Fiscal Policy

Introduction The most important instrument of government intervention in the country is that of Fiscal or Budgetary policy. Fiscal policy refers to the taxation, expenditure and borrowing by the government. The economists now hold the government intervention through Fiscal policy is essential in the matter of overcoming recession or inflation as well as of promoting and accelerating economic growth, which monetary policy will not hold alone. There is no doubt that the government budgetary or fiscal policy must be sound, keeping in view the needs and requirements of a developing economy. In short we can say that, it is a part of government policy, which is concerned with raising revenue through taxation and other means and deciding on the level and pattern of expenditure. The main problem faced by the capitalist economies instability prevailing in them. This instability is reflected in the periodic occurrence of trade cycles, which are a general phenomenon in the free market capitalist economies. During a recession or depression fiscal policy should help in increasing demand.

Objectives of Fiscal Policy in Developing Countries

In developing countries, taxation, the government expenditure, taxation and borrowing have to play a very important role in accelerating economic development. Fiscal policy is a powerful instrument in the hands of the government by means of which it can achieve the objectives of development. There are several peculiar characteristics of a developing country, which necessitate the adoption of a specific fiscal policy, which ensures a rapid economic growth. There are vast and diverse resources human and material, which are lying underutilized. Such countries have weak infrastructure, i.e. they lack adequate means of transport and communications, road ports, highway, irrigation and power and technical know-how. Their population increasing at an explosive rate, which necessitates rapid economic development to, met the requirements of the rapidly- growing population. In order to overcome these handicaps, a suitable fiscal and taxation policy is called.

The principal objectives developing economy are.

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To mobilize resources for economic growth, especially for sector. To promote economic growth in the private sector by incentives to save and invest. To restrain inflationary forces in the economic in order price stability. To ensure equitable distribution of income and wealth so of economic growth are fairly dist

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the public providing to ensure that fruits

ROLE OF FISCAL POLICY In recent weeks, a number of signs have appeared suggesting that the recovery of the U.S. economy from the recent recession is on a bumpy path. During the second quarter of 2002, real GDP grew at an anemic annual rate of barely over 1%, well below market expectations. Unemployment, after rising throughout 2001, has leveled off but has yet to show signs of declining. Adding some gloom to the general outlook, the stock market continued to drop through most of July and has remained volatile. This sluggish economic performance comes despite substantial stimulus from both monetary and fiscal policy. Since January 2001, the Federal Reserve has reduced its benchmark policy interest rate, the federal funds rate, from 6.52% in September 2000 to a current level of 1.75%. Fiscal policy also has become more expansionary. The federal government budget has swung from a surplus of $236 billion in 2000 (2.5% of GDP) to a projected 2002 deficit of $157 billion (1.5% of GDP) as the government has increased expenditures and reduced taxes. This active use of fiscal policy during a recession is somewhat unusual. During the last U.S. recession, in 1990, then President George H.W. Bush resisted attempts to use fiscal policy to stimulate the economy. In fact, his Council of Economic Advisers, in their February 1992 report, argued that increases in fiscal expenditures or reductions in taxes might hamper the economy’s recovery. In contrast, during the current recession, both Congress and the President have supported increases in expenditures and tax cuts as ways to stimulate economic growth, culminating in the passage of the Economic Recovery Act in March 2002.The current recession and the 1990–1991 recession offer contrasting examples of the use of fiscal policy, and theyalso highlight some elements of the longstanding debate in economics over whether fiscal policy can play a useful role in combating business cycle downturns. This Economic Letter discusses some of the issues involved in using fiscal policy to help stabilize short-run fluctuations in the economy. In developing economies, the government has to play a very active role in promoting economic development and fiscal policy is the instrument that the state must see. Hence the great importance of public finance in underdeveloped countries desirous of rapid economic development. In a democratic society, there is an inherent dislike for direct control regulation by the state. The entrepreneur would not like to be ordered about to produce this or that, how much to produce or where to produce. Fiscal incentives in the form of tax concessions, rebates or subside are, therefore, preferable. Similarly, the consumers would not like to be told directly to curtail their consumptions or to consume this and not to consume that. Taxation of articles whose consumptions is to be

discouraged is therefore preferable.Hence, a democratic state must rely on indirect methods of control and regulation and this is doing through fiscal and monetary policies. Thus in democratic countries, fiscal policy is a powerful and least undesirable weapon on which the states can rely for promoting economic development.

