Fiscal Policy

Meaning and Nature of Fiscal Policy

In economics and political science, fiscal policy is the use of government revenue collection (taxation) and expenditure (spending) to influence the economy.[1] The two main instruments of fiscal policy are changes in the level and composition of taxation and government spending in various sectors. These changes can affect the following macroeconomic variables in an economy: o Aggregate demand and the level of economic activity; o The distribution of income; o The pattern of resource allocation within the government sector and relative to the private sector.

Definition of 'Fiscal Policy' Fiscal policy is a policy of public revenue and public expenditure and allied matters thereof. Budget is an important instrument used to describe fiscal policies of the government and the financial plans corresponding to them. The government intervenes in an economy through the instruments of fiscal policy. Government spending policies that influence macroeconomic conditions. Through fiscal policy, regulators attempt to improve unemployment rates, control inflation, stabilize business cycles and influence interest rates in an effort to control the economy. Fiscal policy is largely based on the ideas of British economist John Maynard Keynes (18831946), who believed governments could change economic performance by adjusting tax rates and government spending. Fiscal policy is the use of government spending and taxation to influence the economy. When the government decides on the goods and services it purchases, the transfer payments it distributes, or the taxes it collects, it is engaging in fiscal policy. The primary economic impact of any change in the government budget is felt by particular groups--a tax cut for families with children, for example, raises their disposable income. Discussions of fiscal policy, however, generally focus on the effect of changes in the government budget on the overall economy. Although changes in taxes or spending that are "revenue neutral" may be construed as fiscal policy--and may affect the aggregate level of output by changing the incentives that firms or individuals face--the term "fiscal policy" is usually used to describe the effect on the aggregate economy of the overall levels of spending and taxation, and more particularly, the gap between them.

Nature of fiscal policy

NATURE AND TECHNIQUES The nature of fiscal policy may be either Expansionary or Contractionary.

Expansionary Fiscal Policy . Expansionary fiscal policy increases the AD of the economy. It increases the level of production, and hence the level of employment. It eliminates the recessionary gap existing in the economy.It should be noted that recessionary gap occurs when the equilibrium real GDP is less than the potential real GDP of the country. In this situation, unemployment is greater than natural rate of unemployment. It can be explained with the help of following diagram:

In figure (b), the short-run aggregate supply (SRAS) curve and AD curve are intersecting to each other at point E1 so that the equilibrium price level is OP1 and equilibrium real GDP is OQ1. Here, OQ2 is the potential GDP. It should be noted that potential real GDP refers to the economys full employment level of real GDP. As here the economys equilibrium real GDP is less than the potential real GDP, there is recessionary gap. Recessionary gap is also known as deflationary gap. Fiscal policy can be used to eliminate the recessionary gap. For this, AD should be increased. To increase AD: Government spending should be increased Personal income taxes and business taxes should be reduced

Each of the above actions shift the AD curve from AD1 to AD2 so that economy achieves the potential real GDP as follows:

Contractionary Fiscal Policy . Contractionary fiscal policy reduces the AD of the economy. It reduces the level of production, and hence the level of employment. It eliminates the inflationary gap existing in the economy. It should be noted that inflationary gap occurs when the equilibrium real GDP is greater than potential real GDP. In this situation, unemployment is lower than the natural rate of unemployment. It can be explained with the help of following diagram:

Here, equilibrium is established at point E1 ,where there is the intersection between the SRAS curve and AD curve so that equilibrium price level is OP1 and equilibrium real GDP is OQ1.As here equilibrium real GDP is greater than potential real GDP, which is equal to OQ , there is inflationary gap. The fiscal policy can be used to eliminate the inflationary gap. For this: Government spending should be reduced Personal income taxes and business taxes should be increased

Each of the above actions shift the AD curve from AD1 to AD2 so that the economy produces the potential real GDP as follows:

 Objectives of Fiscal Policy

1. DEVELOPMENT BY EFFECTIVE MOBILISATION 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 the state governments in India have used fiscal policy to mobilise resources. The financial resources can be mobilised 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 mobilised 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 mobilised through government borrowings by ways of treasury bills, issue of government bonds, etc., loans from domestic and foreign parties and by deficit financing.

2. EFFICIENT ALLOCATION OF FINANCIAL RESOURCES The central and state governments have tried to make efficient allocation of financial resources. These resources are allocated for Development Activities which includes expenditure on railways, infrastructure, etc. While Non-development Activities includes expenditure on defence, interest payments, subsidies, etc. But generally the fiscal policy should ensure that the resources are allocated for generation of goods and services which are socially desirable. Therefore, India's fiscal policy is designed in such a manner so as to encourage production of desirable goods and discourage those goods which are socially undesirable.

