ROLE OF FISCAL

POLICY IN UNDER
DEVELOPED
COUNTRIES

NAME: ROHIT SHET

INTRODUCTION

Fiscal policy is the means by which a government adjusts its spending levels and tax rates
to monitor and influence a nation's economy. It is the sister strategy to monetary through which a
central bank influences a nation's money supply. These two policies are used in various
combinations to direct a country's economic goals. Here we look at how fiscal policy works, how
it must be monitored and how its implementation may affect different people in an economy.
Fiscal policy is an vital part of the economic framework of a country and so it is closely linked
with its overall economic policy strategy. Tax policy, expenditure policy, investment or
disinvestment strategies and debt or surplus management is the core basis of the Fiscal policy. It
is the policy of the government which particularly aims for nation's development. In this context
this article laid emphasis on the role of fiscal policy of India.
Tax policy, expenditure policy, investment or disinvestment strategies and debt or surplus
management is the core basis of the Fiscal policy. Fiscal policy is the policy of the government
which includes taxation, public expenditure and public borrowings. Fiscal policy is an vital part
of the economic framework of a country and so it is closely linked with its overall economic
policy strategy. In contemporary economic scenario the government is in trusted t deals with
fiscal policy while the central bank is held responsible for monetary policy. In underdeveloped
countries the importance of fiscal policy is very high. The state is loaded with responsibility in
order to play active role for allocating the revenue and expenditure properly. Hence, fiscal policy
is a powerful tool in the hands of government with the help of which it can attain the objectives
of development. Fiscal policy help government to create a balance between revenue generated
and revenue expend. Surplus occurs when the government receives more than what it spends.
Likely when the government expenditure turns to be more than what it receives it runs into a
deficit. So while formulation of fiscal policy government sees it neither run into deficit nor have
surplus. Planning is made to achieve best use of received revenue.
Before the Great Depression, which lasted from Sept. 4, 1929 to the late 1930s or early
1940s, the government's approach to the economy was laissez-faire. Following World War II, it
was determined that the government had to take a proactive role in the economy to regulate

unemployment, business cycles, inflation and the cost of money. By using a mix of monetary and
fiscal policies (depending on the political orientations and the philosophies of those in power at a
particular time, one policy may dominate over another), governments are able to control
economic phenomena.
Measures employed by governments to stabilize the economy, specifically by adjusting
the levels and allocations of taxes and government expenditures. When the economy is sluggish,
the government may cut taxes, leaving taxpayers with extra cash to spend and thereby increasing
levels of CONSUMPTION. An increase in public-works spending may likewise pump cash into the
economy, having an expansionary effect. Conversely, a decrease in government spending or an
increase in taxes tends to cause the economy to contract. Fiscal policy is often used in tandem
with MONETARY POLICY. Until the 1930s, fiscal policy aimed at maintaining a balanced budget;
since then it has been used counter cyclically, as recommended by JOHN MAYNARD KEYNES,
to offset the cycle of expansion and contraction in the economy. Fiscal policy is more effective at
stimulating a flagging economy than at cooling an inflationary one, partly because spending cuts
and tax increases are unpopular and partly because of the work of economic stabilizers.
How Fiscal Policy Works:
Fiscal policy is based on the theories of British economist John Maynard Keynes. Also
known as Keynesian economics, this theory basically states that governments can influence
macroeconomic productivity levels by increasing or decreasing tax levels and public spending.
This influence, in turn, curbs inflation (generally considered to be healthy when between 2-3%),
increases employment and maintains a healthy value of money. Fiscal policy is very important to
the economy. For example, in 2012 many worried that the fiscal cliff, a simultaneous increase in
tax rates and cuts in government spending set to occur in January 2013, would send the U.S.
economy back to recession. The U.SCongress avoided this problem by passing the American
Taxpayer Relief Act of2012 on Jan. 1, 2013.
Indias fiscal policy architecture
The Indian Constitution provides the overarching framework for the countrys fiscal
policy. India has a federal form of government with taxing powers and spending responsibilities

