What is Fiscal policy
Fiscal policy
Fiscal policy is defined as the policy under which the government uses the instrument of taxation, public spending and public borrowing to achieve various objectives of economic policy. Simply put, it is the policy of government spending and taxation to achieve sustainable growth. Fiscal policy is often contrasted with monetary policy which is regulated by the central bank. It is largely inspired by the ideas of British economist John Maynard Keynes whose theories were developed in the response to the Great Depression and were hugely influential in the formulation of the New Deal in the U.S. that aimed at huge spending for public projects and social welfare development.
How does it work?
When policymakers want to influence the economy, they mainly have two tools at their disposal, Monetary policy and Fiscal policy. The monetary policy is regulated by the central banks. Money supply in the market is adjusted by tweaking the interest rates, bank reserve rates, sale and purchase of government securities and foreign exchange.
On the other hand, fiscal policy is influenced by the governments by adjusting the nature and extent of the taxes, government spending and borrowing. A healthy fiscal policy is important to control inflation, increase employment and maintain the value of money. It has a very important role in managing the economy.
The government has two variables to influence fiscal policy, namely
Taxation- regulating which the government increases or decreases the disposable cash in the hands of the public.
Government spending- using which the government invests in public infrastructural works and other social welfare schemes that directly or indirectly influence the state of the economy.
To incentivize spending, the government may announce tax cuts and when the economy faces high inflation, the government may announce new taxes or raise the levels of existing taxes. During a period of negative growth, the public and investors may lose faith in the economy which in turn may result in lower production and lower demand. To counter that the government may increase spending to tide over the falling private sector investment and to create demand in the market.
This phenomenon was best witnessed during the Second World War when governments invested hugely to build their armed forces. A huge increase in government spending resulted in a massive growth in employment and increased demand in the commodity market. The Second World War is often credited with bringing Europe out of the Great Depression.
Objectives of a fiscal policy
The objectives of a fiscal policy may vary- from spending on public asset creation like roads, railways and other infrastructural works to public health and safety to promoting education, payment of salaries, subsidies, pensions etc. It also aims to incentivise private sectors to scale up their operations that directly or indirectly influence the economy of a country. The tools of fiscal policy also aim to stabilise the economy during various inflationary pressures. In the short term, the governments may focus on macroeconomic stabilisation by cutting taxes and increasing spending to boost a weak economy or increase taxes and reduce spending during inflation. In the long term, it may focus on sustainable growth and the reduction of poverty. An effective fiscal policy will inevitably raise the confidence of the private investors, who in turn, will be encouraged to expand, bringing in investment and driving demand.
It also aims at promoting income equality by levying direct taxes on higher-income individuals while subsidising the consumption items of low-income households. Necessary items like fuels, food items etc are subsidised for the masses while luxury items like imported cars, vanity products etc are indirectly taxed to maintain parity among citizens. This is one of the ways by which the government maintains a balance of receipts and payments.
Why is it necessary?
In the present day scenario, a free market without government control is like a moving car without a driver. It will be fine as long as the conditions are favourable but introducing corrections becomes very difficult once the going gets tough. The recent shocks of the Covid pandemic showed that a prudent fiscal policy is necessary for implementing corrections and sustaining the population while steering the economy at a volatile time. Every government of every country followed some kind of fiscal policy; some incentivised spending while some focused on the supply side of the economics. One of the major differences between an economy that rose above the shocks of the pandemic and the one that got overburdened was an effective fiscal policy.
As in the case of India, a country of 1.3 billion, the pressure to jumpstart the economy was huge. As a policy decision, the government provided a food security net, the largest of its kind in the world, to the vulnerable population. It announced various other rate cuts and monetary support to businesses and MSMEs while focusing on removing the bottlenecks on the supply side of the economy. It invested in huge infrastructural spending and also focused on public health by way of administering free vaccines. As a result, in 2022, IMF predicts India to be the fastest-growing major economy in the world despite geopolitical uncertainties, supply-side disruptions and rising commodity prices.
The downside
Although the fiscal policy is an effective tool to manage the economy, sometimes factors other than economic requirements take centre stage. Politics of popularism in the form of grants, subsidies and other financial stimuli that are hard to roll back creates unnecessary pressure on the economy. The government is forced to fund the deficit by diverting funds from other areas. Many a time, it is seen that the targeted beneficiaries of a policy decision like tax cuts are the middle class which happens to be the largest segment of people in a country. But when inflationary pressures mount, the rising tax becomes a burden for the same segment and they end up paying proportionately more tax than the rich class. Raising tax is an unpopular choice when considered from a political angle. To mitigate that government often resorts to curtailing government spending while keeping the tax rates unchanged.
Also, the policymakers sometimes tend to make decisions without understanding the needs of the people and the pulse of a situation. In such a case, a well-intended initiative may backfire, thus creating situations that may not be desirable.
The biggest dilemma among the policymakers is to figure out how much control should the government have in the economic matters of the country as well as individuals. Too much or too less will constrict the breathing space of the economy. Practical and populist measures often clash and choosing one over the other or finding a middle way becomes difficult. Thus implementing optimum checks and finding the right balance is the secret to a prudent fiscal policy.
Disclaimer: This content is authored by an external agency. The views expressed here are that of the respective authors/ entities and do not represent the views of Economic Times (ET). ET does not guarantee, vouch for or endorse any of its contents nor is responsible for them in any manner whatsoever. Please take all steps necessary to ascertain that any information and content provided is correct, updated and verified. ET hereby disclaims any and all warranties, express or implied, relating to the report and any content therein.