3. 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 semiluxury 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.

4. PRICE STABILITY AND CONTROL OF INFLATION One of the main objective 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.

5. EMPLOYMENT GENERATION The government is making every possible effort to increase employment in the country through effective fiscal measure. 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 generates 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.

6. BALANCED REGIONAL DEVELOPMENT Another main objective of the fiscal policy is to bring about a balanced regional development. There are various incentives from the government for setting up projects in backward areas such as Cash subsidy, Concession in taxes and duties in the form of tax holidays, Finance at concessional interest rates, etc.

7. REDUCING THE DEFICIT IN THE BALANCE OF PAYMENT Fiscal policy attempts to encourage more exports by way of fiscal measures like Exemption of income tax on export earnings, Exemption of central excise duties and customs, Exemption of sales tax and octroi, etc. The foreign exchange is also conserved by Providing fiscal benefits to import substitute industries, Imposing customs duties on imports, etc. The foreign exchange earned by way of exports and saved by way of import substitutes helps to solve balance of payments problem. In this way adverse balance of payment can be corrected either by imposing duties on imports or by giving subsidies to export.

8. CAPITAL FORMATION The objective of fiscal policy in India is also to increase the rate of capital formation so as to accelerate the rate of economic growth. An underdeveloped country is trapped in vicious (danger) circle of poverty mainly on account of capital deficiency. In order to increase the rate of capital formation, the fiscal policy must be efficiently designed to encourage savings and discourage and reduce spending.

9. INCREASING NATIONAL INCOME The fiscal policy aims to increase the national income of a country. This is because fiscal policy facilitates the capital formation. This results in economic growth, which in turn increases the GDP, per capita income and national income of the country.

10. DEVELOPMENT OF INFRASTRUCTURE Government has placed emphasis on the infrastructure development for the purpose of achieving economic growth. The fiscal policy measure such as taxation generates revenue to the government. A part of the government's revenue is invested in the infrastructure development. Due to this, all sectors of the economy get a boost.

11. FOREIGN EXCHANGE EARNINGS Fiscal policy attempts to encourage more exports by way of Fiscal Measures like, exemption of income tax on export earnings, exemption of sales tax and octroi, etc. Foreign exchange provides fiscal benefits to import substitute industries. The foreign exchange earned by way of exports and saved by way of import substitutes helps to solve balance of payments problem.

 Instruments and tools of Fiscal Policy

Governments use instruments of fiscal policy to try and control local, national and even international economies. Instruments of Fiscal Policy which is adopted by the govt. of any country to influence the govt. expenditures, taxes, and govt. borrowings etc., for the purpose of economic stabilization and economic development. Thus it means that fiscal policy can be exercised by the governments of the respective countries with the help of govt. expenditures, and govt. revenues so that the objectives of stability and growth could be attained. The fiscal policy has the instruments of govt. expenditures, taxes (direct as well as indirect), govt. borrowings (borrowings from public, borrowings from nonbank public and borrowings from external sources), and printing of new notes. Budgetary balance policy- keeping budget in balance, in surplus or in deficit is in itself a fiscal instrument .When te government keeps its total expenditure equal to its revenue ,as a matter of policy,it means it has adopted a balanced budget policy.ie. Government's estimated Revenue = Government's proposed Expenditure. When the government spends more than its expected revenue ,as a matter of policy, it is pursuing a deficit budget policy.ie Government's estimated Revenue < Government's proposed Expenditure. Such deficit amount is generally covered through public borrowings or withdrawing resources from the accumulated reserve surplus. In a way a deficit budget is a liability of the government as it creates a burden of debt or it reduces the stock of reserves of the government.In developing countries like India, where huge resources are needed for the purpose of economic growth & development it is not possible to raise such resources through taxation, deficit budgeting is the only option. And when the governments follow a policy of keeping its expenditure substantially below its current revenue,it is following a surplus budget policy . ie. Government expected revenue > Government proposed Expenditure. Surplus budget shows the financial soundness of the government. When there is too much inflation, the government can adopt the policy of surplus budget as it will reduce aggregate demand. Increase in revenue by levying taxes on people reduces their disposable incomes, which otherwise could have been spend on consumption or saved and devoted to capital formation. Since government spending will be less than its income, aggregate demand will decrease and help to reduce the price level. However, in modern times, when governments have so many social economic & political responsibilities it is virtually

impossible to have a surplus budget Balanced, Deficit and Surplus budgets affect the economy in different ways and in different directions.

