What is Fiscal Policy?

Learn about Fiscal Policy, including its Meaning of Fiscal Policy, Instruments of Fiscal Policy, Tools of Fiscal Policy, and real-world Examples of Fiscal Policy, to understand its role in economic management.

Fiscal policy, which refers to the use of government spending and taxation to impact the economy, is an important component of economic management. Governments need it to handle economic issues and accomplish macroeconomic goals including lowering unemployment, fostering growth, and containing inflation. In this article, we’ll explore what fiscal policy is, why it’s important, and give instances of when it’s been utilised well. This article will provide you with a thorough introduction to fiscal policy, whether you’re an economist, a policymaker, or just curious about how the economy functions.

What is a Fiscal Policy?

The use of taxation and spending by the government to affect the economy is referred to as fiscal policy. It is a crucial instrument for governments to use in achieving macroeconomic objectives including job growth, inflation control, and unemployment reduction. Fiscal policy works by changing the economy’s total demand, which therefore has an impact on the level of economic activity. To accomplish its desired economic results, the government can either raise or decrease spending and/or change tax rates.

This is accomplished via a range of policy tools, such as adjustments to transfer payments, tax rates, and government spending. The timing of implementation, the scope of the policy response, and the health of the economy are only a few of the variables that affect how effective fiscal policy is. 

Meaning of Fiscal Policy

• Government strategy for managing its budget to influence the economy.
• Balances taxation and government spending to achieve economic goals.

Tools of Fiscal Policy

• Taxation: Adjusting tax rates to influence economic activity.
• Government Spending: Directing funds to sectors needing growth or support.

Examples of Fiscal Policy

There are several examples of fiscal policy in action, including:

• Transfer Payments: When times are tough economically, governments may raise transfer payments like unemployment benefits to help households. This can keep consumers from cutting back on their spending and keep the economy from getting worse.
• Deficit Spending: The government may occasionally participate in deficit spending, which is when it spends more money than it brings in through taxes. The economy may benefit from this, but it may also result in an increase in government debt, which could have long-term repercussions.
• Tax Incentives: To promote investment and the creation of jobs, governments may provide tax incentives, such as tax reductions for companies that invest in R&D.
• Increased Government Spending: The government may raise its spending on public works initiatives, such as infrastructure repairs, to stimulate the economy during a recession in order to generate jobs and increase consumer confidence.
• Tax Cuts: The government may lower tax rates in times of weak economic development in an effort to boost investment and consumer spending. This in turn may encourage economic expansion.

Changing Tax Rates

• A method to either stimulate spending and investment or cool down an overheated economy.
• Influences consumer behavior and business investments.

How does Fiscal Policy Work?

Taxes and spending are the two main instruments used in fiscal policy. Assume that the economy is operating at a very slow pace. This suggests that people are not investing money to purchase goods. Now, try to comprehend why consumers are not making product demands. The government will reduce taxes in order to put more money in the hands of the populace. People will have more money to spend on other goods and services. The number of work opportunities will rise as a result of this rising demand.

All of these factors will ultimately benefit the economy in a beneficial way. However, if citizens are overspending, the government will raise taxes, which will in turn limit consumer demand and help the economy get back on track. The most important thing is to strike the ideal balance while keeping the economy at the forefront.

Instruments of Fiscal Policy

• Primarily includes taxation and government expenditure.
• Used to control inflation, stimulate growth, and reduce unemployment.

Objectives of Fiscal Policy

Fiscal policy is the use of taxation and spending by the government to affect a nation’s level of economic activity. Governments employ fiscal policy to accomplish a number of economic goals, such as:

Infrastructure Development

• In order to achieve economic growth, the government has prioritized infrastructure construction. Taxation and other fiscal policy initiatives bring in money for the state. The development of the infrastructure is funded in part by tax money. All economic sectors benefit as a result of this.

Decreasing the payment deficit

• Fiscal measures like the exclusion of income tax on export revenues, the exclusion of central excise charges and customs, the exclusion of sales tax and octroi, etc. are all attempts by fiscal policy to increase exports.
• The balance of payments problem is helped by the foreign exchange saved through import substitutes and earned through exports. In this method, a negative balance of payments can be fixed by taxing imports or by subsidizing exports.

Effective Regional Development

• Balanced regional development is one of the fiscal policy’s other primary goals. The government offers a variety of incentives for establishing projects in underdeveloped areas, including cash subsidies, Tax holidays are a type of tax and duty concession. financing with lowered interest rates, etc.

Price Stability and Control of Inflation

• Controlling inflation and maintaining price stability is one of the fiscal policy’s primary goals. As a result, the government always strives to keep inflation under control through the reduction of fiscal deficits, the introduction of tax savings plans, the efficient use of financial resources, etc.

Taxation in Fiscal Policy

• Adjusting tax rates to manage the economy’s demand side.
• Can be used to discourage negative externalities or encourage positive behavior.

Why is Fiscal Policy Necessary?