Fiscal policy is defined as the policy under which the government uses the instrument of taxation, public spending and public borrowing to achieve various objectives of economic policy. Simply put, it is the policy of government spending and taxation to achieve sustainable growth. Fiscal policy is often contrasted with monetary policy which is regulated by the central bank. It is largely inspired by the ideas of British economist John Maynard Keynes whose theories were developed in the response to the Great Depression and were hugely influential in the formulation of the New Deal in the U.S. that aimed at huge spending for public projects and social welfare development.
How does it work?
When policymakers want to influence the economy, they mainly have two tools at their disposal, Monetary policy and Fiscal policy. The monetary policy is regulated by the central banks. Money supply in the market is adjusted by tweaking the interest rates, bank reserve rates, sale and purchase of government securities and foreign exchange.
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On the other hand, fiscal policy is influenced by the governments by adjusting the nature and extent of the taxes, government spending and borrowing. A healthy fiscal policy is important to control inflation, increase employment and maintain the value of money. It has a very important role in managing the economy.
The government has two variables to influence fiscal policy, namely
Taxation- regulating which the government increases or decreases the disposable cash in the hands of the public.
Government spending- using which the government invests in public infrastructural works and other social welfare schemes that directly or indirectly influence the state of the economy.
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To incentivize spending, the government may announce tax cuts and when the economy faces high inflation, the government may announce new taxes or raise the levels of existing taxes. During a period of negative growth, the public and investors may lose faith in the economy which in turn may result in lower production and lower demand. To counter that the government may increase spending to tide over the falling private sector investment and to create demand in the market.
This phenomenon was best witnessed during the Second World War when governments invested hugely to build their armed forces. A huge increase in government spending resulted in a massive growth in employment and increased demand in the commodity market. The Second World War is often credited with bringing Europe out of the Great Depression.
Objectives of a fiscal policy
The objectives of a fiscal policy may vary- from spending on public asset creation like roads, railways and other infrastructural works to public health and safety to promoting education, payment of salaries, subsidies, pensions etc. It also aims to incentivise private sectors to scale up their operations that directly or indirectly influence the economy of a country. The tools of fiscal policy also aim to stabilise the economy during various inflationary pressures. In the short term, the governments may focus on macroeconomic stabilisation by cutting taxes and increasing spending to boost a weak economy or increase taxes and reduce spending during inflation. In the long term, it may focus on sustainable growth and the reduction of poverty. An effective fiscal policy will inevitably raise the confidence of the private investors, who in turn, will be encouraged to expand, bringing in investment and driving demand.
It also aims at promoting income equality by levying direct taxes on higher-income individuals while subsidising the consumption items of low-income households. Necessary items like fuels, food items etc are subsidised for the masses while luxury items like imported cars, vanity products etc are indirectly taxed to maintain parity among citizens. This is one of the ways by which the government maintains a balance of receipts and payments.
Why is it necessary?
In the present day scenario, a free market without government control is like a moving car without a driver. It will be fine as long as the conditions are favourable but introducing corrections becomes very difficult once the going gets tough. The recent shocks of the Covid pandemic showed that a prudent fiscal policy is necessary for implementing corrections and sustaining the population while steering the economy at a volatile time. Every government of every country followed some kind of fiscal policy; some incentivised spending while some focused on the supply side of the economics. One of the major differences between an economy that rose above the shocks of the pandemic and the one that got overburdened was an effective fiscal policy.
As in the case of India, a country of 1.3 billion, the pressure to jumpstart the economy was huge. As a policy decision, the government provided a food security net, the largest of its kind in the world, to the vulnerable population. It announced various other rate cuts and monetary support to businesses and MSMEs while focusing on removing the bottlenecks on the supply side of the economy. It invested in huge infrastructural spending and also focused on public health by way of administering free vaccines. As a result, in 2022, IMF predicts India to be the fastest-growing major economy in the world despite geopolitical uncertainties, supply-side disruptions and rising commodity prices.
The downside
Although the fiscal policy is an effective tool to manage the economy, sometimes factors other than economic requirements take centre stage. Politics of popularism in the form of grants, subsidies and other financial stimuli that are hard to roll back creates unnecessary pressure on the economy. The government is forced to fund the deficit by diverting funds from other areas. Many a time, it is seen that the targeted beneficiaries of a policy decision like tax cuts are the middle class which happens to be the largest segment of people in a country. But when inflationary pressures mount, the rising tax becomes a burden for the same segment and they end up paying proportionately more tax than the rich class. Raising tax is an unpopular choice when considered from a political angle. To mitigate that government often resorts to curtailing government spending while keeping the tax rates unchanged.
Also, the policymakers sometimes tend to make decisions without understanding the needs of the people and the pulse of a situation. In such a case, a well-intended initiative may backfire, thus creating situations that may not be desirable.
The biggest dilemma among the policymakers is to figure out how much control should the government have in the economic matters of the country as well as individuals. Too much or too less will constrict the breathing space of the economy. Practical and populist measures often clash and choosing one over the other or finding a middle way becomes difficult. Thus implementing optimum checks and finding the right balance is the secret to a prudent fiscal policy.
Disclaimer: This content is authored by an external agency. The views expressed here are that of the respective authors/ entities and do not represent the views of Economic Times (ET). ET does not guarantee, vouch for or endorse any of its contents nor is responsible for them in any manner whatsoever. Please take all steps necessary to ascertain that any information and content provided is correct, updated and verified. ET hereby disclaims any and all warranties, express or implied, relating to the report and any content therein.