Fiscal Policy

Meaning, Definition, Instruments and Objectives

Meaning

The ‘fiscal policy’ refers to the government policy of changing its taxation and public expenditure programmes intended to achieve certain predetermined objectives. An effective and good fiscal policy uses various fiscal tools like taxation, expenditure and public borrowing in a proper combination so as to achieve the best possible results in terms of the desired economic objectives like maintaining economic stability, high employment and accelerating economic growth.

Definition

Fiscal Policy is defined as the policy under which the government uses the instruments of taxation, public spending and public borrowing to achieve various objectives of economic policy.

Instruments of Fiscal Policy

The instruments of fiscal policy are the tools that governments use to influence the economy. These include various forms of government spending and taxation. Here are the primary instruments:

1. Taxation

Taxation is a key instrument of fiscal policy used to generate revenue for the government and influence economic activity.

i. Direct Taxes:

1. • Income Tax: Tax on individual and corporate earnings. Progressive income taxes can redistribute wealth and stabilize the economy by taking a larger percentage of income from higher earners.
   • Corporate Tax: Tax on company profits, which can influence business investment decisions and economic growth.
   • Property Tax: Tax on property ownership, which can affect housing markets and local government revenues.

ii. Indirect Taxes:

• • Value-Added Tax (VAT): A consumption tax levied on the value added at each stage of production or distribution. It can impact consumer spending and inflation.
  • Sales Tax: A tax on sales of goods and services, usually imposed at the point of sale.
  • Excise Duties: Taxes on specific goods, such as alcohol, tobacco, and fuel, used to discourage consumption of harmful products and generate revenue.

2. Expenditure (i.e. transfer of funds to state governments and direct consumption of government)

Government expenditure is a critical instrument used to directly influence economic activity, support social programs, and invest in infrastructure.

i. Current Expenditure:

1. • Public Services: Spending on healthcare, education, defense, and law enforcement. These services are essential for social welfare and economic stability.
   • Transfer Payments: Payments like pensions, unemployment benefits, and social security that provide financial support to individuals without requiring a service in return.

ii. Capital Expenditure:

1. • Infrastructure Investment: Spending on roads, bridges, schools, and hospitals. These investments boost long-term economic productivity and growth.
   • Research and Development (R&D): Funding innovation and technological advancements to enhance economic competitiveness.

iii. Subsidies and Grants:

• • Agricultural Subsidies: Financial support to farmers to stabilize food prices and ensure food security.
  • Business Grants: Funding to support small businesses, innovation, and specific industries.

 (iii) Borrowing or debts

Government borrowing is used to finance expenditures when revenues are insufficient. This can help manage economic cycles and fund long-term investments.

i. Government Bonds:

1. • Treasury Bonds and Bills: Long-term and short-term securities issued by the government to raise funds. Investors lend money to the government in exchange for periodic interest payments and the return of principal at maturity.

ii. Loans:

1. • Domestic Borrowing: Borrowing from domestic financial institutions or the public.
   • International Borrowing: Loans from foreign governments, international organizations (like the IMF or World Bank), and foreign investors.

iii. Deficit Financing:

• • Fiscal Deficit: When government spending exceeds its revenue, resulting in the need to borrow to cover the shortfall.
  • Public Debt: Accumulation of past deficits financed through borrowing. Managing public debt is crucial to maintaining fiscal sustainability and economic stability.

These instruments can be used individually or in combination to achieve desired economic outcomes, such as promoting growth, controlling inflation, reducing unemployment, and managing public debt.

Objectives of fiscal Policy

The objectives of fiscal policy differ from country to country according to the level of economic development. The objectives of fiscal policy in developed countries are different from those in underdeveloped countries. The main objectives of fiscal policy in developed countries is to maintain economic stability, while the main objective of fiscal policy in underdeveloped countries is to accelerate economic development.

