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Fiscal Policy

Mr. Rahul Singh | Posted On Saturday, January 24,2009, 04:20 PM

Fiscal Policy



In my previous article on macroeconomics, I covered monetary policy of a central bank (RBI in case of India). Now, I will cover another very important macroeconomics concept – Fiscal Policy.

Fiscal Policy is considered to be acts of a government to influence the direction of nation’s economy by using its financial and regulatory powers. The two main important instruments of fiscal policy are government spending and taxation. These are also known as financial powers. By regulatory powers we mean the ability of government to influence or require its people to change their behavior. For example, Indian government might ask all the industries to conform to universal environmental standards to reduce global warming. Thus, we see fiscal policy is different from the other macroeconomic policy, monetary policy, which attempts to stabilize the economy by controlling interest rates and the supply of money.

Stances of Fiscal Policy
There are three possible stances of fiscal policy- Neutral, Expansionary and Contractionary.

A neutral stance of fiscal policy implies a balanced budget where Government spending (G) is equal to Tax revenue (T) i.e. G=T. 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 rises 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. Hence, when government decides to adopt expansionary fiscal policy, it actually decides to spend more than what it did earlier.

A contractionary fiscal policy occurs when net government spending is reduced either through higher taxation revenue or reduced government spending or a combination of the two i.e. G < T. 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.

Government Spending
One of the tools of fiscal policy is government spending. Government expenditure or spending can be categorized in three ways:

1. Spending on goods and service- Governments can buy planes and military equipments for its defense forces. They can also buy materials for constructing schools, colleges, hospitals, ports, airports, highways, factories etc. Governments can also buy consulting and banking services from consulting and banks to help them on specific projects. Thus, government can directly affect the aggregate demand (AD).
2. Transfer payments- It involves payments to individuals by the government under several welfare schemes such as unemployment benefits, elderly pensions, healthcare benefits or food coupons. Economists believe that changes in government transfer payments influence people’s spending decisions. Higher transfer payments are similar to higher income. However, recipients for such payments may decide to either spend or save the amount.
3. Net interest payments- Most governments have debt which they raise by issuing bonds to banks or other brokers. Governments pay interest rates to people who hold these bonds or debt. Hence, any increase or decrease in the interest rate will directly affect the income from these bonds. If interest rates are increased, government will have to pay more interest payments to people who hold these debts. This would be considered as extra income and may influence spending.

By changing its spending, government can influence aggregate demand in the economy. For example- if government decides to spend more (as Indian government has decided to do now) on say infrastructure, there will be increased demand for different goods such as cements and steel and services such as manpower and consulting. This will increase aggregate demand in the economy.

Government Revenue
We discussed about government spending so much on building schools, hospitals and roads. Ever wondered how government generates revenue to spend on all these schemes. Do governments print new currencies to increase its spending? Not really. Government generates revenue by collecting taxes from its people and businesses. Across the globe, maximum tax is collected as payroll taxes i.e. income taxes, followed by corporate taxes. The next largest category is sales taxes and import duties.
By changes tax rates government can influence demand. For example – lowering of income tax rate will increase the disposable income of people. With more money in hand people will spend those money on goods and service; hence, creating a demand for the same.

Fiscal Deficits
Fiscal deficit is defined as the difference between government expenditure and its revenue i.e.
        Fiscal deficit = Government spending – Government revenue
It is expressed in terms of percentage of GDP. India's fiscal deficit was brought down to 3.17% (Rs 1,43,653 crore) of the gross domestic product in 2007-08 from 3.8% in 2006-07. The government had promised to cut the deficit further to 2.5% of GDP (Rs 1,33,287 crore) by the end of 2008-09, but it didn’t happen. Thus, India's fiscal deficit continues to be among the highest in the world.

When a government has a deficit it borrows money by issuing debt certificates. The value of the outstanding government debt is called National debt. The gross national debt of USA is eye-popping $10 Trillion which is almost 10 times of India’s GDP.

Effects of fiscal policy
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 is used by governments to influence the level of aggregate demand in the economy, in an effort to achieve economic objectives of price stability, full employment and economic growth. This is generally done during recession to boost spending and demand. What we see across the globe these days is governments after governments are coming up with their own bailout plan for recession. They have announced trillions of dollars of economic package to boost growth and generate employment.

Fiscal policy in the short-run
The idea of fiscal policy in the short-run is very simple- if aggregate demand is too low, the government would:
• Buy more goods and service
• Increase transfer payments
• Reduce tax rates on income
• Reduce imports and excise duties

If you have read newspapers recently, you might have come across these measures. The government of India recently lowered excise duties on lot of products - naphtha imported for power generation can be imported duty free. Export duty on iron ore fines has been withdrawn; it is 5% (from 10%) on iron ore lumps.

Once AD increases, firms would see an increased demand for their products and react by raising output and/or raising prices.

Buying more goods and services would:

Increase transfer payments would:

Reducing tax rates on household income would:

Reducing taxes or changing regulations that influence corporate income would:

Directly increase spending and AD

Increase disposable income and generally increased spending by households

Increase disposable income due to lower taxes would increase spending power of individuals and hence increase in AD

Increase business spending depending on the overall sentiments in economy

Fiscal policy in the long-run
In the long-run a poor and mismanaged fiscal policy might lead to persistent deficits and accumulating government debt. Let’s start with debt. To find out the health of an economy, the size of national debt is measured w.r.t. it’s GDP. If the national debt is equal to more than 60% of its GDP, the country is considered as a reasonable financial risk. Higher debt might bring up the issue of insolvency, which is inability of the country to meet its obligations. An insolvent government needs to reduce spending and raise tax revenues – but the internal politics and economics are such that it cannot.
Now coming back to government spending, if a government is not saving, it is basically spending whatever it is earning. The nation’s savings is a very important source of investment because it is the nation’s savings that ends up in banks and other financial institutions. This savings come from three main sources- households, retained earnings of business and government. When government is not saving, it will need money to reduce its deficits. The government will then issue bonds to the public to raise money. So governments with deficits are competing with private firms for the nation’s savings. This not only leaves less for the firms but also drives up interest rates. Either way, the end result is that government deficits “crowd out” private investment spending.

Crowding out
Despite the importance of fiscal policy, a paradox exists. In the case of a government running a budget deficit, funds will need to come from public borrowing (the issue of government bonds), overseas borrowing or the printing of new money. When governments fund a deficit with the release of government bonds, an increase in interest rates across the market can occur. This is because government borrowing creates higher demand for credit in the financial markets, causing a lower aggregate demand (AD) due to the lack of disposable income, contrary to the objective of a budget deficit. This concept is called crowding out. Alternatively, governments may increase government spending by funding major construction projects. This can also cause crowding out because of the lost opportunity for a private investor to undertake the same project. Another problem is the time lag between the implementation of the policy and detectable effects in the economy. An expansionary fiscal policy (decreased taxes or increased government spending) is usually intended to produce an increase in aggregate demand; however, an unchecked spiral in aggregate demand will lead to inflation. Hence, checks need to be kept in place.

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