INTRODUCTION

One major function of the government is to stabilize

the economy (prevent unemployment or inflation) Stabilization can be achieved in part by manipulating the public budget-government spending and tax collections-to increase output and employment or to reduce inflation.

FISCAL POLICY CHOICES

1. Expansionary fiscal policy: used to combat a recession.

2. Contractionary fiscal policy: used to combat demand-pull inflation, due to excess spending.

EXPANSIONARY FISCAL POLICY

Expansionary Policy needed: a decline in investment has decreased AD, so real GDP has fallen, and also employment has declined. A possible fiscal solution may be: a. An increase in government spending, which shifts AD to the right by more than the change in G, due to the multiplier. b. A decrease in taxes (raises income, and consumption rises by MPC times the change in income). AD shifts to the right by a multiple of the change in consumption. c. A combination of increased G spending and reduced taxes. d. If the budget was initially balanced, expansionary fiscal policy creates a budget deficit.

CONTRACTIONARY FISCAL POLICY

Contractionary Policy needed: When demand-pull inflation occurs, a shift of AD to the right in the vertical range of AS, then contractionary policy is the remedy. a. A decrease in G spending shifts AD back left, once the multiplier process is complete. Here price level returns to its pre-inflationary level, but GDP remains at full-employment level. b. An increase in taxes will reduce income, and then consumption at first by the MPC times the decrease in income, and then the multiplier process leads AD to shift leftward still further. c. A combined G spending decrease and tax increase could have the same effect with the right combination. d. If the budget was initially balanced, a contractionary fiscal policy creates a budget surplus.

FISCAL INSTRUMENTS

Taxation

Public expenditure

PRINCIPLES OF TAXATION
Benefit principle Individuals are taxed in the proportion of benefits the receive Ability to pay Individuals pay tax according to their capacity Horizontal and vertical equity

FORMS OF TAXES
Progressive tax Higher the level of income greater will be tax burden Regressive tax Lower income class are imposed with higher taxes as a proportion of income Proportional tax Tax imposed as a proportion of income irrespective of level of income

Fiscal Balance Sheet

A. Receipts
A1. Revenue Receipts
1) Tax-Receipts 2) Non-Tax Receipts
a) Interest Earnings b) Non Interest Earnings

B. Disbursements
B1. Revenue Expenditure
1) Interest Expenditure 2) Non-Interest Expenditure

A2. Capital receipts

3) Recovery of loans 4) Other receipts 5) Borrowings and other liabilities c) Foreign Borrowings d) Domestic Borrowings
i) Other than 91-Day Treasury Bills ii) 91-Day Treasury Bills

B2. Capital Disbursements

3) Capital Expenditure

4) Net Domestic Lending

iii) Cash Balance

GOVERNMENT REVENUE AND EXPENDITURE

Budget deficit
Difference between Total Receipts and Total

Expenditure (revenue receipts + grants + foreign borrowings + domestic borrowings excluding 91 day treasury bills) - (revenue expenditure + capital expenditure + net domestic lending)

GOVERNMENT REVENUE AND EXPENDITURE

Revenue deficit
Difference between Revenue Receipts and Revenue

Expenditure and

GOVERNMENT REVENUE AND EXPENDITURE

Fiscal deficit
Difference between Total Expenditure and Revenue

Receipts excluding Govt. borrowings

Fiscal Deficit revenue expenditure + capital expenditure + net domestic lending - (revenue receipts + other receipts + recovery of loans)

GOVERNMENT REVENUE AND EXPENDITURE

Primary deficit
Fiscal Deficit excluding Interest Payment of the

Govt.

Primary Deficits Fiscal deficit earnings)

(interest

payments-interest

FINANCING DEFICITS
The method used to finance deficits or dispose of surpluses influences fiscal policy: A. Financing deficits can be done 2 ways: 1. Borrowing: (crowding out effect) The government competes with private borrowers for funds, and could drive up interest rates; the government may crowd out private borrowing, and this offsets the government expansion. 2. Money Creation: When the RBI Reserve loans directly to the government by buying bonds, the expansionary effect is greater since private investors are not buying bonds. (Monetarists argue that this is monetary, not fiscal, policy that is having the expansionary effect in this situation).

DISPOSING OF SURPLUSES
B. Disposing of surpluses can be done in 2 ways:

1. Debt reduction is good, but may cause interest rates to fall and stimulate spending, which could then be inflationary. 2. Impounding or letting the surplus funds remain idle would have greater anti-inflationary impact. The government holds surplus tax revenues which keeps these funds from being spent.

FISCAL POLICY

Discretionary policy

Non-Discretionary Policy

To cure Recession

To Control Inflation

Personal Income taxes

Increase in Govt Expenditure

Raising Taxes to Control Inflation

Transfer Payments

Reduction of taxes

Disposing of Budget Surplus

Corporate Income taxes

Corporate Dividend policy