Fiscal policy is the set of principles and decisions of a government regarding the level of public expenditure and mode of financing them. It is about the effort of government to influence the economy's output, employment and prices by altering the level of public expenditure, taxation and public debt. Arthur Smithies points out, 'Fiscal policy is a policy under which the government uses its expenditure and revenue programmes to produce desirable effects and avoid undesirable effects on the national income, production and employment'.
The significance of this policy was not at all recognized by economists before the publication of Keynes's General Theory of Employment, Interest and Money. Keynes gave the concept of fiscal policy new meaning and operation of the public finance a new perspective. He made it clear that taxation, public spending and public debt are the effective instruments of public policy capable of determining the level of output and employment.
The importance of fiscal policy in modern economies arises from the fact that the State under democracy is called upon to play an active and important role in promoting economic development and providing a vast number of essential public utilities and services like drinking water, sanitation, civic services, primary education, public health, social welfare, defence, etc. Most of these goods are characterized by the property viz. non-marketable; that it cannot be sold in the market to the consumer. But payment has to be regulated in another way, through taxation.
In the underdeveloped economies, public finance has to assume yet another role, whereas in developed economies, it aims at maintaining economic stability. In underdeveloped economies, desirous of achieving rapid economic development, the function of public finance is to promote rapid economic development of the country, besides maintaining economic stability.
The principal objectives of fiscal policy in an economy are as follows:
Tax policy is to be directed towards effective mobilization of all available resources and to harness them in the execution of development programmes. This implies, on the one hand, diversion of wasteful and luxury spending to saving and on the other hand productive investment of increments that accrue to production as a result of development efforts. Taxation can be a most effective means of increasing the total quantum of savings and investments in any economy where the propensity to consume is normally high.
In a mixed economy, private sector forms an important constituent of the economy. In spite of the growing importance of the public sector in accelerating the process of economic development, the interest of the private sector cannot be neglected. Therefore rebates, reliefs and liberal depreciation allowances may be granted to boost the private sector.
The above objective can be achieved through proper allocation of resources. We must direct investment in the desirable channels both in the public and private sectors by providing suitable incentives. Productive resources are, within limits capable of being used in various ways, which may accelerate economic growth. The available resources must find their way into the socially necessary lines of development.
The fiscal policy must be used as an instrument for dealing with inflationary or deflationary situations. One way to achieve this is to devise a tax structure, which will automatically counter the economic disturbances as they arise. The second is to make changes in the tax system in order to deal with inflationary or deflationary situations. In countries like India, it is through the direction of the public expenditure rather than taxation that more effective action can be taken to remove the effect of a deflationary spiral. In terms of inflation, anti-inflationary taxes such as excess profit tax and commodity taxes on articles of both general and luxury consumption can be imposed.
The national income should be properly distributed so that the fruits of development are fairly shared by all people. Equality in income, wealth and opportunities must form an integral part of economic development and social advance. Moreover, redistribution of income in favour of the poorer sections of the society is essential. This can be achieved through taxation. We can also achieve this through an increase in public expenditure for promoting welfare to the less privileged class. Expenditure on agriculture, irrigation, education and health and medical expenses will improve the economic conditions of the weaker sections of the society.
Fiscal policy can affect total spending. (aggregate demand determinant) in two ways. The first is the direct change in total spending brought about by the government increasing or decreasing its own expenditure. And the second one is increasing or reducing private spending by varying its own tax revenue.
The fiscal policy to achieve full employment and to maintain stable price in the economy has been developed in the recent past. The ineffectiveness of monetary policy as a means to remove unemployment during the Great Depression paved the way for the development of fiscal policy in achieving this objective. For accelerating the rate of growth, allocation of higher proportion of the fully employed resources is needed. Those activities increase the productive capacity of the economy. Therefore fiscal policy is used through its tax instrument to encourage investment and discourage consumption so that production may increase. It is also necessary to increase capital formation by reducing the high income tax on personal income. To increase employment, the state expenditure should be directed towards providing social and economic overheads. The state should undertake local public works of community development involving more labour and less capital per head.
Fiscal policy such as taxes, tariffs, transfer payments, rebate and subsidies are expected to spur long run economic growth through increased capital formation. Capital formation is considered an important determinant of economic growth. The economic theory tells us that the optimal amount of capital formation serves a useful key to economic growth in developing economies. At the same time, the economic distortions brought about by lack of adequate fiscal incentives can cause capital formation to fall short of the socially optimal level.
Though the fiscal policy has an important place in economic development and in particular, in the stepping up of saving and investment both in public and in private sectors, it has the following limitations.
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 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.
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.
Large scale underemployment, lack of coordination from the public, tax evasion, low tax base are the other limitations of fiscal policy.
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