being divided between the central and the state governments according to the Constitution. There
is also a third tier of government at the local level. Since the taxing abilities of the states are not
necessarily commensurate with their spending responsibilities, some of the centres revenues
need to be assigned to the state governments. To provide the basis for this assignment and give
medium term guidance on fiscal matters, the Constitution provides for the formation of a Finance
Commission (FC) every five years. Based on the report of the FC the central taxes are devolved
to the state governments. The Constitution also provides that for every financial year, the
government shall place before the legislature a statement of its proposed taxing and spending
provisions for legislative debate and approval. This is referred to as the Budget. The central and
the state governments each have their own budgets. The central government is responsible for
issues that usually concern the country as whole like national defence, foreign policy, railways,
national highways, shipping, airways, post and telegraphs, foreign trade and banking. The state
governments are responsible for other items including, law and order, agriculture, fisheries,
water supply and irrigation, and public health. Some items for which responsibility vests in both
the Centre and the states include forests, economic and social planning, education, trade unions
and industrial disputes, price control and electricity. There is now increasing devolution of some
powers to local governments at the city, town and village levels. The taxing powers of the central
government encompass taxes on income (except agricultural income), excise on goods produced
(other than alcohol), customs duties, and inter-state sale of goods. The state governments are
vested with the power to tax agricultural income, land and buildings, sale of goods (other than
inter-state), and excise on alcohol. Besides the annual budgetary process, since 1950, India has
followed a system of five year plans for ensuring long-term economic objectives. This process is
steered by the Planning Commission for which there is no specific provision in the Constitution.
The main fiscal impact of the planning process is the division of expenditures into plan and nonplan components. The plan components relate to items dealing with long-term socioeconomic
goals as determined by the ongoing plan process. They often relate to specific schemes and
projects. Furthermore, they are usually routed through central ministries to state governments for
achieving certain desired objectives. These funds are generally in addition to the assignment of
central taxes as determined by the Finance Commissions. In some cases, the state governments
also contribute their own funds to the schemes. Non-plan expenditures broadly relate to routine
expenditures of the government for administration, salaries, and the like.

While these institutional arrangements initially appeared adequate for driving the
development agenda, the sharp deterioration of the fiscal situation in the 1980s resulted in the
balance of payments crisis of 1991, which would be discussed later. Following economic
liberalization in 1991, when the fiscal deficit and debt situation again seemed to head towards
unsustainable levels around 2000, a new fiscal discipline framework was instituted. At the
central level this framework was initiated in 2003 when the Parliament passed the Fiscal
Responsibility and Budget Management Act (FRBMA).Taxes are the main sources of
government revenues. Direct taxes are so named since they are charged upon and collected
directly from the person or organisation that ultimately pays the tax (in a legal sense).2Taxes on
personal and corporate incomes, personal wealth and professions are direct taxes. In India the
main direct taxes at the central level are the personal and corporate income tax. Both are till date
levied through the same piece of legislation, the Income Tax Act of 1961. Income taxes are
levied on various head of income, namely, incomes from business and professions, salaries,
house property, capital gains and other sources (like interest and dividends).3 Other direct taxes
include the wealth tax and the securities transactions tax. Some other forms of direct taxation that
existed in India from time to time but were removed as part of various reforms include the estate
duty, gift tax, expenditure tax and fringe benefits tax. The estate duty was levied on the estate of
a deceased person. The fringe benefits tax was charged on employers on the value of in-kind
non-cash benefits or perquisites received by employees from their employers. Such perquisites
are now largely taxed directly in the hands of employees and added to their personal income tax.
Some states charge a tax on professions. Most local governments also charge property owners a
tax on land and buildings. Indirect taxes are charged and collected from persons other than those
who finally end up paying the tax (again in a legal sense). For instance, a tax on sale of goods is
collected by the seller from the buyer. The legal responsibility of paying the tax to government
lies with the seller, but the tax is paid by the buyer. The current central level indirect taxes are the
central excise (a tax on manufactured goods), the service tax, the customs duty (a tax on imports)
and the central sales tax on inter-state sale of goods. The main state level in direct tax is the postmanufacturing (that is wholesale and retail levels) sales tax (now largely a value added tax with
intra-state tax credit). The complications and economic inefficiencies of this multiple cascading
taxation across the economic value chain (necessitated by the constitutional assignment of taxing
powers) are discussed later in the context of the proposed Goods and Services Tax (GST).

