Fiscal Policy

Outline
Fiscal Policy: Concept Objectives of Fiscal Policy Impact of Fiscal Policy Instruments of Fiscal Policy Target Variables Types of Fiscal Policy Fiscal Policy Lag

Fiscal Policy
Fiscal policy refers to the policy by which the government tries to regulate or modify the economic affairs keeping in view certain objectives. It is a deliberate adjustment of taxation and government expenditures. In other words, fiscal policy is the government policy of making discretionary changes in the pattern and level of its expenditure, taxation and borrowings in order to achieve predetermined objectives of attaining higher economic growth, employment, income equality and overall economic stability.

Fiscal Policy.. Fiscal Policy Goals

Attainment of higher economic growth Achieving full/higher employment Reducing inequality of income and wealth Maintenance of economic stability

Fiscal Policy Goals. Attainment of higher economic growth:

Given the human resources, technology and natural resources; the growth rate of a country depends, among other things, on the rate of savings and investment. The fiscal policy can play a vital role in promoting savings and investment by providing incentives through appropriate tax policies Similarly, the expansion of government investment for building infrastructure and financing developmental works promotes economic growth.

Fiscal Policy Goals. Achieving full/higher employment:

Fiscal policy can reduce unemployment by creating more employment opportunities through public spending. However, government deficit financing by borrowing from central bank may have adverse effect in the economy as it leads to inflation Fiscal policy can promote employment by providing incentives to the labor-intensive technique of production through various fiscal measures, such as tax, tariff policies, etc.

Fiscal Policy Goals. Reducing inequality of income and wealth:

Both taxation and expenditure measures used for reducing inequality of income and wealth Personal and corporate income tax at progressive rate Taxation on high priced and luxury goods Imposition of wealth and property tax Making public expenditure on the projects to enhance the earning capacity of poor Efficient allocation of resources Making provisions for transfer payments and subsidies targeting low income group

Fiscal Policy Goals. Maintaining economic stability

Maintaining stability through contra-cyclical fiscal policy. Reducing the gap between income and expenditure, saving and investment, exports and imports by appropriate tax and expenditures policies. Private sector-friendly policies for minimizing crowding out effects and growth stabilization

Impact of Fiscal Policy on Growth

Increase in government expenditure has expansionary effect through multiplier. Due to the expansionary effect of fiscal policy, deficit financing is suggested for development (for breaking the vicious circle of poverty in LDCs). The reduction in tax also has the same effect but it is less than that of increase in government expenditures. The balance budget is not so expansionary.

Impact of Fiscal Policy.

AD

+G C+I +G C+I

r 20 10

LM

r
IS 40 80 y

If b = 0.75

K=4

may lead to crowding out effect

Instruments of Fiscal Policy

Government Expenditure: Current (regular) and Capital (development) Taxation: Direct and Indirect Tax Borrowing: Internal and External Target Variables Private disposable income Private consumption expenditure Private savings and investment Exports and imports Price level

Instruments of Fiscal Policy

Based on the frequency and purpose of changes made in governments revenue and expenditure programs, fiscal policy can be broadly categorized as follows: Automatic Stabilization Fiscal Policy Discretionary Fiscal Policy

Types of Fiscal Policy Automatic Stabilization Measure: Automatic stabilization fiscal policy refers to the adoption of fiscal measures with built-in-flexibility of tax revenue and government spending. It is the automatic adjustment in the government expenditure and tax revenue in response to the change in national income. In such policy, the government adopts tax and expenditure policy that is linked to national income, output and employment.
This can be exemplified by the following automatic stabilizer:

Types of Fiscal Policy Discretionary Fiscal Policy:

Under discretionary fiscal policy measures, the government makes deliberate changes in the level and pattern of its fiscal instruments viz. taxation, spending and borrowings for attaining the predetermined economic goals. Such discretionary policy may have both contractionary and expansionary effect on the economy depending upon the situation. Mostly applicable in developing countries

Nepals Fiscal Policy (Budget Speech) for FY 2010/11

Primary Objectives: To create a foundation for strong and sustainanable economic development To support successful peace process, state restructuring and constitution formation Budget size: Rs. 337.9 billion (Recurrent expenditure-56%, Capital expenditure-38% and Principal repayment-5%) Fiscal Instruments: Revenue - Tax and non-tax revenue Expenditure- recurrent and capital Borrowing- internal and external

Nepals Fiscal Policy (Budget Speech) for FY 2010/11

Economic Targets
Economic growth- 4.5 % Inflation- 7% (annual average) Balance of Payments (BOP) Surplus- Rs. 9 billion

Budget Targets
Total revenue -Rs. 216.6 billion Foreign grants- Rs. 65.3 billion Deficit (after foreign grants) - Rs. 55.9 billion

Sources of Financing Deficit:

External borrowing- Rs. 22.2 billion Internal borrowing- Rs. 33.7 billion For detail, refer to the Budget Speech for FY 2010/11, Ministry of Finance/GON), www.mof.gov.np

Fiscal Policy Constraints

Political and administrative problems Self-offsetting Effect (crowding-out effect) Obstacles arising out of the structure of the economy or external shocks, etc. Policy Lag
Inside Lag Outside Lag

Recognition Lag

Administrative Lag

Operational Lag

Questions for review

What do you mean by expansionary and contractionary fiscal policy? How does fiscal policy affect the economic growth? Explain the major objectives and instruments of fiscal policy? Monetary policy is often linked with fiscal policy, known as monetary-fiscal policy mix. When there is high government spending or large reduction in tax rates, inflation is likely to arise. In such situation, tight monetary policy may be helpful in controlling inflation. But, this may have adverse effect on growth. Then, how is it possible to have policy coordination?