[Updated 2020-21] Fiscal Policy – Objectives, Instruments & Limitations

Fiscal Policy – Objectives, Instruments & Limitations

Fiscal policy – Introduction

In modern times, the policies of the government of a country have very much influence on economic activities. Fiscal policy is the policy related to revenue, expenditure, and debt of the government for achieving a set of definite objectives.

Term ‘Fisc’ in the English language means ‘Treasury’. Hence policy relating to the treasury is called fiscal policy.

Objectives of Fiscal Policy

a) Full Employment

Every government aims at maintaining full employment situation in the country. To achieve this objective and to increase aggregate demand the government increases public expenditure and reduces tax. Increase in aggregate demand will lead to more production and employment.

b) Price stability

Another important objective of fiscal policy is to achieve price stability. In the case of rising prices or inflation, the fiscal policy seeks to reduce aggregate demand by reducing public expenditure and increasing direct and indirect taxes.

In the event of falling prices or deflation, the fiscal policy seeks to increase aggregate demand by increasing public expenditure and lowering the rate of taxation.

c) Reduction in Economic Inequality

In a democratic country economic equality is also to be removed through appropriate fiscal measures.

To achieve this objective, progressive direct taxes – like Income tax, wealth tax, are levied.

The incidence of these taxes is more on the rich. The taxes collected are spent in providing more and more facilities to the weaker sections of the society. As such, the standard of living of the poor begins to improve.

d) Economic Development

The fiscal policy seeks to increase the rate of capital formation. In an underdeveloped economy, an increase in the rate of capital formation is the sole determining factor to increase output and employment and hence, economic employment and development.

Fiscal Policy – Objectives, Instruments & Limitations

Instruments of Fiscal Policy

The main instruments of fiscal policy are –

a) Taxation policy-

The government collects large funds from the public by way of taxes. Aggregate can be influenced by taxes. There are various kinds of taxes broadly classified as direct and indirect tax.

As a result, of taxes either the monetary income of the people is diminished or prices of goods increase.

In other words, the real income of the people is diminished and so, also their aggregate demand.

Effect of taxes on aggregate demand depends on taxation multiplier

Kt = Y/T = – B/ 1-b

Here, Kt = Taxation Multiplier

   △Y = Change in Income

          △T = Change in Taxation

           B = Marginal Propensity to Consume

Value of taxation is negative. It means that change in taxation has an Inverse effect on national income.

Fall in taxation leads to increase national income.

Rise in taxation leads to decrease in national income.

b) Government Expenditure policy-

Aggregate demand is influenced by government expenditure also. On account of the increase in public (government) expenditure, there is an increase in aggregate demand and vice versa.

 — Public expenditure can be of two types-

i) Public expenditure incurred to buy goods and services. It has a direct effect on aggregate demand.

ii) Public expenditure can also be incurred without buying goods and services, e.g. Expenditure made on pensions, scholarship, education, medical facilities, etc., by the government. Such expenditure is called Transfer payment.

Transfer payments have an indirect effect on aggregate demand. Aggregate demand increase when there is an increase in transfer payments.

c) Deficit Financing-

It refers to the financing of the deficit of the government budget. When the government meets its budgetary deficit by borrowing from the central bank it is called ‘Deficit financing’.

As a result of deficit financing, the income of the people goes up along with its, aggregate demand also goes up.

[instruments of fiscal policy]

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Fiscal Policy and Stabilization –

Economic stability refers to the minimum possible changes in the internal price level and foreign exchange rate. Fiscal policy can help to achieve economic stabilization in the following ways –

1) Fiscal Policy and Inflation-

a) Decrease in Public Expenditure

One of the main cause of inflation is the increase in government expenditure. It is, therefore, necessary to curb inflation government should reduce its unnecessary expenditure.

b) Increase in taxes

To check inflation, the government should levy new taxes and raise the rate of old ones.

c) Delay in the Payment of Old Debts

Another way of checking inflation is to defer the repayment of old debts. It will restrict the current flow of money in the economy.

d) Surplus Budget Policy

It implies that the expenditure of the government should be less than its revenue. It will help check inflation.

