expansionary fiscal policy

This policy aims to stimulate economic growth by increasing aggregate demand. The government achieves this by

• Increasing government spending: This injects more money into the economy, boosting consumption and investment.
• Decreasing taxes: This leaves individuals and businesses with more disposable income, which they are likely to spend or invest, again increasing aggregate demand.

Contractionary fiscal policy

This policy controls inflation by reducing aggregate demand. The government achieves this by

• Decreasing government spending: This reduces the amount of money circulating in the economy.
• Increasing taxes: This reduces disposable income, leading to less consumption and investment.

Neutral fiscal policy

This policy aims to maintain the status quo in the economy by keeping aggregate demand stable. The government achieves this by

• Balancing government spending with tax revenue: This ensures that the government is not injecting additional money into the economy or taking money out.

What is Fiscal Consolidation?

Fiscal consolidation refers to the efforts made by governments to improve their fiscal health and sustainability by reducing budget deficits and stabilising or reducing the level of public debt relative to the size of the economy. It involves implementing policies to achieve a more balanced budget or a surplus over the medium to long term. Fiscal consolidation measures typically include increasing tax revenues, reducing government spending, implementing structural reforms to improve the efficiency of public services, and enhancing fiscal discipline.

The primary goal of fiscal consolidation is to restore fiscal credibility, strengthen economic stability, and reduce the risk of fiscal crises. By reducing budget deficits and stabilising debt levels, governments can effectively create room for counter-cyclical fiscal policies to address economic downturns and emergencies. Fiscal consolidation is often essential for maintaining investor confidence, promoting sustainable economic growth, and safeguarding long-term fiscal sustainability. However, implementing consolidation measures may involve trade-offs between short-term economic stability and long-term fiscal sustainability, requiring careful consideration of economic and social priorities.

Expansionary Fiscal Policy

Expansionary fiscal policy is when the government decides to put more money into the economy by either spending more or cutting taxes. This gives people and businesses more money to spend. The aim is to boost economic growth, especially when the economy is going through a tough time. The government does this to reduce unemployment, increase demand for goods and services, and stop a recession from worsening. It is like pushing the economy to get back on track.

The government does this in two main ways: Spending more on infrastructure or healthcare and cutting taxes so people have more money. These actions can lead to the government borrowing more money but are seen as necessary to get the economy moving again during tough times.

Contractionary Fiscal Policy

Contractionary fiscal policy is a government policy that aims to slow down the economy. It is designed to reduce aggregate demand and close an inflationary gap. Contractionary fiscal policy occurs when there is a reduction in government spending, an increase in taxes, or a combination of both. As government spending drops and taxes rise, less disposable income flows into the economy, causing demand to drop.

Some examples of contractionary fiscal policy include:

• Decreasing government spending,
• Increasing taxes,
• Reducing transfer payments
• Increasing tax rates,
• Eliminating social benefit programs

Fiscal Policy vs. Monetary Policy

Fiscal policy and monetary policy are two essential tools used by governments and central banks to manage economic conditions. Both policies have distinct mechanisms and objectives, yet they often work in tandem to achieve macroeconomic stability and growth. This table will help illustrate the distinguished fiscal and monetary policy features.

Three Types of Fiscal Spending

Here are three types of fiscal spending

Mandatory Spending: This category has entitlement programs like Social Security and Medicare, where the government must allocate funds to meet the financial needs of eligible individuals or groups.

Discretionary Spending: Discretionary spending covers annual expenditures for various administrative functions. The largest portion of this category is typically allocated to national defence. Still, it also includes funding for education, healthcare, infrastructure, and other government programs.

Supplemental Spending: Supplemental spending refers to additional budget allocations required for unexpected or emergencies. These funds address unforeseen expenses or urgent priorities throughout the fiscal year.

Fiscal Responsibility and Budget Management Act (FRBMA), 2003

The main objective of the Fiscal Responsibility and Budget Management (FRBM) Act is to instil fiscal discipline within the government. This entails conducting fiscal policy responsibly and disciplined, whereby government deficits and borrowings are maintained within reasonable limits. The government is expected to plan its expenditure in alignment with its revenues to ensure that borrowing remains within manageable thresholds.

The NK Singh committee has played a significant role in assessing and addressing fiscal deficit concerns, offering recommendations and strategies to enhance fiscal management and stability.

Fiscal Federalism pertains to allocating resources between the central and state governments. The distribution of taxes between these entities is delineated in the 7th Schedule of the Indian Constitution. Taxes are allocated across three lists:

• Union List
• State List
• Concurrent List

Each list specifies the areas where taxes are levied and collected by either the central or state governments or concurrently by both. Please refer to the linked article for a comprehensive understanding of fiscal federalism and its implications on resource distribution.
Methods of Fiscal Policy Funding

Methods of Funding Fiscal Policy

• Taxation: Governments raise revenue through various forms of taxation, such as income tax, corporate tax, value-added tax (VAT), excise duties, customs duties, and property tax. Taxation is a primary source of government funding and provides a steady stream of revenue to finance public expenditures.

• Borrowing: Governments may borrow funds from domestic or international financial markets to cover budget deficits or finance infrastructure projects and other capital expenditures. Government bonds, treasury bills, and loans from banks or international institutions are common instruments used for borrowing.

• Seigniorage: Seigniorage refers to the profit made by the government from issuing currency. When the government prints money, the difference between the face value of the currency and the cost of producing it represents seigniorage revenue. While this method can provide additional funding, excessive money creation can lead to inflationary pressures.

• Privatisation: Governments can generate revenue by selling state-owned assets or enterprises to private investors. Privatisation of public utilities, transportation systems, and other government-owned entities can provide a one-time infusion of funds and reduce the government’s long-term financial obligations.

• User fees: Governments may impose fees or charges for specific services or facilities provided to individuals or businesses. Examples include tolls for road usage, entrance fees for national parks, and licensing fees for professional services. These user fees contribute to government revenue while ensuring that those who benefit from the services bear some of the costs.
• Grants and Aid: Governments may receive grants or financial assistance from other governments, international organisations, or donor agencies to support specific programs or initiatives. Foreign aid, development assistance, and project grants are examples of external funding sources that governments can utilise to supplement their fiscal resources.

Overall, governments employ these funding methods to finance their fiscal policies and meet expenditure requirements, aiming to maintain fiscal sustainability while promoting economic growth and social welfare.

Fiscal Federalism

Fiscal Federalism pertains to allocating resources between the central and state governments. The distribution of taxes between these entities is outlined in the 7th schedule of the Indian Constitution, which delineates three distinct lists:

• Union List
• State List
• Concurrent List

FAQ on Fiscal Policy

What is fiscal policy?

Fiscal policy refers to using government spending and taxation to impact the economy. Governments commonly employ fiscal policy to foster robust and sustainable economic growth while also aiming to reduce poverty.

What are the three tools of fiscal policy?

Fiscal policy involves using government spending, taxation, and transfer payments to influence aggregate demand. These three tools constitute the fiscal policy toolkit.

What is the difference between monetary policy and fiscal policy?

Monetary policy is managed by the central bank and involves controlling money supply and interest rates. Fiscal policy is controlled by the government and involves adjusting government spending and taxation to influence the economy.

What are the different types of fiscal policy?

There are two main types of fiscal policy: expansionary fiscal policy, which aims to stimulate the economy through increased government spending or tax cuts, and contractionary fiscal policy, which aims to slow down economic growth through decreased spending or increased taxes.

What is the aim of the fiscal policy?

The aim of fiscal policy is to manage the economy by regulating government spending and taxation. It seeks to achieve economic stability, control inflation, reduce unemployment, and promote economic growth.