Fiscal Policy

Written By Fathimath Sama on Saturday, 22 June 2013 | 23:24

Meaning of Fiscal Policy: 

Fiscal Policy may be defined as that part of governmental economic policy which deals with taxation, expenditure, borrowing and the management of public debt in an economy. It is an indispensable instrument of modern public finance. The importance of fiscal policy has greatly increased in modern times, both in the developed as well as the underdeveloped countries of the world. In developed countries, fiscal policy is being increasing used as an instrument to achieve full employment and economic stability. In underdeveloped countries, on the contrary, fiscal policy is more and more being used as a means to step up the rate of economic growth. Fiscal policy primarily concerns itself with the flow of funds in the economy. Taxation diverts the funds from the private sector to the governmental sector. Public expenditure on the contrary, diverts funds from the governmental sector back to the economy. Public borrowing, like taxation also diverts funds from the private sector to the governmental sector, but the two diversions influence the private sector in different ways. Management of public debt includes functions, such as, floating of governmental loans, payment of interest thereon and retirement of matured debts. Fiscal policy, thus, exerts a very powerful influence on the working of the national economy. It directly affects the volume of output, income and employment in the economy. The greater the percentage of national income and expenditure represented by the governmental budget, the greater would be the influence of fiscal policy on aggregate economic activity. 

Objectives of Fiscal Policy in a Developed Capitalist Economy: 

There are two broad objectives of fiscal policy in a developed capitalist economy, namely, 1. To achieve and maintain full employment in the economy, and 2. To achieve economic stability in the economy through avoidance both of inflation as well as deflation. In short, the basic goal of fiscal policy in a developed economy is one of full employment and economic stability. 

Objectives of Fiscal Policy in Underdeveloped Economy: 

The nature of fiscal policy in an underdeveloped economy is bound to be different from that of a developed economy. In a developed economy, the problem is not so much that of development as that of achieving economic stability on account of business fluctuations caused by the operation of the trade cycles. But the problem of an underdeveloped economy is not so much that of economic stability as that of promoting rapid economic growth in the country. 

The major objectives of fiscal policy in an underdeveloped country are: 
  • The first objective of fiscal policy in an underdeveloped country should be to maximize the level of aggregate saving by applying a cut to the actual and potential consumption of the public at large. The fiscal policy should especially curb conspicuous consumption of the rich and force them to save more for capital formation. 
  • The second objective should be to maximize the rate of capital formation to break economic stagnation and to lead the country on to the path of rapid economic progress and growth. 
  • The third objective of fiscal policy in an underdeveloped economy should be to divert capital resources from less productive to more productive and from socially less desirable to socially more desirable uses.
  • The fourth objective of fiscal policy should be to protect the economy of an underdeveloped country from inflation. Inflation can ruin an underdeveloped country. As such, the fiscal policy of an underdeveloped country should be designed in such a manner so as to curb inflationary forces arising during the process of growth. 
  • The fifth objective of fiscal policy should be to eliminate as far as possible, sectoral imbalances arising in the economy from time to time. 
  • The sixth objective of fiscal policy should be to provide incentives for encouraging those industries which have a high employment potential in the economy. 
  • The seventh objective of fiscal policy in an underdeveloped country should be eliminate as far as possible, the glaring economic inequalities in the economy and bring about an equitable redistribution of income and wealth in society. 

Fiscal Policy and Economic Growth: 

Fiscal policy is also a potent weapon for the achievement of accelerated economic growth in a backward, underdeveloped economy. Without an appropriate fiscal policy, the process of economic growth in a country is bound to suffer. In achieving a fast economic growth, the government may have to deploy all the instruments of fiscal policy at its disposal, namely, taxation, public expenditure, public debt and deficit financing. The problem in a backward underdeveloped economy is not one of lack of real resources, but that of shortage of financial resources. So the instruments of fiscal policy may have to be used to raise adequate finance for economic growth. 

