Home ›› 19 May 2023 ›› Editorial
Fiscal Policy is a deliberate manipulation of government income and expenditure so as to achieve desired economic and social goals. The instruments of fiscal policy (taxation and government spending) act directly on the major economic variables. (e. g. output, employment, prices). A budget surplus will remove purchasing power from the economy and reduce aggregate demand, whereas, a budget deficit will inject purchasing power and raise aggregate demand.
Fiscal policy has two major roles in financing of development. One is to maintain an economy at full employment so that the savings capacity of the economy is not impaired. The second is to raise the marginal propensity to save of the community as far above the average propensity as possible without discouraging work effort or violating the canons of equity. Using fiscal policy to maintain full employment will involve deficit financing if there exists unemployed or underused real resources.
While deficit financing is likely to be inflationary in the short run until supply had time to adjust, there is an important analytical distinction between the means by which resources are made available for investment through deficit financing at less than full employment and the means by which savings are generated by inflation. In the former case savings are generated by the increase in real output, in the latter case by a reduction in real consumption through a combination of factors including a real balance effect on outside money, income redistribution from low savers to high savers and money illusion.
The deliberate use of government spending and taxing as a possible means of attaining and maintaining full employment, a stable price level, and a satisfactory rate of growth now dates back to 1930 great depression. Fiscal policy began during the 1930s, largely as a result of three developments: the apparent ineffectiveness of monetary policy as a means of overcoming the severe unemployment of the ‘Great Depression’, the new economics advanced by John. M. Keynes with its emphasis on aggregate demand and the growing importance of government spending and taxation in relation to the economy’s total income and output.
From its relative modest beginnings fiscal policy has become a major means by which the government attempts to achieve high employment and prevent inflation. The success of the Keynesian economics was such that from the 1940s into 1960s few people doubted that government could raise or lower aggregate demand through appropriate changes deliberately brought about in government purchases, transfers and tax collection. Most monetarist economists agree that fiscal policy can be used to vary aggregate demand in a way and to a degree that contributes to economic stabilization. It can indeed be so used, it then becomes necessary to face the many real world problems that complicate the planning and execution of fiscal policies.
It is known to policy planners that government has four major macroeconomic policies to be achieved through implementation of fiscal policy. These are to achieve full employment with little or no inflation in a high growth economy with external balance (current account) equilibrium. Fiscal policy affects each of these variables through its impact on aggregate demand. Fiscal policy is therefore, an example of Demand Side Policy.
Inflation: An increase in government spending or a fall in taxes which leads to a higher budget deficit or lower budget surplus will have a tendency to be inflationary. A higher budget deficit or a lower budget surplus leads to an increase in aggregate demand. This in turn leads to an increase in price level. So inflation increases.
Unemployment: A greater budget deficit or a lower budget surplus tends to reduce the level of unemployment at least in the short term. A greater budget deficit will lead to an increase in aggregate demand will lead to a higher equilibrium level of output. The higher the level of output, the lower will be the level of unemployment.
Economic growth: Expansionary fiscal policy is unlikely to affect the long term growth rate of an economy. This is because economic growth is caused by supply side factors such as investment, education and technology. However, expansionary fiscal policy is likely in the short term, to increase GDP. An increase in aggregate demand in the short term leads to higher output. Keynesian economists argue that expansionary fiscal policy is an appropriate policy to use if the economy is in recession or below full employment.
The Balance of Payments: The expansionary fiscal policy leads to an increase in aggregate demand. This means that domestic consumers and firms will have more income and so will increase their spending on imports. Hence, the current account (exports-imports) position will deteriorate. On the other hand, tighter fiscal policy reduces domestic demand and therefore, demand for imports falls and so current account position improves.
Fiscal policy to raise the marginal propensity to save above is concerned with the design and implementation of taxes to reduce private consumption. Tax revenue as a percentage of national income and the relative importance of different taxes in the total tax revenue has emerged as major tools of fiscal policy. Generally it is seen that tax revenue as a percentage of GNP is typically low in developing countries compared to developed countries. Taxes on income are a minor source of tax revenue compared with indirect tax revenue, in the developing countries, whereas, in developed countries it is around 40per cent. On the surface there would appear to be a great deal of scope for using tax policy to raise the level of community saving relative to income. Here two important points must be borne in mind.
The first is that the rudimentary nature of the tax system in developing countries is partly a reflection of the stage of development itself. Thus the scope for increasing tax revenue as a proportion of income may in practice be severely circumscribed. There are difficulties of defining and measuring the tax base and of assessing and collecting taxes where the population is dispersed and primarily engaged in producing for subsistence and where illiteracy is rife. And there is also the fact that, as far as income tax is concerned, the income of vast majority of the economic agents is so low anyway that they must fall outside the scope of the tax system.
Even if there was scope for raising more revenue by means of taxation, whether the total level of saving would be raised depends on how tax payments are financed--whether out of consumption or saving and how income (output) is affected. It is often the case that taxes which would make tax revenue highly elastic with respect to income are taxes which would be met mainly out of saving or have the most discouraging effect on incentives.
The very progressive income tax will discourage work effort if the substitution effect of tax outweighs the income effect and to the extent that high marginal rates of tax fall primarily on the upper income groups with low propensities to consume, saving may fall by nearly as much as revenue rises. To avoid such large reductions in private saving, an expenditure tax on upper-income groups, which exempts saving from taxation, is an alternative to a progressive income tax, but the disincentive effects on work effort are not avoided.
Flexibility of Fiscal Policy: Economists generally rely on the ‘Full Employment Budget Surplus’ (FEBS) to indicate whether the budget programme is expansionary or contractionary from period to period. An increase in FEBS from one quarter to another suggests that the budget programme is turning more contractionary or less expansionary a decrease from one quarter to the next suggests that it is turning less contractionary to more expansionary. If at one time the intent of the policy makers is to use fiscal policy to combat an ongoing recession, how much it is doing in this direction will be indicated by the extent to which the FEBS from one quarter to the next. Some measure like the FEBS is essential to give the policy makers an indication of the expansionary or contractionary effect of the policy actions they have taken.
Another issue faced by the policy makers: is it possible to secure the required flexibility in government or tax rates to produce at one time the change in the FEBS in one direction and at another time the change in the opposite direction that may be required to meet the needs of the situation? The decision making process in the area of fiscal policy involves the government.
The political motivation is obviously of an altogether different kind. Decisions in the fiscal policy area involve higher tax rates, are not made without allowance for the electorates in many developing countries for the next election. Apart from the political bias, a certain maneuverability follows that the decision making power in the fiscal area does not rest in the hands of a few. In addition to what has been discussed flexibility in fiscal policy may be an in- built flexibility or flexibility through discretionary action.
Finally flexibility in fiscal policy may be applied to adjust government spending and taxes with the degree that may be needed, if those adjustments are to be useful in combating the cyclical fluctuations in the economy.
The writer is former Director General of EPB. He can be contacted at hassan.youngconsultants@gmail.com