Governments need a fiscal policy because it gives them the power to affect the level of economic activity in a nation. It is one of the key strategies employed by governments to maintain economic stability and achieve their goals. There are several reasons why fiscal policy is necessary:

• In periods of recession or poor growth, fiscal policy can be utilized to boost the economy. To encourage consumer spending and investment, for instance, a government can raise spending or lower taxes. This can assist in boosting economic activity and rescuing a struggling economy.
• Inflation can be decreased by fiscal policy. Prices can increase quickly if an economy is expanding too quickly and there is an excessive amount of demand for goods and services. A government may raise taxes or cut spending in order to slow down economic growth and lower inflation.
• It enables governments to pay for the services and programs they offer their populations. Governments rely on tax money to pay for things like infrastructure, healthcare, and education. Governments can make sure they have the funds available to deliver these services by altering their budgetary policies.

Check: Difference between Primary Deficit and Fiscal Deficit

Types of Fiscal Policy

There are two main types of fiscal policy:

• Expansionary fiscal policy
• Contractionary fiscal policy

Expansionary Fiscal Policy

Expansionary fiscal policy refers to measures taken to increase demand and economic growth by lowering taxes or increasing government spending. In order to increase demand and encourage economic activity, these policies are generally used during periods of economic recession or slowdown.

Governments can execute expansionary fiscal policy in a number of ways:

• Increase government spending: Spending increases by governments are possible in a number of areas, including infrastructure, education, and defence. This can boost the economy’s demand and generate jobs.
• Reduce taxes: To boost disposable income and promote spending, governments might lower taxes on individuals or corporations. This could increase demand and promote economic expansion.
• Implement transfer payments: Transfer payments, like social security or unemployment benefits, which put money in the hands of those who are likely to spend it, are another way for governments to boost demand.

It is important to keep in mind that an expansionary fiscal policy may result in higher budget deficits since the government is spending more than it is bringing in through taxes. This could be a problem if the deficit grows too large since it could result in higher levels of government debt.

Contractionary

In order to lower demand and moderate the economy, methods known as contractionary fiscal policy involve raising taxes or cutting back on spending by the government. These measures are often employed to lower demand and prevent economic overheating during periods of inflation or economic boom.

Governments can adopt a contractionary fiscal policy in a number of ways:

• Reduce government spending: Governments have the option of reducing their expenditures on a range of products and services, including infrastructure, training, and defence. This might lower economic demand.
• Tax increases: Governments can raise taxes on citizens or corporations to reduce disposable income and deter expenditure. This can lower demand and cause a slowdown in the economy.
• Implement austerity measures: Governments can also enact austerity measures to lower spending and demand, such as reducing social safety programs.

In light of the fact that the government is collecting more money in tax receipts than it is spending, it is important to note that contractionary fiscal policy can result in lower budget deficits or even budget surpluses. However, as it decreases demand in the economy, contractionary fiscal policy can also cause a slowdown or recession.

Check: Difference between Fiscal Deficit and Revenue Deficit

Economic Influence of Fiscal Policy

• Directly impacts economic growth, inflation rates, and employment levels.
• Shapes the overall economic environment and stability.

Components of Fiscal Policy

The components of the policy are categorized as.

• Government receipts
• Government expenditures 
• Public account of India  

Government Receipts

Government receipts are any funds received by the government in the form of interest, taxes, investment gains, and other payments for rendered services. It is the overall sum of money that the various sources of government send forth. However, their income enables them to invest in other industries. Capital receipts and Revenue receipts are the two categories into which the government’s receipts are divided. Capital receipts are government payments that increase liabilities or decrease assets. Revenue receipts are sums received by the government that neither decrease assets nor increase liabilities.

1. Capital receipts: A government receives money for operating expenses in a variety of ways, which are referred to as capital receipts. The ways might be forced to liquidate its assets or take on debt to the government. However, capital inflows are also referred to as incoming cash flows.

As the governing bodies pay back the money and interest, all loans and borrowings are regarded as debt receipts.

2. Revenue receipts: Revenue receipts are those that neither increase assets nor decrease obligations. It is separated into tax and non-tax forms, respectively. Direct and indirect taxes make up the two different categories of tax revenue. Cess, interest, dividends on government investments, and other receipts are included in the non-tax revenues.

Government Expenditures

Revenue expenditure and capital expenditure are the two divisions of government spending.

1. Revenue expenditures: Revenue expenditures are one-year, short-term spending. It includes the costs necessary to cover the government’s operating expenses. It also covers routine maintenance and repairs, which are necessary to keep assets functional without extending their useful lives.

2. Capital expenditures: Investments made by governing bodies to grow their operations and bring in more money are referred to as capital expenditures. These include investing in long-term assets with a shelf life of at least a year.

Frequently, such costs can be covered by purchasing fixed assets like machinery. Examples include company acquisitions, manufacturing equipment, furniture, etc.

India’s open account

In the Public Account of India, flows for transactions in which the government acts as a banker are included. According to Article 266 of the Indian Constitution, it was established. Small savings, provident funds, and other examples of public accounts are available in India. The government requests a return of this money to their owners on a periodic basis; they are not its property. Therefore, the Parliament is not required to approve any expenditures made from the public account.