1. Taxation: 

It is an indispensable instrument for raising finance for economic development. For this purpose, the government may resort to direct as well indirect taxation. Direct taxes, such as, income tax, wealth tax, gift tax, capital gains tax etc may have to be levied to net adequate revenues for development purposes. The incidence of these taxes mostly falls on the richer classes. As such, they are quite justified from the point of equity. The government may impose steep excise duties and import taxes on luxury goods which are consumed exclusively by the rich. To raise enough revenue for developmental purposes, it may also be necessary to levy excise taxes on articles of mass consumption, though the burden of such taxes is mostly borne by the poor and middle-class. 

2. Public Debt: 

Taxation taken alone may not yield adequate revenue for mobilizing the real resources of the country. The government may therefore resort to public borrowings, short-term as well as long-term, to add to its fund of investible resources. There may be opposition to heavy taxation, but no one opposes public borrowings because the government pays interest on public loans. While borrowing from the public, the government should ensure that the burden of interest charges does not turn to be unbearable for it. For this purpose, the government may adopt a cheap money policy to keep interest-rates at a comparatively low level. Since the amount raised through internal borrowings may not be adequate there is no harm if the government if the government resorts to the international money market for raising the necessary funds for developmental purposes. The government may even take loans from foreign countries or international lending agencies on suitable conditions and terms of repayment. While raising external loans, the government has to be alert enough to see that such loans do not compromise its economic and political sovereignty in any way. 

3. Public Expenditure: 

The government of an underdeveloped country should devote quite a substantial portion of its expenditure to the building up of the necessary infrastructural facilities for economic growth, such as, roads. Railways, communications, irrigation works, power stations, coal-mining, general and technical education. These facilities will induce the rapid growth of the economy. Along with that, a part of the purpose expenditure may also be allocated for the growth and development of basic industries which will provide the foundation of industrial growth in future. Agriculture which is generally the most important segment of an underdeveloped economy should receive special attention of the government. Expenditure incurred by the government on the promotion of labour and social welfare also aids the rapid growth of the economy by improving the productivity of the labour force. 

4. Deficit Financing: 

It is still another important instrument of fiscal policy. It has proved to be a dispensable means of financing the economic growth of underdeveloped economy. Several developing countries have in recent years, employed the technique of deficit financing as a means of financing economic development. 

Limitations of Fiscal Policy: 

Fiscal policy as an instrument of economy stability and economic growth suffers from certain limitations which may be as follows; 
  1. Firstly, the difficulty of accurately forecasting the onset of depression robs fiscal policy of much of its utility and effectiveness as an anti-cyclical device. More often than not, a country finds itself already knee-deep in depression before it moves about to take corrective action. 
  2. Secondly, the corrective action taken by the government does not produce immediate results, because, there is often a prolonged time interval between the enforcement of fiscal measures and their final impact on the functioning of the economy. 
  3. Thirdly, fiscal steps taken by the government to curb unemployment may fail to yield results if the unemployment is due to causes other than the deficiency of aggregate demand. Fiscal measures for example will fail to create any dent on unemployment, if it is due to seasonal, frictional, structural or technological causes. 
  4. Fourthly, fiscal measures may prove inadequate or ineffective in dealing even with cyclical unemployment caused by the deficiency of aggregate demand for several reasons. For example: increased public expenditure intended to create more employment opportunities may be accompanied by a decline in private expenditure due to an increase in factoral prices. Increased public expenditure may also have adverse effect on employment-generation in the private sector through a general increase in wage-levels. 
  5. Fifthly a strong and powerful fiscal policy adopted to deal with more mass unemployment may unduly inflate the size of the public debt which will impose an unbearable burden on the future generations. 
  6. Sixthly, while dealing with hyper-inflation and boom, the government may carry its fiscal measures to the other extreme, namely, far too high taxation and cut-back in public investment, which will pave the way for the forth coming depression. 
  7. Lastly, fiscal measures taken to finance economic growth in an underdeveloped economy may not suffice unless and until recourse is taken to monetary devices such as deficit financing etc.

Notes provided by Prof. Sujatha Devi B (St. Philomina's College)
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