FISCAL POLICY

How the Government affects my

money!
 Fiscal Policy

• Def. Government decisions on spending and

taxation that are intended to improve or
maintain the economy.

• Because the government is so large and has

such an impact on business, the decisions it
makes has a HUGE influence on the economy.
 Fiscal Policy and the Economy

• The total level of government spending can be

changed to help increase or decrease the
output of the economy

• Expansionary Policies: Policies that try to

increase the output of the economy
• Contractionary Policies: Policies that try to
decrease the output of the economy
 Expansionary Policies

• During a contraction or recession, the

government can do two things:

1. Decrease Taxes
Or
2. Increase Spending
 Decreasing Taxes

1. Gives people more money to spend

2. More money = more demand
3. More demand = more production
4. More production = more jobs
5. More jobs = more demand etc. etc.
 Increase Spending

1. Increases demand for goods

2. More demand = more production
3. More production = more jobs
4. More jobs = more demand etc. etc.
 Contractionary Policies

• During a period of excessive inflation (during

a period of expansion), the government can
do two things:

1. Increase Taxes
Or
2. Decrease Spending
 Increase Taxes

1. People have less money to spend

2. Less money = less demand
3. Less demand = lower inflation
 Decrease Spending

1. Less money in economy

2. Less money = less demand
3. Less demand = lower inflation
 INSTRUMENTS OF FISCAL POLICY

Some of the major instruments of fiscal policy are as

follows:
• Budget
• Taxation
• Public Expenditure
• Public Works
• Public Debt.
 INSTRUMENTS OF FISCAL POLICY
A. Budget:
• The budget of a nation is a useful instrument to assess the fluctuations in an
economy.
– Annual budget,
– cyclical balanced budget and
– fully managed compensatory budget.

Annual Balanced Budget:

The principle is based on the notion that government should increase the taxes to
get more money and reduce expenditure to make the budget balanced.
• Cyclically Balanced Budget:
Such a budget implies budgetary surpluses in prosperous period and employing
the surplus revenue receipts for the retirement of public debt. During the period
of recession, deficit budgets are prepared in such a manner that the budget
surpluses during the earlier period of inflation are balanced with deficits.
 INSTRUMENTS OF FISCAL POLICY
• Fully Managed Compensatory Budget:
This policy implies a deliberate adjustment in taxes,
expenditures, revenues and public borrowings with the motto
of achieving full employment without inflation. It assigns only
a secondary role to the budgetary balance. It lays down the
emphasis on maintenance of full employment and stability in
the price level. With this principle, the growth of public debt
and the problem of interest payment can be easily avoided.
Thus, the principle is also called ‘functional finance.’
 INSTRUMENTS OF FISCAL POLICY
• B. Taxation:
• Anti Recession Tax Policy
An anti- depression tax policy increases disposable income of the individual, promotes consumption and
investment. Obviously, there will be more funds with the people for consumption and investment
purposes at the time of tax reduction.
This will ultimately result in the increase in spending activities i.e. it will tend to increase effective demand
and reduce the deflationary gap. In this regard, sometimes, it is suggested to reduce the rates of
commodity taxes like excise duties, sales tax and import duty. As a result of these tax concessions,
consumption is promoted.
 INSTRUMENTS OF FISCAL POLICY
• B. Taxation:

• Anti-Inflationary Tax Policy:

An anti-inflationary tax policy, on the contrary, must be directed to plug the inflationary gap.
During inflation, fiscal authorities should not retain the existing tax structure but also evolve such
measures (new taxes) to wipe off the excessive purchasing power and consumer demand. To this
end, expenditure tax and excise duty can be raised.
• The burden of taxation may be raised to the extent which may not retard new investment. A
steeply progressive personal income tax and tax on windfall gains is highly effective to curb the
abnormal inflationary pressures. Export should be restricted and imports of essential commodities
should be liberated.
• The increased inflow of supplies from origin countries will have a moderate impact upon general
prices. The tax structure should be such which may impose heavy burden on higher income group
and vice versa. Therefore, proper care must be taken that the government policies should not
bring violent fluctuations and impede economic growth. To sum up, despite certain short-comings
of taxation, its significance as an effective anti-cyclical and growth inducing 
 INSTRUMENTS OF FISCAL POLICY
C. Public Expenditure:
The increased public spending will have a multiple effect upon income, output and employment exactly in the
same way as increased investment has its effect on them. Similarly, a reduction in public spending, can
reduce the level of economic activity through the reverse operation of the government expenditure
multiplier.

• Public Expenditure in Inflation:

During the period of inflation, the basic reason of inflationary pressures is the excessive aggregate spending.
Both private consumption and investment spending are abnormally high. In these circumstances, public
spending policy must aim at reducing the government spending. In other words, some schemes should be
abandoned and others be postponed. It should be carefully noted that government spending which is of
productive nature, should not be shelved, since that may aggravate the inflationary dangers further.

• Public Expenditure in Depression:

In depression, public spending emerges with greater significance. It is helpful to lift the economy out of the
morass of stagnation. In this period, deficiency of demand is the result of sluggish private consumption and
investment expenditure. Therefore, it can be met through the additional doses of public expenditure
equivalent to the deflationary gap. The multiplier and acceleration effect of public spending will neutralize
the depressing effect of lower private spending’s and stimulate the path of recovery.
 INSTRUMENTS OF FISCAL POLICY
D. Public Works:
• There are two forms of expenditure i.e., Public Works and
‘Transfer Payments.
• Public Works according to Prof. J.M. Clark, are durable goods,
primarily fixed structure, produced by the government.They
include expenditures on public works as roads, rail tracks,
schools, parks, buildings, airports, post offices, hospitals,
irrigation canals etc. Transfer payments are the payments such
like interest on public debt, subsidy, pension, relief payment,
unemployment, insurance and social security benefits etc. The
expenditure on capital assets (public works) is called capital
expenditure.
 INSTRUMENTS OF FISCAL POLICY
E. Public Debt:
The government borrowing may assume any of the following forms mentioned as under:
• (a) Borrowing from Non-Bank Public:
• When the government borrows from non-bank public through sale of bonds, money may
flow either out of consumption or saving or private investment or hoarding. As a result, the
effect of debt operations on national income will vary from situation to situation. If the bond
selling schemes of the government are attractive, the people induce to curtail their
consumption, the borrowings are likely to be non inflationary.
• When the money for the purchase of bonds flows from already existing savings, the
borrowing may again be non-inflationary. Has the government not been borrowing, these
funds would have been used for private investment, with the result that the debt operations
by the government will simply bring about a diversion of funds from one channel of spending
to another with the similar quantitative effects on national income.
• If the government bonds are purchased by non bank individuals and institutions by drawing
upon their hoarded money, there will be net addition to the circular flow of spending.
Consequently, the inflationary pressures are likely to be created. But funds from this source
are not commonly available in larger quantity. Its main implication is that borrowings from
non bank public is more advantageous in an inflationary period and undesirable in a
depression phase. In short, the borrowing from non bank public are not of much significant
magnitude whether it comes out of consumption, saving, private investment or hoarding.
 INSTRUMENTS OF FISCAL POLICY
• Public Debt:

• (b) Borrowing from Banking System:

• The government may also borrow from the banking institutions. During
the period of depression, such borrowings are highly effective. In this
period, banks have excessive cash reserves and the private business
community is not willing to borrow from banks since they consider it
unprofitable.
• When unused cash lying with banks is lent out to government, it causes a
net addition to the circular flow and tend to raise national income and
employment. Therefore, borrowing from banking institution have
desirable and favourable effect specially in the period of depression when
the borrowed money is spend on public works programmes.