Government expenditure- The government expenditure includes total public spending on purchase of goods and services, payment of wages, and salaries of public servants, public investment , transfer payments (eg; pensions .subsidies, unemployment allowance ,grants ,and aid ,payments of interest, and amortization of loans).Given the expendable resources of the government, the size and the composition of government expenditure is s matter of government discretion. the government expenditure is an injection into the economy: it adds to the aggregate demand . Government spending has been found to be an important determinant of growth for many countries. It can affect growth through a number of channels by improving the quality of human capital, improving infrastructure in the country, or it could even hurt the economy by promoting corruption and large, inefficient bureaucracies. The overall effect of government expenditure on the economy depends on how it is financed and its multiplier effect.

Taxation- a tax is a non quid pr quo payment by the people to the government. By this definition ,taxation means non quid pro quo transfer of private income to public coffers by means of taxes .Taxes is classified as direct taxes and indirect taxes. Direct taxes include taxes on personal incomes, corporate incomes, wealth and property. Personal income tax contributed 17.0 % and corporate income tax 21.3 5 of the gross tax revenue.indirect taxes include taxes on production and sale of the goods and the services. Indirect taxes are also called commodity taxes. The two most important central indirect taxes are excise yielded 38.1 % and customs 20.7% of the gross tax revenue.Thus in order to promote the work effort, savings and investment in most of the developing countries the income tax is imposed with great care. Taxation has an effect on the Pattern of Demand ie. Changes to indirect taxes can alter the pattern of demand for goods and services. For example, the rising value of duty on cigarettes and alcohol is designed to cause a substitution effect and reduce the demand for what are perceived as de-merit goods. Taxation also has an effect on work incentives: Changes to the tax and benefit system seek to reduce the risk of the poverty trap where households on low incomes see little financial benefit from supplying extra hours of their labor.

Public borrowing it includes both internal and external borrowings .the government make borrowing, generally, with a view to finance their budget deficits. Internal borrowings are of two types (i) borrowing from the public by the means of government bonds and treasury bills., and (ii) borrowings from the central bank , i.e. , deficit financing.

The two types of borrowings have different effects on the economy. Borrowings from the public to finance budget deficit is ,in effect, simply a transfer of purchasing power from the public to the government ,whereas borrowings from the central bank for financing budget deficits , i.e. ,monetized deficit financing ,is straightway borrowings from (a) foreign governments (b) international organizations like world bank and IMF , and (c) market borrowings .It has the same effect on the economy as deficit financing.

Public borrowing also helps in curbing inflation and seize away the excessive and unnecessary purchasing power from the public during an inflationary period.However, when even that is exhausted to an extent then the government borrows from the Reserve Bank Of India when it wants to meet the remaining part of deficit in the budget and thus it is also known as deficit financing. Deficit financing helps the government meet their resource crunch expeditiously and also the interest that the government pays back to the RBI upon returning those borrowings actually come back to them in the form of profits so it is a beneficial tool for the government. However, deficit financing involves printing of new currency through RBI to give to the government and that leads to infusion of excess money supply into the market through government activities leading to money getting concentrated in the hands of a few who can afford and thus consumption increases leading to less supply and so prices rise which in short is inflation. Therefore deficit financing leads to inflation. Thus , Fiscal policy tools impact the domestic economy but tariffs are tools that can impact the economy in other nations. Tariffs are usually imposed on imported goods, and as tariffs rise the cost of buying overseas goods rises. Foreign producers either have to raise prices to cover the cost of these taxes or eliminate other expenses. If these firms raise prices then the tariffs have created inflation but if these firms cut costs then the tariffs may result in job losses overseas. Therefore, tariffs are among the fiscal policy tools that have the most far-reaching impact.

 Fiscal Policy 2011-12 in India

Global economic situation during 2008-09 and 2009-10 impacted the performance of emerging market economies and India was no exception. The swift revival during 2010-11, wherein Indian economy grew at 8.4 per cent on the base of similar growth in2009-10, showed that resilience of Indian economy in steering through difficult international scenarios have further improved. However, continuance of the financial crisis in Euro Zone coupled with exogenous shocks like increase in the international crude prices brought out the vulnerability of Indian economy towards global events back to the forefront. Growth in Indian economy is estimated to moderate to 6.9 per cent in 2011-12 as against the earlier estimate of 9 per cent at the time of presentation of Budget 2011-12.

Fiscal Policy In India

In India, fiscal policy plays a multi-dimentional role. The role of fiscal policy consist the following: Creating and sustaining the country by providing public services and by undertaking public investments. Reallocating resources according to the national priorities. Redistributing income and wealth in favour of poorer sections of the society. Promoting private savings and investment. Maintaining stability in the country Improving growth of the country and ensuring social justice to people.

