It means the use of taxation and public expenditure by the govt. for stabilisation or growth.

The word fisc means state treasury and fiscal policy refers to policy concerning the use of state treasury or the govt. finances to achieve the macroeconomic goals.

By fiscal policy we refers to govt. actions affecting its receipts and expenditure which we ordinarily taken as measured by the govt.s receipts, its surplus or deficit. Culberston A policy under which the govt. uses its expenditure and revenue programmes to produce desirable effects and avoid undesirable effects on the national income, production and employment. Arthur Smithies Changes in taxes & expenditures which aim at short run goals of full employment & price level stability. Otto Eckstein

To maintain and achieve full employment To stabilise price level To stabilise growth rate of an economy To maintain equilibrium in the BoP To promote economic development of underdeveloped countries.

Fiscal policy through variations in govt. expenditure and taxation profoundly affects national income, employment, output & prices. An increase in public expenditure during depression adds to the aggregate demand and leads to a large increase in income via the multiplier process; while reduction in taxes has the effect of raising disposable income thereby increasing consumption & investment expenditure of the people. The govt. can control deflationary & inflationary pressures in the economy by a judicious combination of expenditure and taxation programmes.

Compensatory Fiscal Policy: It aims at continuously

compensating the economy against chronic tendencies towards inflation and deflation by manipulating public expenditures and taxes. When there are inflationary tendencies, the govt. should reduce its expenditures by having surplus budget and raising taxes in order to stabilise the economy. On the other hand when there are deflationary tendencies in the economy, the govt. should increase its expenditures through deficit budgeting and reduction in taxes.

Compensatory fiscal policy has two approaches:

Built-in Stabilisers

Discretionary fiscal policy

Built-in Stabilisers It involves the automatic adjustment of the expenditures and taxes in relation to cyclical upswings and downswings within the economy without delicerate action on the part of the govt. This technique is called as automatic stabilisation Various automatic stabilisers are corporate profit tax, income tax, excise taxes, and unemployment insurance and unemployment relief payments.

Merits of Built-in Stabilisers

It serves as cushion for private purchasing power,

when it falls and lessen the hardships on the people during deflationary period. They prevent national income and consumption spending from falling at low level There are automatic budgetary changes in this device and the delay in taking administrative decisions is avoided. Automatic stabilisers minimise the errors of wrong forecasting and timing of fiscal measures They integrate short-run and long run fiscal policy

Limitations of Built-in Stabilisers

The effectiveness depends on the elasticity of tax

receipts, the level of taxes and flexibility of public expenditures. The greater the elasticity of tax receipts, the greater will be the effectiveness in controlling inflationary & deflationary tendencies. With low level of taxes even a high elasticity of tax receipts would not be very significant as an automatic stabiliser doing a down swing. It keeps silence about the stabilising influence of local bodies, state govt. and the pvt. sector economy. They cant eliminate business cycle.

It requires deliberate change in the budget by such actions as changing tax rates or govt. expenditures or both. It may take three forms

Changing taxes with govt. expenditures constant. Changing govt. expenditures with taxes constant. Variations in both expenditures and taxes simultaneously.

The first method is more effective in controlling inflation, the second method is more useful in controlling deflationary tendencies and third is more effective and superior to the other two methods in controlling inflationary and deflationary tendencies.

Limitations of Discretionary Fiscal Policy:

Accurate forecasting is essential to judge the stage of

cycle. There are delays in proper timing of public spending. In fact it is subject to three time lags
Decision lag: time reqd to study the problem and taking the decision Execution lag: it involves expenditure which is to be allocated for the execution of the programme. Certain public work projects are so cumbersome that it is not possible to accelerate or slow them down.

Budgetary policy exercises control over size and relationship of govt. receipts and expenditures. Budget Deficit Fiscal Policy during Depression:
When govt. expenditure exceeds receipts.

C is the consumption function C+I+G represents consumption, investment and Govt. expenditure before budget. Suppose govt. expenditure G is injected to the economy, that will lead to upward shift of total spending function C+I+G1. Income increases from OY to OY1, the new equilibrium position is now E1. Increase in income YY1=EA=E1A is greater than govt expenditure E1B= G. BA represents increase in consumption.

450

Expenditure

C+I+G1 E1 B A C+I+G C

Y1 Income

Budget deficit may also be secured by reduction in taxes and without govt. spending. Reduction in taxes tends to leave larger disposable income and thus stimulates increase in aggregate demand output, income & employment. Suppose tax is reduced by ET, the consumption function will shifts upward to C1. Income will increase from OY to OY1. However, reduction in tax may be saved and not spent on consumption. To safeguard this govt. should reduce tax with increase in govt. expenditures.

450

Consumption

C1 E1 T C

Y1 Income

Occurs when govt. revenues exceeds expenditures. It is followed to control inflationary pressures. It may be through
Increase in taxation Reduction in govt. expenditures Both of the above

There may be budget surplus without govt. spending when taxes are raised. Enhanced taxes reduce the disposable income and encourage reduction in consumption expenditure. The result is fall in aggregate demand, output income and employment.

C is the consumption function before the imposition of the tax. Suppose a tax equal to ET is introduced. The consumption function shifts downward to C1. The new equilibrium position is E1. So income falls from OY to OY1.

450

Consumption

C E T C1

E1

Y1

Y Income

Here, increase in taxes and in govt. expenditure are of an equal amount. This has the impact of increasing net national income. This is because reduction in consumption resulting from the tax is not equal to the govt. expenditure.

C is the consumption function before the imposition of the tax with income OY0. Suppose a tax equal to AG is imposed. The consumption function shifts downward to C1. Now govt. expenditure of GE amount is injected into the economy which is equal to the tax yield AG. The new govt. expenditure line is C1+G which determines OY income at point E. Increase in income Y0Y=tax yield AG = increase in govt. expenditure GE.

450 E Consumption & Govt. Expenditure C1 + G C A G C1

Y0 Income