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Home Fiscal Policy Principles/Tools of Fiscal Policy

 

Principles/Tools of Fiscal Policy:

 

The government uses various fiscal principles/tools in order to achieve rapid economic growth. The main tools of fiscal policy are grouped under two main heads:

 

(1) Discretionary Fiscal Policy.

 

(2) Non Discretionary Controls.

 

(1) Discretionary Fiscal Policy:

 

By discretionary policy is meant the deliberate changing of taxes and government spending by the central authority for the purpose of offsetting cyclical fluctuations in output and employment. The discretionary fiscal policy has short, as well as long-run objectives.

 

The short-run counter cyclical fiscal policy aims at eliminating business fluctuations and maintaining moderate stability. In case of deflationary situation, the long-run program of fiscal policy is to raise the level of income and employment in the country. In case of sustained long-run inflationary gap in the economy, the objective of fiscal policy is to reduce the average level of purchasing' power. Let us now examine the short and long run tools of discretionary fiscal policy in more detail.

 

Short Run and Long Run Counter Cyclical Fiscal Policy:

 

The main weapons or stabilizers of short-run and long run discretionary fiscal policy are: (i) Precautions or Guide map, (ii) Changes in tax rates (iii) Varying public works expenditure, (iv) Credit aids and (v) Transfer payments.

 

(i) Guide maps: In a capitalistic, society, the entrepreneurs are not aware of each other investment plans. They, therefore, in competition with one another over-invest capital in a particular industry or industries and thus cause overproduction and unemployment in the economy, similarly, in depression period, there is no agency to guide them, If government publishes the total investment plans and marginal efficiency of capital in various industries, much of the investment can proceed at a moderate speed and there can be stability to some extent in income, output and employment.

 

(ii) Changes in tax rates: it is an important weapon of fiscal policy for eliminating the swings of the business cycle. When the government finds that planned investment is exceeding planned savings and the economy is likely to be threatened with inflationary gap, it increases the rate of taxes. The higher taxes, other things remaining the same, reduce the disposable income of the people they are forced to cut down their expenditure. The economy is, thus, saved from the inflationary situation.

 

If, on the other band, planned saving is in excess of planned investment and the economy is likely to be faced with deflationary gap, the taxes are lowered considerably so that people are left with more disposable income. When purchasing power of the people increases, the rate of spending on consumption and investment increases. The economy is. thus, saved from the deflationary situation.

 

(iii) Varying public works expenditure: Another important factor which influences economic activity is public expenditure. In times of depression, the government can contribute directly to the income stream by initiating public works programs and in boom period, it can withdraw funds from the income stream by curtailing them. This policy have the following limitations:

 

It seems very easy that public works can be undertaken as a recession cure. But when we put these anti cyclical fiscal measures into actual practice, we find that the work on public investment project cannot be undertaken at a short notice. When a work is to be initiated, plans are to be made, blue-prints are to be prepared, land is to be acquired, material is to be purchased. All these preparations require time. The situation, on the other hand, demands that immediate step should he taken up to restore the economy to its full employment equilibrium level. Thus, the government may not be able to improve the deflationary situation in short period. When after some time, the program is undertaken, the conditions in the economy may change.

 

The state may not be able to control the inflationary or deflationary situation, if the private expenditure incurred on consumption and investment moves in the opposite direction. For instance, if the government apprehends that depression is likely to takes place in the near future, it initiates public works programs. This may give a signal to the private investors that country is likely to be threatened with a deflationary situation. They may curtail their expenditure on consumption and investment, the result will be that pace of economic development will be retarded and the economy quickly plunges into depression.

 

(iv) Credit aids: The government can also avert depression by offering long term credit aids to the needy industrialists for starting or expanding the business. It can also give financial help to insurance companies and bankers to prevent their failures.

 

(v) Transfer payments: Variation in transfer expenditure programs can also help in moderating the business cycle. When the business is brisk, the government can refrain from giving bonuses to the workers and thus can lessen the pressure of too great spending to some extent. When the economy is in recession, these payments can be released and more bonuses can be given to stimulate aggregate effective demand.

 

(2) Non Discretionary Control:

 

Automatic or Built in Stabilizers:

 

The automatic fiscal stabilizers are those which contribute to keep economic system in balance without human control. These controls are built into the economy and so are called built in stabilizers. The main automatic stabilizer is given below:

 

Progressive Income Tax:

 

Personal income taxes are the largest source of revenue to the government. The tax rate, the individuals pay on their rising income is progressive. When the disposable income of the people increases in the boom period, the higher amount of tax reduces disposable income, reduces consumption and decreases the aggregate demand which help in curbing economic boom. A reduction in income tax increases disposable personal income, increases consumption, increases aggregate demand and thus helps in curbing recession. The expansionary and contractionary fiscal policies can be summed up and brought under two approaches.