FISCAL POLICY FOR 2011-12

The fiscal policy of 2011-12 has been calibrated with two fold objectives first, to aid economy in growth revival; and second, to bring down the deficit from 2010-11 level so as to leave space for private sector credit as the investment cycle picks up. Being the first year of the 12th Five Year Plan, an ambitious outlay which is 22.1 per cent higher than RE 2010-11 has been provided. Even with higher increase in plan allocation, fiscal deficit has been reduced from 5.9 per cent of GDP in RE 2010-11 to 5.1 per cent in BE 2011-12. With policy measures, it is estimated that non-plan expenditure could be controlled with a growth of 8.7 per cent in BE 2011-12 over RE 2010-11. This would result in overall expenditure increase of 13.1 percent in BE 2011-12 over RE 2010-11. As percentage of GDP, total expenditure is estimated to marginally reduce to 14.7 per cent in BE 2011-12 from 14.8 per cent in RE 2010-11.

Thus most of the correction in fiscal deficit has been targeted through revenue augmentation. It may be recalled that gross tax revenue as percentage of GDP declined sharply from high of 11.9 per cent in 2007-08 to 9.7 per cent in 2009-10. It is now estimated to increase from 10.1 per cent of GDP in RE 2011-12 to 10.6 per cent in BE 2011-12 (reflecting growth of 19.6 per cent over RE 2010-11). This level of growth may look ambitious if seen in isolation. However, , after netting off the impact of additional resource mobilization proposed in indirect taxes, BE 2011-12 is estimated at a growth of 15.0 per cent over RE 2011-12. netting off the impact of additional resource mobilization proposed in indirect taxes, BE 2011-12 is estimated at a growth of 15.0 per cent over RE 2010-11. In order to keep the overall expenditure under the estimated level, government has taken certain decisions to control the growth of expenditure in subsidies and other related items. Decision of the Government on move towards nutrient based subsidy (NBS) regime in fertiliser is expected to reduce expenditure on this component of fertilser subsidy during 2010-11. At the same time, NBS regime is also expected to promote balanced use of fertilize leading to increase in agricultural productivity. With respect to rationalization of petroleum subsidy, government has already decontrolled the pricing of petrol. With the help of AADHAAR (unique identity programme), it would be possible to attempt a direct cash transfer mechanism in phased manner for LPG and kerosene which in turn may reduce the subsidy requirement. States have been given this option to opt for direct cash transfer mechanism. Though in principle decision regarding decontrol of diesel price has been taken, the implementation of this decision has not yet not taken place in view of prevailing high international prices. Tax Policy During the fiscal consolidation period, the tax-GDP ratio improved significantly from 9.2 per cent in 2003-04 to 11.9 per cent in 2007-08. This was achieved through rationalisation of the tax structure (moderate levels and a few rates), widening of the tax base and reduction in compliance costs through improvement in tax administration. The extensiveadoption of information technology solutions and re-engineering of business processes have also fostered a less intrusive tax system and encouraged voluntary compliance. These measures have resulted in increased buoyancy in tax revenues till 2007-08 and helped in fiscal consolidation. However, due to the stimulus measures undertaken during the crisis period of 2008-09 and 2009-10 to insulate Indian economy from the adverse impact of global economic crisis and lower growth in economy, the gross tax revenue as percentage of GDP declined sharply to 9.7 per cent in 2009-10. On the positive side, however, the results of these stimulus measures have helped in swift and broad based recovery, particularly in manufacturing and services sector during 2010-11. With the moderation in growth in 2011-12 and prevailing high inflation situation, government had to further reduce taxes/duty on petroleum products. During 2011-12, gross tax receipts as

percentage of GDP is estimated to decline to 10.1 per cent from 10.3 per cent in 2010-11. However, with partial roll back of stimulus measures in indirect taxes, it is estimated that tax receipt as percentage of GDP would improve to 10.6 per cent.

