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Learning Outcomes

• To understand the meaning of fiscal policy.

• To understand the various instruments of fiscal
policy.
• To differentiate between financial instruments and
target variables.
• To analyze the working of fiscal policy to achieve
macroeconomic goals.
Which of the following is not an instrument of fiscal
policy?
A. Taxation
B. Repo rate
C. Public Debt
D. Public expenditure
 Fiscal policy

• Fiscal policy means the use of taxation and public expenditure

by the government for stabilization or growth of the economy. 
• According to Culbarston, “By fiscal policy we refer to
government actions affecting its receipts and expenditures
which ordinarily as measured by the government’s receipts, its
surplus or deficit.”
• The government may change undesirable variations in private
consumption and investment by compensatory variations of
public expenditures and taxes.
 Fiscal Policy

Fiscal Policy is the policy of revenue and expenditure of the

government. The various fiscal instruments are as under:

1. Government expenditure

2. Taxation

3. Public borrowings (Debt)

4. Budgetary deficit or surplus budgeting

Which of the following will be the action of fiscal
policy during inflation?
A. Rise in Repo rate
B. Rise in CRR
C. Rise in SLR
D. None of these
 Three Stances of Fiscal Policy

(1) A neutral stance of fiscal policy implies a balanced budget

where G = T (Government spending = Tax revenue).
Government spending is fully funded by tax revenue and
overall the budget outcome has a neutral effect on the level
of economic activity.
(2) 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.
(3) A contractionary stance of fiscal policy (G < T) occurs when
net government spending is reduced either through higher
taxation revenue or reduced government spending or a
combination of the two. 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.
 The fiscal policy is designed to achieve certain
objectives as follows:

(1) Development by effective Mobilization of Resources: The principal

objective of fiscal policy is to ensure rapid economic growth and
development. This objective of economic growth and development can
be achieved by Mobilisation of Financial Resources. The central and
state governments in India have used fiscal policy to mobilise
resources.
The financial resources can be mobilized by:
Taxation: Through effective fiscal policies, the government aims to
mobilise resources by way of direct taxes as well as indirect taxes
because most important source of resource mobilisation in India is
taxation.
•  
• Public Savings: The resources can be mobilized through public savings by
reducing government expenditure and increasing surpluses of public sector
enterprises.
• Private Savings: Through effective fiscal measures such as tax benefits, the
government can raise resources from private sector and households.
Resources can be mobilized through government borrowings by ways of
treasury bills, issuance of government bonds, etc., loans from domestic and
foreign parties and by deficit financing.
(2) Reduction in inequalities of Income and Wealth: Fiscal policy
aims at achieving equity or social justice by reducing income
inequalities among different sections of the society. The direct
taxes such as income tax are charged more on the rich people as
compared to lower income groups. Indirect taxes are also more
in the case of semi-luxury and luxury items which are mostly
consumed by the upper middle class and the upper class. The
government invests a significant proportion of its tax revenue in
the implementation of Poverty Alleviation Programmes to
improve the conditions of poor people in society.
(3) Price Stability and Control of Inflation
One of the main objectives of fiscal policy is to control inflation
and stabilize price. Therefore, the government always aims to
control the inflation by reducing fiscal deficits, introducing tax
savings schemes, productive use of financial resources, etc.
(4) Employment Generation: 
The government is making every possible effort to increase
employment in the country through effective fiscal measures.
Investment in infrastructure has resulted in direct and indirect
employment. Lower taxes and duties on small-scale industrial
(SSI) units encourage more investment and consequently
generate more employment. Various rural employment
programmes have been undertaken by the Government of India
to solve problems in rural areas. Similarly, self employment
scheme is taken to provide employment to technically qualified
persons in the urban areas.
(5) Balanced Regional Development: 
There are various projects like building up dams on rivers,
electricity, schools, roads, industrial projects etc run by the
government to mitigate the regional imbalances in the country.
This is done with the help of public expenditure.
(6) Reducing the Deficit in the Balance of Payment: 
Some time government gives export incentives to the exporters
to boost up the export from the country. In the same way import
curbing measures are also adopted to check import. Hence the
combine impact of these measures is improvement in the
balance of payment of the country.
(7) Increases National Income: 
It’s the strength of the fiscal policy that is brings out the desired
results in the economy. When the government want to increase
the income of the country then it increases the direct and
indirect taxes rates in the country. There are some other
measures like: reduction in tax rate so that more peoples get
motivated to deposit actual tax.
(8) Development of Infrastructure
 When the government of the concerned country spends money
on the projects  like railways, schools, dams, electricity, roads etc
to increase the welfare of the citizens, it improves the
infrastructure of the country. A improved infrastructure is the key
to further speed up the economic growth of the country.
(9) Foreign Exchange Earnings: 
When the central government of the country gives
incentives like, exemption in custom duty, concession
in excise duty while producing things in the domestic
markets, it motivates the foreign investors to increase
the investment in the domestic country.
Fiscal Instruments affects the following Target
Variables
1. Private disposable incomes,