Role of Fiscal Policy in under developing Countries

The fiscal policy in under developing countries should apparently be conducive to rapid
economic development. In a poor country, fiscal policy can no longer remain a compensatory
fiscal policy. It has a tough role to play in a developing economy and has to face the problem of
growth-cum-stability.
The main goal of fiscal policy in a newly developing economy is the promotion of the highest
possible rate of capital formation. Underdeveloped countries are encompassed by vicious circle
of poverty on account of capital deficiency; in order to break this vicious circle, a balanced
growth is needed. It needs accelerated rate of capital formation.
Since private capital is generally shy in these countries, the government has to fill up the lacuna.
A mounting public expenditure is also required in building social overhead capital. To accelerate
the rate of capital formation, the fiscal policy has to be designed to raise the level of aggregate
savings and to reduce the actual and potential consumption of the people.
Another objective of fiscal policy, in a poor country is to divert existing resources from
unproductive to productive and socially more desirable uses. Hence, fiscal policy must be
blended with planning for development.
An important aim of fiscal policy in a developing economy is to create an equitable distribution
of income and wealth in the society. Here, however, a difficulty arises. The aims of rapid growth
and attainment of equality in income are two paradoxical goals because growth needs more
savings and equitable distribution causes reduction of aggregate savings as the propensity to save
of the richer section is always high and that of the poor income group low.
As such, if high economic growth is the objective, the question arises as to what extent
inequalities should be reduced. Of course, many a time, under the goal of socialism, the
government unduly resorts to reduction of inequalities at the cost of growth which may lead to

the distribution of poverty rather than prosperity. A reconciliation of these two contradictory
goals of growth and reduction of inequalities can definitely bring forth better results.
Furthermore, fiscal policy in a poor country has an additional role of protecting the economy
from high inflation domestically and unhealthy developments abroad. Though inflation to some
extent is inevitable in the process of growth, fiscal measures must be designed to curb
inflationary forces. Relative price stability constitutes an important objective.
The approach to fiscal policy in an economy which is developing must be aggregative as well as
segmental. The former may lead to overall economic expansion and reduce the general pressure
of unemployment; but due to the existence of bottlenecks though general price stability may be
maintained, sectoral price rise may inevitably be found.
These sectoral imbalances are to be corrected by appropriate segmental fiscal measures which
would remove frictions and immobilitys turn demands into proper directions, seek to eliminate
bottlenecks and other obstacles to growth.
For less developed countries such as India the following main objectives of fiscal policy may
be restated as:
(i) To increase the rate of investment and capital formation, so as to accelerate the rate of
economic growth.
(ii) To increase the rate of savings and discourage actual and potential consumption.
(iii) To diversify the flow of investments and spendings from unproductive uses to socially most
desirable channels.
(iv) To check sectoral imbalances.
(v) To reduce widespread inequalities of income and wealth.
(vi) To improve the standard of living of the masses by providing social goods on a large scale.