People will have less purchasing power when the revenue of the government is more than its expenditure.

2) Fiscal Policy and Deflation

a) Increase in Government Expenditure

Under the deflationary situation government (public) expenditure must increase. As a result of it, demand will increase. Increase in demand will check the tendency of the prices to fall.

b) Decrease in Taxes

During the depression, taxes should be decreased. As a result of a decrease in direct taxes like- Income Tax, Corporation tax, investors and rich section of the society will promote to invest more.

As a result aggregate demand will increase and depression be brought under check.

c) Price Support Policy

During the depression, prices fall heavily. Government, therefore, has to pursue price sport policy.

During this period, the government buy itself stocks of essential goods at a fixed price, called support price. As a result of this, the tendency of the falling price is arrested.

d) Pump Priming

During depression, private investment is at its lowest peak. To increase it, public investment becomes very essential. Increase in public investment serves as an incentive to private investment. Such a policy is called pump priming.

Government spending design to overcome depression is known as pump priming. Pump priming encourages investment in two ways-

= In order to increase public investment government borrows from Bank.

= On account of an increase in public investment, there is many times more increase in total income under the impact of the multiplier. And hence it will help in combating depression.

Fiscal Policy – Objectives, Instruments & Limitations

Fiscal Policy – Objectives, Instruments & Limitations
Fiscal Policy – Objectives, Instruments & Limitations

Limitations of Fiscal Policy-

Following are the main limitations of fiscal policy of less developed country –

a) Limited scope

Fiscal policy has its effects only on limited sectors.  Most of the sectors in the economy remain unaffected by it.

For example, in India burden of taxation is borne by the urban Sector, the agriculture sector enjoys exemption from it.

b) Delay of Decision

In democratic countries, the decision regarding fiscal measures must have the prior approval of the Legislative Assemblies of the Parliament. It is a long and time-consuming process.

Hence, fiscal policy decisions are delayed. Besides, there is a time lag between the enforcement of fiscal policy and its effect on output.

c) Non Monetized Sector

A part of the economy is non-monetized. These sectors of the economy remain unaffected by the fiscal policy.

d) Lack of elasticity

The taxation system of underdeveloped countries is not modern, rational and elastic. It is difficult to earn adequate revenue by way of taxes in these economies.

A very small fraction of the population is covered by the tax net.

e) Problems of Deficit Financing

Most of the governments, in underdeveloped countries, resort to large scale deficit financing as a fiscal measure for economic development.

Deficit financing, beyond a particular limit, becomes a potent source of inflation. It has an adverse effect on economic development.

f) Illiteracy

Because of rampant illiteracy in underdeveloped countries, most of the people fail to appreciate the significance of fiscal policy. They try their best to avoid taxes.

[limitations of fiscal policy]

What is meant by fiscal policy?

Fiscal policy is the policy related to revenue, expenditure, and debt of the government for achieving a set of definite objectives.

What are the main objectives of fiscal policy?

a) Full Employment
b) Price stability
c)Reduction in Economic Inequality
d) Economic Development
Continue reading

What are the main instruments of fiscal policy?

The main instruments of fiscal policy are –
a) Taxation policy-
The government collects large funds from the public by way of taxes. Aggregate can be influenced by taxes. There are various kinds of taxes broadly classified as direct and indirect tax.
Continue reading

What are the limitations of fiscal policy?

a) Limited scope
Fiscal policy has its effects only on limited sectors. Most of the sectors in the economy remain unaffected by it. For example, in India the burden of taxation is borne by the urban sector, the agriculture sector enjoys exemption from it.
Continue reading

Fiscal Policy – Objectives, Instruments & Limitations

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