Fiscal Policy-Meaning

The word fiscal means state treasury and fiscal policy refers to policy concerning the use of state treasury or the govt. finances to achieve the macroeconomic goals. This implies: any decision to change the level, composition or timing of govt. expenditure or to vary the burden ,the structure or frequency of the tax payment is fiscal policy. -G.K. Shaw G

Objectives of Fiscal Policy

It has 2 major objectives: ii. GENERAL obj-. aimed at achieving macroeconomic goals iii. SPECIFIC obj-. relating to any typical problems of an economy

General Objectives
Economic Growth: By creating conditions for increase in savings & investment. Employment: By encouraging the use of labourabsorbing technology Stabilization: fight with depressionary trends and booming (overheating) indications in the economy Economic Equality: By reducing the income and wealth gaps between the rich and poor. Price stability: employed to contain inflationary and deflationary tendencies in the economy

instrument of Fiscal Policy

Budgetary surplus and deficit Government expenditure Taxation- direct and indirect Public debt Deficit financing

Budgetary surplus and deficit

A budget is a detailed financial plan of operations for some specific future period Keeping budget balanced (R=E) or deficit (R<E) or surplus (R>E) as a matter of policy is itself a fiscal instrument. An accumulated deficit over several years (or centuries) is referred to as the government debt A deficit is a flow. And a debt is a stock. Debt is essentially an accumulated flow of deficits

COMPONENTS OF BUDGET
Revenue receipts Capital receipts Revenue expenditure Capital expenditure

BUDGET FINANCIALS 2007-08

Revenue receipt
Income tax 13%

Corporate tax
customs excise

21%
12 % 17%

Service and other taxes

Non-debt capital receipts Borrowing

7%
1%

19%

Govt. Expenditure
It includes : Government spending on the purchase of goods & services. Payment of wages and salaries of government servants Public investment Transfer payments

Revenue: Taxation
Meaning : Unilateral transfer of private income to public treasury by means of taxes. Classified into 1. Direct taxes- Corporate tax, Div. Distribution Tax, Personal Income Tax, Fringe Benefit taxes, Banking Cash Transaction Tax 2. Indirect taxes- Central Sales Tax, Customs, Service Tax, excise duty

Revenue: Public debt

Internal borrowings Borrowings from the public by means of treasury bills and govt. bonds Borrowings from the central bank (monetized deficit) External borrowings foreign investments international organizations like World Bank & IMF market borrowings

FISCAL POLICY CHOICES

Expansionary fiscal policy: used to combat a recession. 2. Contractionary fiscal policy: used to combat demand-pull inflation, due to excess spending

EXPANSIONARY FISCAL POLICY

Expansionary Policy needed: a decline in investment has decreased AD, so real GDP has fallen, and also employment has declined. A possible fiscal solution may be: a. An increase in government spending, which shifts AD to the right by more than the change in G, due to the multiplier. b. A decrease in taxes (raises income, and consumption rises by MPC times the change in income). AD shifts to the right by a multiple of the change in consumption. c. A combination of increased G spending and reduced taxes. d. If the budget was initially balanced, expansionary fiscal policy creates a budget deficit

CONTRACTIONARY FISCAL POLICY

Contractionary Policy needed: When demand-pull inflation occurs, a shift of AD to the right in the vertical range of AS, then contractionary policy is the remedy. a. A decrease in G spending shifts AD back left, once the multiplier process is complete. Here price level returns to its pre-inflationary level, but GDP remains at full-employment level. b. An increase in taxes will reduce income, and then consumption at first by the MPC times the decrease in income, and then the multiplier process leads AD to shift leftward still further. c. A combined G spending decrease and tax increase could have the same effect with the right combination. d. If the budget was initially balanced, a contractionary fiscal policy creates a budget surplus.

FINANCING DEFICITS
The method used to finance deficits or dispose of surpluses influences fiscal policy: Financing deficits can be done 2 ways: 1. Borrowing: (crowding out effect) The government competes with private borrowers for funds, and could drive up interest rates; the government may crowd out private borrowing, and this offsets the government expansion. 2. Money Creation: When the Federal Reserve loans directly to the government by buying bonds, the expansionary effect is greater since private investors are not buying bonds. (Monetarists argue that this is monetary, not fiscal, policy that is having the expansionary effect in this situation).

EVALUATING FISCAL POLICY

To evaluate the direction of discretionary fiscal policy, adjustments need to be made to the actual budget deficits or surpluses. The standardized budget is a better index than the actual budget in the direction of government fiscal policy because it indicates when the Federal budget deficit or surplus would be if the economy were operating at full employment. In the case of a budget deficit, the standardized budget: Removes the cyclical deficit that is produced by swings in the business cycle, and Reveals the size of the standardized deficit, indicating how expansionary the fiscal policy was that year.