For the purpose of development, not only an expansionary budget but a deficit is desirable too in
a developing country. The government expenditure on developmental planning projects must be
increased.
It may be financed even by means of deficit financing. Deficit financing, here, refers to the
creation of new money by printing additional notes by the government or by borrowing from the
central bank which ultimately means creation of additional money supply. However, the
government must use the technique of deficit financing cautiously. An excessive dose of deficit
financing may lead to inflation which may endanger economic growth.
Public borrowing also is an important means of getting resources for development of the public
sector. External loans are useful to some extent when the country has to import machines, capital
goods, etc., from a foreign country and the country has a scarcity of foreign exchange.
Anyway the effectiveness of fiscal measures in promoting development in a poor country
depends on the incentives administered to the strategic points in the productive set up by virtue
of the consequences of taxation and public spending.
It must be noted that fiscal policy in a developing economy has to operate within a framework
influenced by social, cultural and political conditions and institutions, which may inhibit the
formulation and implementation of good economic policies.
Further, fiscal policy in a poor country may be used to reduce inequalities in income and wealth
distribution by means of taxes and government expenditure. Taxation has to be progressive and
government spending must be welfare-oriented.
In short, for promoting economic growth, the fiscal policy must be first formulated in such a way
that it will increase the rate of volume of investment in the public and private sectors. The tax
policies must discourage unproductive and speculative investment. Second, fiscal policy must
mobilise more and more resources for capital formation. Hence, taxation must be used to curb
excessive consumption. Third, it must encourage an inflow of foreign capital.

Fiscal policy, however, cannot be effective when there are loopholes in the taxation laws and the
tax administration is corrupt so that there is large-scale tax evasion. Again, if the government is
extravagant in spending on non-developmental items, then a technique such as deficit financing
may prove to be inflationary. Again, market imperfections, bottlenecks, shortages of raw
materials, and lack of entrepreneurial skills, do not allow fiscal policy to be effective.
A high population growth, and an orthodox society also come in the way of development and
without a coordinated, sound, physical plan and its proper implementation, fiscal policy cannot
be very effective in reaching its goal of rapid economic development with stability.
Nonetheless, of all economic policies, fiscal policy today assumes unique importance in realising
general economic goals, depending on the size of the fiscal measures adopted and their timing.
The exact change effected in the national economy will depend on the form and the magnitude of
public revenue, especially, the rates and structure of taxation and the mode of public spending by
the government.
Further, when prices are rising, government has to adopt a surplus budget at an appropriate time
in order to avoid secular inflation. But, there is practical difficulty in knowing the changing
conditions or appearance of price stability; hence it is very difficult to forecast perfect timing.
Political and administrative delays tend to aggravate the problem and the desired effect of fiscal
programme may not be realised. Sometimes, even if the fiscal action is taken at a right time, in
quantitative or qualitative terms, it may not be adequate or appropriate.
Quite often, trade union activities come in the way of operating fiscal measures. The workers
may resent certain taxation measures or may demand high wages during inflation, and when the
government is forced to raise the wage level on account of demand- pull inflation, cost-push
inflation may also emerge to make the situation worse.

Importance of Fiscal Policy in the Economic Development of India

The attitude of economists and government regarding the role of fiscal policy has
radically changed owing to the Keynesian impact. The old conception of neutrality of public
finance has yielded place to a new one namely functional finance, public finance with its fiscal
measures has been assigned a positive and dynamic role for the promotion and acceleration of
the rate of economic development. The Keynesian analysis of fiscal policy is however,
applicable to the advanced and well-to-do countries of Europe and it has little relevance to
underdeveloped economies. The problem of developed countries is to stabilize the rate of
economic growth by maintaining effective demand at a high pitch and for that fiscal policy aims
at reducing the savings of the people and increasing their propensity to consume, The problem of
under-developed countries is however different.
They need more savings so as to increase the rate of capital formation and thereby
achieve higher rate of economic development. But in these countries the general level of incomes
of the people is low and their propensity to consume is high and hence the rate of savings is
small. The fiscal measures in these countries, therefore, should aim at raising the rate of capital
formation by reducing consumption and encouraging propensity to save. Our analysis of the
problems connected with voluntary savings indicated that the per capita incomes and savings are
extremely low and as such capital formation in underdeveloped economies cannot be left to
voluntary savings. According to an expert UN study, the annual per capita incomes in the Middle
East, in Asia and in Latin America are less than 200 US dollars or less than one-seventh of the
US level and one-fourth of the Canadian level. It was revealed in the I.M.F. staff papers that in
India savings contributed only 2 percent of the national income for development purpose.
The crucial determinant of economic growth is the rate of savings and, therefore savings
cannot be left to themselves to grow automatically. On the contrary, fiscal measures have to be
adopted to increase the savings of the people and to mobilize them for productive purpose. In the
words of Nurkse, fiscal policy, assumes a new significance in the face of the problem of capital
formation in under-developed countries.The backward countries are caught in the vicious circle
of low income, high consumption, low savings, and low rate of capital formation and therefore,
low incomes. To get out of this vicious circle of poverty, the fiscal policy can play a constructive

