Fiscal Policy and its Tools

The word fiscal is derived from the word Fisc which means treasury therefore fiscal policy deals with the matters of treasury or public finance. Fiscal policy refers to the government policy of public expenditure and taxes. Fiscal policy plays an important role in determining the stability of an economy because it affects the level of income and employment in a country. For example income and employment increases with increase in government expenditure and vise versa.

Stances of Fiscal Policy

There are two important stances of fiscal policy which are given and explained below.

• Contractionary Fiscal Policy

Contractionary fiscal policy refers to the reduction in government aggregate expenditures and raising taxes. During business-cycle expansion, inflationary problems arise in an economy which is corrected with the help of contractionary fiscal policy. In case of contractionary fiscal policy, government expenditures as well as transfer payments are reduced whereas taxes are increased. This reduces the purchasing power of people due to which aggregate demand for goods and services. In this way inflation is controlled.

• Expansionary Fiscal Policy

Expansionary fiscal policy refers to the increase in government aggregate expenditures and decrease in taxes. In case of business cycle contraction, rate of unemployment increases very rapidly. Therefore in order to tackle the problem of unemployment, expansionary fiscal policy is used in which government expenditures as well as transfer payments are increased whereas taxes are reduced. Due to increase in government expenditures such as construction of dams, roads, railways, parks etc. various job opportunities are created and the problem of unemployment is addressed.

Tools of Fiscal Policy

Tools of fiscal policy are generally divided into two i.e. discretionary fiscal policy and automatic stabilizers.

    1.  Discretionary Fiscal Policy

Discretionary fiscal policy refers to the tools employed with the discretion in order to achieve the desired objectives. Such tools include government expenditures, taxation, transfer payments etc.  Among these tools, government expenditures and taxation are important one.

    a.   Changes in Government Expenditures

Government can change the aggregate demand directly by altering its own purchases of goods and services. For example a government places $30 billion order for the construction of new dam. This order increases the demand for cement which induces the cement manufacturers to hire more workers and increase the production. Due to increase in the demand for cement at each price level the aggregate demand will shift. Now in order to know whether the shift in aggregate demand is higher or lower than the government purchases we must know two important macroeconomic concepts.

• The Multiplier Effect

Multiplier shows how the economy can amplify the impact of changes in spending therefore it is an important concept of macroeconomics. When the government decides to construct a dam for $30 billion it causes various impacts in the economy. For example cement is widely used in the construction of dam therefore demand for cement will increase. This increase in demand increases the profits of producers and thus they try to produce more for which they need additional workers. In this way purchasing power of both producers and working group rises due to which they increase their own spending on consumer goods. Therefore decision of government to construct a dam raises the demand for the products of many other firms in the economy which means that the decision has a multiplier effect on the aggregate demand.

• Formula for Spending Multiplier

The size of multiplier effect that arises when an increase in government purchases induces increase in consumer spending can be achieved with the help of simple formula given below.

Multiplier= 1?(1-MPC)

Here MPC is the marginal propensity to consume which shows the fraction of extra income that a household consumes rather than saves. This formula shows that the size of multiplier is dependent upon the marginal propensity to consume. It means that the size of multiplier increases with the increase in MPC and vise versa.

Suppose that marginal propensity to consume is ¾ and government decides to construct a dam for $30 billion. Now we can easily find the size of multiplier effect for the particular spending of government with help of above formula.

Multiplier= 1/(1-3/4)

Multiplier= 1/(1-0.75)

Multiplier= 1/0.25

Multiplier= 4

Therefore, Size of Multiplier = 4×30 = $120 billion

It means that increase in government spending by $30 billion will increase the aggregate demand by $120 billion.

• The Crowding-Out-Effect

When government increases its expenditure in a particular sector, the aggregate demand for goods and services could rise by more or less than the spending of government. It depends on whether the multiplier effect or the crowding-out effect is larger. The multiplier effect suggests that the aggregate demand for goods and services will be higher than the government spending whereas the crowding-out effect indicates that the aggregate demand for goods and services will be lower than the government spending. Crowding-out effect occurs when fiscal expansion raises the interest rates because of excessive demand for money. Due to high interest rates, borrowings become more expensive therefore demand for business investment goods declines. In this way government spending may also crowd out investment.

  b.  Changes in Taxes

Other important instrument of fiscal policy is the level of taxation. Government can increase or decrease the tax rates depending upon the prevailing economic conditions. For example if government wants to increase the aggregate demand for goods and services it can do so by reducing personal income taxes. The decrease in income taxes boosts the purchasing power of people due to which they demand more goods and services and the aggregate demand increases. However shift in aggregate demand is also affected by the multiplier and crowding-out effects. When government cut taxes, spending of people increases along with the aggregate demand for goods and services. This is the multiplier effect. On the other hand reduction in taxes increases the income of consumers due to which they demand more money whereas the supply of money is fixed. Therefore interest rates raises due to imbalance between demand and supply of money. Higher interest rates discourage borrowings for investment purposes therefore it is called crowding-out effect.

    2.  Automatic Stabilizers

All those tools which operate automatically to stabilize the economy are commonly known as automatic stabilizer. These tools include progressive taxes, unemployment allowances, support prices and stable government expenditures. The explanation of these tools is given below in detail.

• Progressive Taxes

Progressive tax is one in which the rate of tax increases with the increase of the size of income e.g. personal income tax, corporate profit tax etc. such type of taxes play a vital role in stabilizing the economy. For example in case of expansion more people enter the tax bracket because tax exemption ceiling is fixed so increase in money income of people make them liable to pay more tax. Collection of more taxes results in the surplus budget which can be used to stabilize the economy. On the other hand in case of contraction, money income of people decreases due to which they pay fewer taxes. The lower amount of tax collection results in deficit budget which can be used to make developmental expenditures therefore it takes the economy out of depression.

• Unemployment Allowances

Social security payments and unemployment allowances are important automatic stabilizers. During the phase of expansion there is a tendency towards full employment therefore government expenditures are reduced by cutting down the social security payments. This results in the automatic stabilization of economy. On the other hand, in case of contraction government expenditures are increased by providing more social security payments. This increases the purchasing power of people along with the increase in demand for goods and services. Increase in the aggregate demand boosts the investment in a country and the slump in the economy is eliminated automatically.

• Stable Government Expenditures

In case of economic fluctuations, stable government expenditures are very helpful to stabilize the economy automatically. If the economy is in phase of expansion then the government expenditure is lower than the government revenue therefore budget would become surplus. This surplus budget can be used to stabilize the economy. Similarly during the phase of contraction, government expenditures exceed its revenues therefore budget becomes deficit. This deficit budget will automatically stabilize the economy.

• Support Policy for Farm Prices

The fluctuation in the prices of agricultural products is higher than prices of all other products. Such fluctuations in the prices of agricultural products has great impact on the over all economy. Therefore stabilizing the prices of agricultural products automatically stabilize the economy. For example in the phase of contraction, the prices of agricultural products are very low due to which government purchases these products at higher prices and build up stock of the products. In this way prices of the agricultural products as well as over all economy is stabilized. On the other hand, in case of contraction the prices of agricultural products are very high due to which government releases the stocks to bring down the prices at the desired level.