 The full-employment budget measures what the Federal budget deficit or surplus would be with existing taxes and government spending if the economy is at full-employment. 4. Actual budget deficit or surplus may differ greatly from full-employment budget deficit or surplus estimates.

PROBLEMS, CRITICISMS, AND COMPLICATIONS

Political considerations: Government has other goals besides economic stability, and these may conflict with stabilization policy. 1. A political business cycle may destabilize the economy: Election years have been characterized by more expansionary policies regardless of economic conditions. 2. State and local finance policies may offset federal stabilization policies. They are often procyclical, because balanced-budget requirements cause states and local governments to raise taxes in a recession or cut spending, making the recession possibly worse. In an inflationary period, they may increase spending or cut taxes as their budgets head for surplus

 The crowding-out effect may be caused by fiscal policy. a. crowding-out may occur with government deficit spending. It may increase the interest rate and reduce private spending which weakens or cancels the stimulus of fiscal policy. b. Some economists argue that little crowding out will occur during a recession. c. Economists agree that government deficits should not occur at Full-Employment. It is also argued that monetary authorities could counteract the crowding-out by increasing the money supply to accommodate fiscal policy.

 With an upward sloping AS curve, some portion of the potential impact of an expansionary fiscal policy on real output may be dissipated in the form of inflation. FISCAL POLICY IN AN OPEN ECONOMY Shocks or changes from abroad will cause changes in net exports which can shift aggregate demand leftward or rightward. The net export effect reduces the effectiveness of fiscal policy by offsetting its effects. For example: Expansionary fiscal policy may increase domestic interest rates, which can cause the dollar to appreciate and exports to decline. Contractionary fiscal policy may reduce domestic interest rates, which would cause the dollar to depreciate, and net exports to increase.

Evaluation of the fiscal Policy in India

Main objectives of the fiscal policy in India are two folds: Growth performance and equity In order to ensure high growth in the economy Indian fiscal policy was framed on the basis of two aspects. 1. resource mobilization 2. efficient allocation of resources

Resource allocation
In the period of license Raj, Indias tax/ GDP ratio was very high. This ratio was on the rise till 199091 and was 15.8 per cent then. After liberalization, gradually tax GDP ratio has been brought down to 13.4 per cent. However Tax GDP ratio was 16.8 per cent in 2005-06. In the last few years due to expansion of private sector and employment creation in the higher income brackets, there is buoyancy in both personal and corporate tax collection has been taking Place

 In recent years due to rationalization of direct tax structure, direct tax compliance has improved Govt. has gone ahead with further reforms of direct tax that to be introduced ad Direct tax code from the financial year of 2012-13. Through a number of reforms the structure of direct tax gas been simplified and widen the net of direct tax reach. The reforms aims at restricting the operation of black money.

 Apart from tax revenue, resources are mobilized through non-tax revenue, from the surplus of public sector as well as fines and license fees etc. Allocation of resources: This is influenced through the indirect tax system. During the planning period , reliance on indirect tax was very high. For example 84 per cent of total tax revenue was collected through indirect tax . High and irrational indirect tax system led to inefficiency of resource allocation ; One of the examples cited is high and irrational customs duties have provided high protection to many domestic industries, that led to inefficacy of Indian industries.

 Introduction of Value added tax and GST are some of the reform gradually being introduced in the economy.

Fiscal Imbalance and corrective measures

year 190-91 1993-94 2002-03 2006-07 Revenue deficit 3.35 4.25 6.63 2.0 Gross fiscal deficit 7.02 8.26 9.56 3.7 Primary deficit 2.27 3.25 3.06 0.15

Fiscal correction needed

Thus defects in terms of various indicators reflects unsustainability and immediate need for correction. Interest payments on accumulated debts increased from 29 percent to 39.1 per cent of the total revenue in 1990-91 Interest payments contributed to most of the fiscal imbalance and tax rates were already high there was no scope to increase revenue through additional taxation. Therefore suggestions of the Chelliah Committee was to reduce the expenditure of the govt.

 In 2004 Fiscal Reform and Budget management Act (FRBM) was enacted. This mandates central govt. to eliminate revenue deficit by march 2009 and then subsequently build up revenue surplus. This act also mandates the central govt. to reduce fiscal deficit to 3 per cent of GDP by march 2009. This also provides annual targets for reducing fiscal and revenue deficits The FRBM Act provides greater transparency in fiscal operations and quarterly review of situations to regulate direct borrowing from RBI.