Indirect taxes In keeping with the overall thrust of fiscal policy, in the realm of indirect taxes too, the stance during2012-13 would be in favour of further fiscal consolidation. This agrees with the medium term objective of enhancing the tax-GDP ratio both through base expansion as well as administrative improvement. Among the latter, the emphasis is on more intense deployment of Information Technology in business processes so that physical interface between the taxpayer and the Department is reduced and return data critical for developing compliance strategies and interventions is captured and updated seamlessly. In the medium term, the most significant step from the point of view of broadening the tax base and improving revenue efficiency through better compliance is the introduction of Goods and Services Tax (GST). As far as Central taxes viz. Central Excise duties and Service Tax are concerned, a fair amount of integration has already been achieved, especially through the crossflow of credits across the two taxes. Further measures such as adoption of a common return format are proposed in the Budget. It would be possible to realise full integration of the taxation of goods and services only when the State VAT is also subsumed and a full-fledged GST is launched. The Constitution Amendment Bill to put in place the enabling legal framework has already been introduced in the Lok Sabha and is currently being examined by the Standing Committee on Finance. In the meanwhile, the dialogue with the State Governments for finalizing the structure, design and roadmap for the implementation of GST would continue. There are several specific proposals in the Budget 2011-12 to recalibrate the tax effort on indirect taxes so that fiscal consolidation may be achieved in the short term. The important and revenue significant proposals include: Shift from a positive list approach to a negative list approach in the taxation of services review and withdrawal of several exemptions from service tax; Enhancement in the standard rate of Service Tax from 10% to 12% Increase in the standard rate of excise duty from 10% to 12% by way of partial roll back of the fiscal stimulus (provided in 2008-09); Increase in the merit rate of excise duty from 5% to 6% and lower merit rate from 1% to2% (except coal, fertilisers and precious metal jewellery); Increase in excise duty on cars both small and large, MUVs, SUVs etc.

Increase in excise duty on demerit goods such as cigarettes, bidis, and other tobacco products Rationalisation of the scheme of levy/ rate structure applicable to precious metal jewellery and chassis for automobiles Increase in the rate of cess on indigenously produced crude petroleum from 2500 per tonne to 4500 per tonne. Measures proposed to contain the Current Account Deficit such as enhancement in customs duty on standard gold bars and platinum bars from 2% to 4% may also have a favourable impact on revenue collections in the immediate future

Direct Taxes The policy in the case of direct taxes has been to achieve growth while maintaining moderate rates of tax. To this end, the initiative has been to reduce the tax revenue foregone on account of exemptions and deductions. This has been attempted primarily through the gradual phase out of profit linked deductions and the levy of Minimum Alternate Tax (MAT) on all companies to ensure a minimum level of tax contribution by all sectors. The other aspect of this policy has been to use information technology to widen the reported tax base, e.g., electronic filing of annual information returns regarding third party transactions, in order to ensure the reporting of major financial transactions for tax purposes. Electronic filing of income tax returns and tax deduction at source statements as well as e-payment of taxes is also a part of this strategy in order to more effectively monitor taxpayer compliance, besides reducing the compliance burden of tax payers The current direct tax legislation is proposed to be simplified and consolidated through the Direct Taxes Code Bill 2010 which was introduced in Parliament in August 2010.

 Fiscal Imbalance and Deficit Finance

Fiscal imbalance Fiscal imbalance is a mismatch in the revenue powers and expenditure responsibilities of a government. In the literature on fiscal federalism, two types of fiscal imbalances are measured: Vertical Fiscal Imbalance and Horizontal Fiscal Imbalance. When the fiscal imbalance is measured between the two levels of government (Center and States or Provinces) it is called Vertical Fiscal Imbalance. When the fiscal imbalance is measured between the governments at the same level it is called Horizontal Fiscal imbalance. This imbalance is also known as regional disparity. While Horizontal Fiscal Imbalance requires equalization transfers, Vertical Fiscal Imbalance is a structural issue and thus needs to be corrected by re-assignment of revenue and expenditure responsibilities between the two senior order of the governments. Horizontal Fiscal Imbalances A horizontal imbalance describes a situation where revenues do not match expenditures for different regions of the country. Vertical Fiscal Imbalance A vertical fiscal imbalance describes a situation where revenues do not match expenditures for different levels of government

Deficit Finance
Deficit financing, practice in which a government spends more money than it receives as revenue, the difference being made up by borrowing or minting new funds. Although budget deficits may occur for numerous reasons, the term usually refers to a conscious attempt to stimulate the economy by lowering tax rates or increasing government expenditures. The influence of government deficits upon a national economy may be very great. It is widely believed that a budget balanced over the span of a business cycle should replace the old ideal of an annually balanced budget. Some economists have abandoned the balanced budget concept entirely, considering it inadequate as a criterion of public policy.

Deficit financing, however, may also result from government inefficiency, reflecting widespread tax evasion or wasteful spending rather than the operation of a planned countercyclical policy. Where capital markets are undeveloped, deficit financing may place the government in debt to foreign creditors. In addition, in many less-developed countries, budget surpluses may be desirable in themselves as a way of encouraging private saving.