 

First: Demand Side Fiscal Policy.

 

Second: Supply Side Fiscal Policy.

 

(i) Demand side policy: It was originated as a direct result of Keynesian belief. According to Keynes, during recession, the goal is to raise aggregate demand to the full employment level. This objective may be achieved by (a) an increase in government spending (G), (b) a decrease in tax revenue (T) brought about by reduction in tax rates.

 

During a period of rapid inflation, the goal is to lower aggregate demand to the full employment level. The fiscal policy will be (a) a decrease in government expenditure (b) an increase in taxes brought about by rise in the rates.

 

(ii) Supply side fiscal policy: It is a new approach to fiscal policy. The modern economists are of view that fiscal policies can also influence the level of economic activity through their impact on aggregate supply. When the firms experience, an increase in resource costs due to a sharp rise in the world price of a major raw material say oil, the higher costs causes a decrease in aggregate supply creating a recessionary gap. Therefore, an expansionary fiscal policy in the form of reduced corporate taxes and pay roll tax can help in closing the recessionary gap. Conversely, an increase in the corporate tax rate and pay roll tax etc., can help in closing the inflationary a gap.

 

(iii) Unemployment compensation: In advanced countries of the world, people receive unemployment compensation and other welfare payments when they are out of job. As soon as they get employment, these payments are stopped. When national income is increasing, the unemployment fund grows due to two main reasons: (a) The government receives greater amount of payroll taxes from the employees and (b) the unemployment compensation decreases.

 

Thus, during boom years, the unemployment compensation reserve funds help in moderating the inflationary pressure by curtailing income and consumption. When the economy is contracting, unemployment, consumption and other welfare payments augment the income stream and they prove a powerful factor increasing income, output and employment in the country. In the words of Samuelson:

 

"During boom years, therefore, the unemployment reserve fund grows and exerts stabilizing pressure against too great spending. Conversely, during years of slack employment, the reserve funds are used to pay out income to sustain consumption and moderate the decline".

 

(iv) Farm aid programs: Farm aid programs also stabilize against the wave like cyclical fluctuations. When the prices of the agricultural products are falling and the economy is threatened with depression, government purchases the surplus products of the farmers at the set prices. The income and total spending of the agriculturists thus remain stabilized and the contraction phase is warded off to some extent. When the economy is expanding, the government sells these stocks and absorbs the surplus purchasing power. It, thus, reduces inflationary potential by increasing the supply of goods and contracting the pressure of too great spending.

 

(v) Corporate saving and family savings: The credit of having automatic or built in stabilizer does not go to the state alone. The corporations and companies and wise family members withhold part of the dividends of the boom years to pay in the depression years. Thus holding back some earnings of good years contracts the purchasing power and releasing of money in poorer years expands the purchasing power of the people. Similarly, wise persons also try to save something during the prosperous days in order to spend the savings in the rainy days.

 

Limitation of built in stabilizers: The automatic or built in stabilizers can no doubt minimize the upward and downward movements of business cycle to some extent but they cannot help in achieving full employment without inflation. They can be used as a first line of defense but they cannot cure the economic ills of the society. So the policy makers have to be vigilant and adopt other suitable fiscal measures which can counter cyclical fluctuation in the economy.

Relevant Articles:

What is Fiscal Policy
Principles/Tools of Fiscal Policy
Fiscal Policy With Reference to Underdeveloped Countries
 

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Definition and Explanation of Economics
Theory of Consumer Behavior
Indifference Curve Analysis of Consumer's Equilibrium
Theory of Demand
Theory of Supply
Elasticity of Demand
Elasticity of Supply
Equilibrium of Demand and Supply
Economic Resources
Scale of Production
Laws of Returns
Production Function
Cost Analysis
Various Revenue Concepts
Price and output Determination Under Perfect Competition
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Rent
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Interest
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National Income and Its Measurement
Principles of Public Finance
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Fiscal Policy
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Determination of National Income
Theories of Employment
Theory of International Trade
Balance of Payments
Commercial Policy
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Introduction to Development Economics
Features of Developing Countries
Economic Development and Economic Growth
Theories of Under Development
Theories of Economic Growth
Agriculture and Economic Development
Monetary Economics and Public Finance

History of Money
 

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