2. Private consumption expenditure,

3. Private savings and investment,

4. Exports and imports, and

5. Level and structure of prices

 Working of Fiscal Policy during Inflation
1. Decrease in Public expenditure- When the government want to reduce
the money supply in order to contract the inflation then the government
will reduce the public expenditure on pensions, scholarships etc. When
the expenditure is reduced, money supply will reduce which can lead to a
fall in the aggregate demand and fall in inflation.
2. Increase in public debt- During inflation the government will take more
loans/ debt from the public. When more debt is taken from the public
money supply from the economy will goes down and inflation will be
controlled.
3. Delay in payment of old debts: During inflation government will make
delay in the payment of the old debts so that the money supply can be
controlled from the economy.
4. Increase in taxes: In order to curb inflation the government will impose
more and more taxes on the people, if more tax is imposed then money
supply will be increased.
5. Surplus budget policy: During inflation the government will follow the
surplus budget policy means government will earn more from the
economy and will spend less, this will help to solve the problem of
inflation.
 Working of Fiscal Policy during Deflation
1. Increase in Government Expenditure: when the government wants to
solve the deflation in the economy, then the government will increase the
supply of money. In this case government will do the more spending.
2. Decrease in Taxes: In order to solve the deflation the government will
reduce taxes on the public and when taxes are reduced then money
supply will be more and leads to fall in deflation.
3. Payment of old debts: During deflation it is needed to increase the
supply of money in the economy so the government will pay the old
debts to the people and there will be more supply of money in the
market.
4. Fall in Taxes: In order to solve deflation it is needed to raise the supply of
money in the market. Therefore the government will reduce the tax and
this will generate more supply of money in the market.
5. Deficit Budget Policy: During deflation the government will follow deficit
budget policy, it means government will spend more money and generate
less revenue from the economy.
 Limitations of Fiscal Policy

• Size of fiscal measures

The budget is not a mere statement of receipts and revenues of
the government. It explains and shapes the economic structure
of a country. When the budget forms a small part of the national
income in developing economies, fiscal policy cannot have the
desired impact on the economic development. Direct taxation at
times become an instrument of limited applicability, as the vast
majority of the people are not covered by it. Further, when the
total tax revenue forms a smaller portion of the national income,
fiscal measures will not step up the sagging economy requiring
massive help.
Fiscal policy as ineffective anti-cyclical measure
Fiscal measures- both loosening fiscal policy and tightening fiscal
policy- will not stimulate speedy economic growth of a country, when
the different sectors of the economy are not closely integrated with
one another. Action taken by the government may not always have the
same effect on all the sectors. Thus we may have for instance the
recession in some sectors followed by a rise in prices in other sectors.
An increasing purchasing power through deficit financing, a policy
advocated by J.M. Keynes in 1930s may not have the effect of reviving
the recession hit economies, but merely result in a spiralling rise in
prices.
Administrative delay
Fiscal measures may introduce delay, uncertainties and
arbitrariness arising from administrative bottlenecks. As a result,
fiscal policy fails to be a powerful and therefore a useful
stabilization policy.
Poor Information
Fiscal policy will suffer if the government has poor information.
For example, if the government believes there is going to be a
recession, they will increase AD, however if this forecast was
wrong and the economy grew too fast, the government action
would cause inflation.
Time Lags: If the government plans to increase
spending this can take a long time to filter into the
economy and it may be too late. Spending plans are
only set once a year. There is also a delay in
implementing any changes to spending patterns.
Budget Deficit: Expansionary fiscal policy (cutting
taxes and increasing G) will cause an increase in the
budget deficit which has many adverse effects. Higher
budget deficit will require higher taxes in the future
and may cause crowding out.
Other Limitations
Large scale underemployment, lack of coordination from the
public, tax evasion, low tax base are the other limitations of fiscal
policy.
Thanks