The main objectives of fiscal policy are as follows:

1. Economic Stability

One of the main objectives of fiscal policy in the case of developed countries is to achieve economic stability. Economic stability means that level of economic activity is maintained at a stable level so that there is no fluctuations in output and employment. In boom periods both output and employment are at high levels, whereas in the periods of recession both output and employment fall. Extreme form of recession is known as depression. In the depression period level of output and employment is very low as a consequence of which there is huge unemployment in the economy. Economic stability requires that the cyclical fluctuations i.e. booms and depressions are checked. Situations of booms are undesirable because they lead to sharp rise in prices. Periods of depression need to be averted in the economy. Fluctuations in the level of output and employment can be checked by counter-cyclical fiscal policy to counteract fluctuations in private expenditure.

 

2. To achieve full employment

Full employment refers to a situation when all those persons who are willing to work at the existing wage rate are able to get work. Full employment is a situation when involuntary unemployment is zero. In an economy those who are willing to work at the going wage rate but do not get job are called involuntarily unemployed. Persons who are unemployed voluntarily i.e. people who are not willing to work at the existing wage rate, are not regarded unemployed. Moreover, there are always some workers who are moving from one job to another, they are unemployed for a while. This is known as frictional unemployment. Persons who are frictionally unemployed are not regarded as unemployed. Thus, full employment does not mean achieving zero unemployment. Indeed, zero unemployment is impossible in any economy. It is now agreed that full employment exists when the rate of employment is about 5-6 % in the economy. In other words, full employment stands for 94 to 95 % employment rather than 100 % employment.

Full employment is a leading objective of fiscal policy. Attainment of objective of full employment means that the economy is able to produce the maximum level of output with the available resources.

 

3. Economic growth

For accelerating rate of economic growth of the developing economies, fiscal policy can be used as an effective instrument. Economic growth simply means rise in real national income as well as per capita real income over time. Less developed and poor countries suffer from the vicious circle of poverty and to break this vicious circle a large dose of investment (big push) is necessary. Government can directly interfere on economic activities and design fiscal policy to raise the level of savings and to reduce potential consumption of the people. Different fiscal measures can induce the process of capital formation and create favorable environment for rapid economic growth. In addition, the government can redesign its tax policies to encourage both private and public investment in those economies. A mounting investment on social overhead capital (development of roads and communications, generation of electricity etc.) also creates a favorable a favorable environment for rapid economic growth. All these can be achieved by means of appropriate fiscal policy.

4. Price stability

Another objective of fiscal policy in a developing economy is to achieve price stability. There is a tendency of prices to rise in these countries because of the large development expenditure without a corresponding increase in production during the early phases of economic development. Therefore, there is need for controlling price rise.

Price stability does not mean that prices remain absolutely stable. A certain degree of price rise is both unavoidable and desirable in a developed ecocnomy. Moreover, some rise in prices is essential for healthy functioning of the economy. Price stability is needed because it keeps the value of money stable, eliminates economic fluctuations, brings stability in the economy, checks arbitrary redistribution of income and wealth and promotes economic welfare.

5. Reducing inequalities in Income and Wealth

Fiscal policy reduces income inequality by implementing progressive taxation and providing social welfare programs. Fiscal policy insists on the programmes like free medical care, free education, old age pension scheme, widow pension scheme and other social security measures to provide social justice to the society. Public expenditure, particularly grants and subsidies to poor helps in redistributing income from the rich to the poorer section of the society. Suitable fiscal policy means can also reduce regional developmental imbalance in an economy.

6. Attaining External Equilibrium

An important objective of fiscal policy is to attain external equilibrium, i.e. to attain equilibrium in the balance-of-payments. An equilibrium in the balance-of-payments implies that, as far as possible, imports should be equal to exports. Particularly, the situation of deficit in the balance-of-payments i.e. excess of imports over exports, should be avoided. Instability in the exchange rate has been a major problem of developing countries which has sometimes given rise to serious balance of payments problems.

While these are the major objectives of economic policy, including fiscal policy, it should be remembered that these policy objectives are not complementary to each other. Instead, they may conflict with each other. If we try to achieve one objective, we may move away from some other objectives. In other words, the economy has to sacrifice one objective to attain the other. This is what we call ‘trade-off’ in economies. All the objectives cannot be achieved simultaneously. Hence, there is the need for making a choice among the objectives.

 

Related Topics

Fiscal deficit                                                                                                    Monetary Policy