Fiscal policy (Methods and Goals)

Methods of Fiscal Policy

Basically, there are three methods which are used in this context: (i) Built in flexibility or automatic stabilizers, (ii) Discretionary action, and (iii) Compensatory fiscal policy

1. Built-in Flexibility

The technique of built-in flexibility involves the automatic adjustment of the expenditures and taxes in a reduction to cyclical upswings and downswings within the economy. It is also defined as the automatic adjustment in the government expenditure and tax revenue in response to rise or fall in GDP. In this kind of fiscal policy, the government adopts a tax system and an expenditure program linked to GNP and unemployment. Under this system, changes in the budget are automatic and hence this technique is also known as an automatic stabilizer. The various automatic stabilizers are corporate profit tax, income tax, excise taxes, old age pensions, unemployment insurance, etc. As instruments of automatic stabilization, taxes and expenditures have relation with national income. Given an unchanged tax rate, tax yields vary directly with national income, while government expenditures vary oppositely with national income.

In the downward phase of the business cycle when national income is falling, taxes which are based on a percentage of national income automatically, decline. Meanwhile, government expenditures on unemployment relief automatically increase. Thus, there would be an automatic budget deficit, which would counteract deflationary propensities. On the other hand, when the national income rises, the tax yield would automatically rise with the rise in tax rates. Government expenditures on unemployment relief automatically decrease. This condition creates a budget surplus and inflationary tendencies would be controlled.

2. Discretionary Fiscal Policy

Under this policy, the government makes deliberate changes in (a) the level and pattern of taxation, (b) the size and pattern of expenditure and (c) the size and composition of public debt.

The government makes following types of discretionary changes in both direct and indirect taxes.

1. Imposition of new taxes or abolition of old taxes
2. Imposition of taxes on new tax bases
3. Increasing or decreasing the tax rates

All these kinds of changes in taxation result in either transfer of household incomes to government or to a reduction in such transfers. The discretionary changes in the government spending include changes in (i) the size of the government expenditure, (ii) the composition of government expenditure, (iii) the practices of financing government expenditure, (iv) transfer payments, (v) overall budgetary surplus and deficit, and (vi) the methods of deficit financing.

3. Compensatory Fiscal Policy

It is a deliberate budgetary action taken by the government to compensate for the deficiency in or excess of aggregate demand. The compensatory action is taken by the government in the structure of surplus budgeting or deficit budgeting. Under this policy, the government uses a greater level of discretion than in automatic stabilization policy and this policy can be revised year after year. Besides, the policy of surplus or deficit budgeting is adopted as and when the government is required to control inflation and deflation.

Goals or Objectives of Fiscal Policy

As an instrument of fiscal policy, the goals of fiscal policy are different in different countries and in the same country in different situations. However, the objectives of the fiscal policy are as follows:

i. Economic Growth
The developing countries are caught in a ‘vicious circle of poverty’ on account of capital deficiency. Therefore, such countries need a balanced growth in order to break down the vicious circle of poverty through capital formation. In this regard the following fiscal measures can be used:

• Raising the saving ratio to income by curtailing consumption.
• Mobilizing them for raising the rate of productive investment.
• Encouraging the flow of spending in a productive way.

ii. Mobilization of resources
The fiscal policy helps to secure an optimum allocation of resources. It is possible by diverting the existing resources from unproductive to productive and socially more desirable uses.

iii. Minimize the inequalities of income and wealth
Growth with equity is the primary objective of economic policy in the developing countries. The government, therefore, should formulate its fiscal policy in such a manner so that it may reduce the inequalities of income and wealth. Extreme inequalities create political and social dissatisfaction and generate instability in the economy. The tax system should be made progressive. Heavy direct taxes should be imposed on the rich and the poor should be exempted from taxes.

iv. Increase Employment Opportunities
Due to a low rate of capital formation (or deficiency of investment), most of the developing countries are suffering from unemployment, underemployment, and disguised unemployment. Fiscal policy, therefore, should aim at increasing employment opportunities and reduce unemployment and underemployment in these countries. The government in a developing country can resort following different methods to raise the level of employment in the country.

• Public expenditure on economic and social overheads should be incurred to generate employment and increase productive efficiency on the economy in the long run.
• The government may resort to compulsory savings by the public.
• The government can impose heavy taxes on the rich people and the proceeds of these taxes may be distributed among the poor or may be invested in such projects.

v. Counteract Inflation
A developing country does not possess adequate capital resources to finance developmental expenditure. The scope of taxes and public borrowing is also limited. Therefore, the government has to resort to deficit financing. But the technique of deficit financing may prove to be inflationary in most of the developing countries. Similarly, there is always an imbalance between the demand for and supply of economic resources. With the increasing purchase power, the demand for consumer goods rises but the supply remains relatively inelastic due to structural rigidities, market imperfections, bottlenecks. This leads to an inflationary rise in prices. It may also tend to raise the demand for wages in the organized sectors of the economy, which in turn push up costs and a further rise in price. Some of the important measures are as follows:

• Excess purchasing power should be withdrawn through taxes, compulsory savings, and public borrowings.
• Progressive direct tax, commodity tax, etc. should be imposed.
• Market perfections and structural rigidities should be removed. Moreover, for the fiscal policy to be effective, it must be supplemented by anti-inflationary monetary measures.

Reference

Bernake and Abel, Macroeconomics, Singapore, Pearson Education latest edition