Altering Government Spending

• Adjustments in government expenditure to target specific economic issues.
• Can be increased to combat recession or decreased to control inflation.

Fiscal Policy and Business Effects

• Influences business environment through tax incentives, subsidies, and public investment.
• Can determine business costs, opportunities, and economic climate.

How Does Fiscal Policy Affect People?

People can be impacted by fiscal policy in a variety of ways. Changes in tax law are one way that fiscal policy can have an impact on people. If the government raises taxes, people and companies could have less money available to spend, which could limit economic growth. On the other hand, if the government lowers taxes, people and businesses might have more money that they can spend, which could promote economic expansion.

Changes in government spending can have an influence on people as a result of changes in fiscal policy. If the government increases spending on services or programs like healthcare or education, the people who use these programs may immediately benefit. However, if the government makes cuts to its spending on programs or services, those whose lives depend on them may suffer.

Finally, the impact of fiscal policy on the whole economy can have an impact on people. Increased employment possibilities and greater earnings for workers may result from fiscal policy’s success in encouraging economic growth and stabilizing the economy. However, ineffective fiscal policy may result in slower growth and economic instability, which could have a detrimental impact on individuals.

Government Spending and Fiscal Policy

• Involves investment in public services, infrastructure, and welfare.
• Aims to stimulate economic activity and ensure public well-being.

Government Transfers

• Redistribution of income through welfare programs.
• Supports vulnerable populations and can stimulate economic activity.

Who Handles Fiscal Policy?

Fiscal policy is created and carried out by the government in the majority of nations. This can occur at the national level, when the federal government is in charge of formulating fiscal policy, or at the regional or municipal level, where those governments have some discretion in doing so.

The finance ministry or the treasury department often oversees fiscal policies at the federal level. These organizations are in charge of handling the budget and revenue of the government, as well as choosing how to distribute cash and modify fiscal policy. In some nations, fiscal policy may also be developed and coordinated by a different organization or council.

A municipal council, a state or provincial government, or other local governmental organizations may be in charge of fiscal policy at the regional or local level. These governments may have a certain amount of independence in deciding on fiscal policy, but they may also be subject to directives or restrictions from the federal government.

Fiscal Policy for Strong Economy

• Balances short-term interventions with long-term economic health.
• Aims for stability, growth, and equitable distribution of wealth.

Act on Financial Responsibility and Budget Management (FRBM)

The Fiscal Responsibility and Budget Management (FRBM) Act was passed by India in an effort to encourage fiscal responsibility, accountability, and openness in the administration of public funds. The Act mandates the government to take action to lower these indicators over time by setting targets for the fiscal deficit, revenue deficit, and public debt. The government must also create an independent fiscal responsibility and budget management committee, publish yearly financial reports, and reveal budget information in order to comply with the Act.

Since its implementation in 2003, the FRBM Act has enhanced India’s budgetary restraint. However, it has also drawn criticism, with some contending that it has resulted in a decrease in public spending on infrastructure and social services and that it has been used as an excuse for enforcing austerity measures. Some have also complained that the Act’s aims are overly rigid and fail to consider how outside influences may affect the economy.

Check: Measures of Government Deficit

Sustainable Economic Growth through Fiscal Policy

• Long-term planning to ensure growth without depleting resources.
• Focuses on renewable energy, education, and healthcare.

Conclusion

Governments can utilize fiscal policy as a potent instrument to affect economic activity and accomplish a number of macroeconomic goals. However, because fiscal policies can have unforeseen consequences and distributional implications, it is crucial to carefully analyze their design and implementation. Additionally, it is critical to think about fiscal policy’s long-term viability and, when necessary, to integrate it with monetary policy. Overall, governments can utilize fiscal policy to help advance economic growth, stability, and a variety of other objectives.

What is Fiscal Policy – FAQs

What is fiscal policy?

Fiscal policy involves government spending and taxation to influence the economy, aiming for sustainable growth, inflation control, and job creation.

What are the main tools of fiscal policy?

The primary tools include changing tax rates, adjusting government spending, and altering government transfers.

How does fiscal policy influence the economy?

By adjusting spending and taxation, fiscal policy can control economic activity, manage inflation, stimulate growth, and reduce unemployment.

What are some examples of fiscal policy in action?

Examples include tax cuts to stimulate economic growth, increased government spending during a recession, and reducing government spending to control inflation.

What is the difference between fiscal policy and monetary policy?

Fiscal policy is managed by the government and involves spending and taxation, while monetary policy is controlled by the central bank and involves managing interest rates and money supply.

How can fiscal policy promote job growth?

By investing in infrastructure, education, and other public services, fiscal policy can create jobs and stimulate economic activity.

What role does taxation play in fiscal policy?

Taxation is used to fund government spending, redistribute income, and influence economic activity through tax rates and incentives.

Can fiscal policy control inflation?

Yes, by reducing government spending or increasing taxes, fiscal policy can help cool down an overheated economy and control inflation.

Why is fiscal policy important for sustainable economic growth?

It helps manage the economic cycle, supports public services, and invests in the future, contributing to long-term sustainable growth.