Concepts in Fiscal Policy

Fiscal policy deals with the government policy concerning changes in the taxation and expenditure overheads and components, while Monetary policy, deals with the changes in the factors and instruments that affect the supply of money in the economy and the rate of interest. These are routinely used by governments world over in various policy mix or combinations to have desired effects and to steer the broader aspects of the economy. In case of India as with most other economies, the government of India deals with fiscal policy (through Annual Budget and other timely interventions), while there is central bank (Reserve bank of India), that is responsible for execution of monetary policy.

‘Fiscal policy is result of several component policies or mix of policy instruments. These include, policy on taxation, subsidy, welfare expenditure, etc; investment or disinvestment strategies; and debt or surplus management. Fiscal policy is an important constituent of the overall economic framework of a country and is therefore intimately linked with its general economic policy strategy.’

Types of Fiscal Policy

Neutral Fiscal Policy:  This implies a balanced budget where (Government spending = Tax revenue). It further means that government spending is fully funded by tax revenue and overall the budget outcome has a neutral effect on the level of economic activity.

Contractionary (restrictive) Fiscal policy: This policy involves raising taxes or cutting government spending, so that (Government spending < Tax revenue) it cuts up on the aggregate demand (thus, economic growth) and to reduce the  inflationary pressures in the economy.

Expansionary Fiscal Policy: It is generally used for giving stimulus to the economy ,i.e., to speed up the rate of GDP growth or during a recession when growth in national income is not sufficient enough to maintain the present standards of living. A tax cut and/or an increase in government spending would be implemented to stimulate economic growth and lower unemployment rates.  This is not a sustainable policy, as it leads to budget deficits and thus, should be used with caution.

Various combinations of fiscal policies

Reduction in Government Spending and no Change in Tax Rates (Contractionary fiscal policy): This policy is useful in moderate inflation, which though is part of government’s priority, is not the foremost objective. This would affect the growth little and sometimes even boost growth due to cut in inflation.

Reduction in Government Spending and Increase in Tax Rates (Contractionary fiscal policy): This policy is useful in high inflation, when curbing inflation is the foremost objective, even above the economic growth in the short run.

Rigid Government Spending and Increasing Tax Rates (Contractionary fiscal policy): This is used when economy is overheated (When a prolonged period of good economic growth and activity causes high levels of inflation as producers overproduce and create excess production capacity in an attempt to capitalize on the high levels of wealth) due to too much excitement on the part of investors. Increase in taxes and interest rates (through monetary policy) would curb the investments in short-run and prevent economy from going into recession after over-heating.

Reduction in Government Spending and an Equivalent Reduction in Taxes (Balanced Fiscal Policy): This, is a balanced budget approach, when a government decides to reduce its size and level of its intervention in economy, then this policy can be adopted. It simply means government is managing less money and hence less impact on markets and business.

Increase in government spending and tax rates (Balanced fiscal policy): This would be opposite to the previous policy as it would increase the size of government. A government on the path of socialization would adopt such policy.

Increase in government spending and decrease in tax rates (Expansionary fiscal policy): This would be adopted to give economy a stimulus though injection of funds, first the government decreases taxes and leaves more income with people to spend and invest, then it also spends more to give further boost to demand through additional income generated through government work. This is only possible in short-run as this policy leads to massive deficits and thus, should be used when situation is alarming.

Increase in government spending and no change in tax rates (Expansionary fiscal policy): This is also a stimulus policy (through public sector), but a more moderate one, which can be used for a bit longer compared to previous.

Rigid Government spending and decrease in tax rates (Expansionary fiscal policy): This policy is usually adopted to give incentive to private sector to invest and boost growth. Again, a short-run stimulus policy like previous two.

Tools of fiscal policy

Components of Spending

Maintenance (including staff salaries): This component can’t be altered in short-run and hence is hardly a part of policy making, however, in long-run, through VRS and reducing new jobs in public sector or vice versa, this expenditure can be altered.

Loan payments: This again is a component, which can’t be touched in short-run, however, governments in long-run can reduce these payments or eliminate them by running the budget surplus.

Subsidies: This component is a major part of policy as it can be altered in short-run, but unfortunately, subsidies as policy instrument, have been abused in India. These are used by politicians as poll promise and political instruments to gain more popular support. Ideally only meritorious subsidies shall be in operation and all the wasteful subsidies must be phased out, for example, fertilizer subsidy and power subsidy benefits the large farm holder and capitalist farmers instead of the needy ones. Similarly, the recent example of Aam Aadmi Party manifesto is a good example, how subsidies should not be used. In place of these, subsides for health programs, renewable energy, public transport shall be encouraged to ensure good health and sustainable growth.

Welfare schemes: These are one of the policy options that once introduced can’t be removed due to their populist nature. Similarly, in most of the cases these are necessary too and important instrument of social welfare and economic growth. However, it is the implementation part, which is key, as these schemes generally suffer from poor implementation and massive corruptions and loopholes. Thus, despite being meritorious expenditure in nature, these at time appears as waste.

Wasteful expenses: Needless to say these are the expenditures that must be curbed with immediate effect; however, no government in world has neither shown the intention to curb them, though there are efforts to reduce them from time to time under public pressure. For example, full page government advertisements in newspaper to generate favorable public opinion.

Components of Earning

Tax: single: Single most important source on government revenue is also a very important policy measure as elaborated in the policy combinations above.

Borrowing:  Borrowing is a necessary source of funds, though not a desirable one. Particularly, in developing countries, as tax/GDP ratio is low due to less per capita income. However, it becomes an important part of monetary policy as well due to its impact on interest rates and credit creation and thus, overall money supply.

Proceeds from sale/lease of assets: This is a both a one-time and regular source of income. For example, lending government buildings for private use, or other assets such as telecom spectrum or lease of a mine block for certain years, is a regular source of income, whereas sale of PSUs is a onetime income. These however, are good sources of revenue, as they provide government more room to spend without increasing taxes.

Profits from PSU: Profits from PSUs can also be a potential source of revenue, however, since most of PSUs are generating losses, Indian government usually ends up subsidizing them. At times PSUs are deliberately kept in losses to keep prices low and ensure wider outreach for social welfare, example, PSU banks in pre-reform era and post-offices. Similarly, at other times, they are in losses due to inefficiency and wasteful expenditure. Most striking case in India, is of ministerial corruption to keep PSUs in loss deliberately to benefit private sector, for example, CAG report says that, Indian Airlines was deliberately kept in losses by avoiding flights on profitable routes to benefit private airlines during UPA government’s rule. Similarly, in previous NDA government, BSNL was deliberately pushed into loss, by increasing tariffs to provide competitive edge to a newly launched company by one of the biggest business conglomerate in India.