INSTRUMENTS OF FISCAL POLICY

I. BUDGET:Keeping budget in balance, in surplus or deficit, is in itself a fiscal instrument. When the government keeps its total expenditure equal to its revenue, as a matter of policy, it means it has adopted a balanced budget policy. When the government spends more than its expected revenue, as a matter of policy, it is pursuing a deficit-budget policy. And when the government follows a policy of keeping its expenditure substantially below its current revenue, it is following a surplus budget policy. II.TAXATION A tax is a non quid pro quo payment by the people to the government. By this definition, taxation means non quid pro quo transfer of private income to public coffers by means of taxes. Taxation takes many forms in the developed countries including taxation of personal and corporate income, so-called value added taxation and the collection of royalties or taxes on specific sets of goods. Government may want to smooth out the nation's income in order to minimize the pejorative effects of the business cycle or they may want to take steps designed to increase the national income. They may also want to take steps intended to achieve specific social objectives deemed to be appropriate by the political or legal process. Sound tax system, with moderate rates and a broad base, is an integral part of the prudent fiscal policy. The expansion in the tax base is sought to be achieved through expansion in the scope of taxes, specifically service tax, removal of exemptions and improvement in tax administration. With a decline in non-tax revenue receipts as a proportion of overall revenue receipts, the burden of fiscal corrections is expected to be mainly on tax revenues. However, the measures to increase the tax-GDP ratio must be harmonized with the overall growth objective. The strategy seeks to increase tax compliance, improve the efficiency of tax administration

and with intense focus on recovery of arrears of tax revenues and prevent further build-up of such arrears. Agricultural taxation: This economic surplus mainly goes to rich farmers, landlords, intermediaries in the absence of suitable taxation on agriculture. It has potential surplus & to achieve maximum utilization of land through devising a system of land taxation which would penalize poor use of good land. III.PUBLIC EXPENDITURE Suppose the government spends more on an electricity project for which the contract is given to a PSU like BHEL. Then the money that the government spends comes back to it in the form of BHEL's earnings. Similarly, suppose that the government spends on food-forwork programmers, and then a significant part of the expenditure allocation would consist of food grain from the Public Distribution System which would account for part of the wages of workers employed in such schemes. This in turn means that the losses of the Food Corporation of India (which also includes the cost of holding stocks) would go down and hence the money would find its way back to the government. In both cases, the increased expenditure has further multiplier effects because of the subsequent spending of those whose incomes go up because of the initial expenditure. The overall rise in economic activity in turn means that the government’s tax revenues also increase. Therefore there is no increase in the fiscal deficit in such cases.

IV. GOVERNMENT BORROWING:

Government borrowing is another fiscal Method by which savings of the community may be mobilized for economic development. In developing economies, the government resort to borrowing in order to finances schemes of economic development. Government or what is also called public borrowing becomes necessary because taxation alone cannot provide sufficient funds for economic development. Besides, too heavy taxation has an adverse effect on private saving and investment. . Fiscal Policy Can Be Divided In Two Types.

I) DISCRETIONARY FISCAL POLICY FOR STABILISATION Fiscal policy is an important instrument to stabilize the economy, that is, to overcome recession and control inflation in the economy. By discretionary policy we mean deliberate change in the Government expenditure and taxes to influence the level of national output and prices. Fiscal policy generally aims at managing aggregate demand for goods and services. II) NON_DISCRETIONARY FISCAL POLICY: AUTOMATIC STABILIZERS There is an alternative to use of discretionary fiscal policy, which generally involves the problem of, large in recognizing the problem of recession or inflation and large of the taking appropriate action to tackle the problem. In this Non-discretionary fiscal policy, the tax structure and expenditure are so designed that taxes and government spending vary automatically inappropriate direction with the changes in National Income. That is, these taxes and expenditure pattern without any special deliberate action by the government and parliament automatically raise aggregate demand in times of recession and reduce aggregate demand in times of boom and inflation and there by help in insuring economic stability. These fiscal measures are therefore called automatic stabilizers or built-in stabilizers. Since these automatic stabilizers do not require any fresh deliberate policy action or legislation by the government, they represent non-discretionary fiscal policy. Built-in-stability of tax revenue and government expenditure of transfer payment of subsidies is created because they vary with national income. These taxes and expenditure automatically bring about appropriate change in aggregate demand and reduce the

impact to recession and inflation that might occur in an economy at sometimes. This means that because of existence of this automatic or built-in-stabilizers recession andinflation will be shorter and less intense than otherwise is the case. Important automatic fiscal stabilizes compensation, welfare benefits corporate dividends.

Limitations of fiscal policy 1. Formulation of an appropriate fiscal policy requires reliable forecasting of the target variables, like GNP, consumption, investment and its determinants, technological changes, and so on. But no one has yet discovered a foolproof method of economic forecasting.’ 2. The Overall effect of changes in the policy instruments, like, changes in government spending and taxation is determined by the rate of dynamic multiplier. Forecasting the multiplier is in itself an extremely difficult task and a time consuming process. Therefore, by the time the full impact of one policy change is realized, economic conditions change necessitating another change in the fiscal policy. 3. A decision and execution lag in case of discretionary fiscal policy makes both working andefficacy of fiscal policy shrouded with uncertainty. 4. Working and effectiveness of fiscal policy in underdeveloped countries is severely limited by a) low levels of income, b) small proportion of population in taxable income groups, c) existence of large non - monetized sector, d) all pervasive corruption and inefficiency in administration,especially in tax collection machinery. 5. Countries which are excessively dependent on fiscal policy for their economic management, the governments are often forced to have recourse to internal and external borrowings and deficit financing. Excessive borrowings take such countries close to debt trap and deficit financing beyond the absorption capacity of the economy accelerates the pace of inflation,which further creates other control problems.