and dynamic role for the economic development of the underdeveloped countries.To break out
of this circle, apart from foreign aid, observes an expert UN study calls for vigorous taxation
and government development programmes. Thus in poor countries, the importance of fiscal
policy lies in raising the rate and volume of savings and to divert them into the desired channels.
In this connection, the UN report on Taxes and Fiscal Policy says, Fiscal policy is assigned the
central task of wresting from the pitifully low output of under-developed countries sufficient
savings to finance economic development programmes and to set the stage for more vigorous
private and public investment activity.
The limitations and ineffectiveness of monetary policy in securing an accelerated rate of
economic growth has further added to the importance of fiscal policy. Fiscal policy was designed
to supplement monetary policy but now it seems to have supplanted monetary policy altogether.
The role of fiscal policy in economic development cannot be overemphasized. The importance of
fiscal policy as an instrument of economic development was first envisaged by Keynes in his
General Theory wherein he showed that the total national income was an index of economic
activity and brought out the relation of economic activity of total spending.
The direct and indirect effects of fiscal policy on aggregate spending in the community
were clearly established and as a result the budgetary policy of the government as a weapon of
economic control and development came into prominence. The fiscal policy can affect the rate of
economic development in a variety of ways such as by increasing the rate of saving and
investment, affecting the allocation of resources, controlling inflation, promoting economic
stability. We now discuss them in detail.
To Increase the rate of saving and Investment:

Shortage of financial resources is the main obstacle in the way of economic development
of under- developed countries. There are certain forces operating in these countries which
increase consumption and reduce savings. The first among them is the population pressure.

Besides, the high income groups spend much of their income on conspicuous
consumption and their propensity to consume is further reinforced by the demonstration effect.
According to Still-worse, a large part of the meager savings is dissipated in unproductive
channelsreal estate, hoarding, gold, jewellery, speculation etc.
The fiscal policy can be employed effectively to divert savings of the people into
productive channels. It should aim at raising the incremental saving ratio through taxation and
forced loans and make funds available for investment purposes in the public and private sectors
of the economy.
This can be done by checking conspicuous consumption and preventing the flow of funds
for unproductive purposes. For this, high taxes on personal and corporate incomes and
commodity taxation on articles of widest use and conspicuous consumption should be imposed
to check the actual and potential consumption of the people.
In this connection, report of the Taxation Enquiry Commissions, Government of India,
observes, A tax system, which on the whole, promotes capital formation in is two aspects of
saving and investment fulfills an essential desideration.
It should be borne in mind that the purpose of taxation should not be merely to transfer
funds from private to public use but to enlarge the total volume of savings available for
investments. This requires that the general emphasis should be on curtailing and restraining
consumption and thereby increasing the volume of saving in the community.
In Japan, for example, agricultural productivity was doubled between 1885 and 1915 and
the instruments of taxation was used effectively and much of the increase was taken away from
the farmers by imposing on them higher rents and taxes and the resources thus collected were
channelled into productive investments.
Forced loans were also imposed on the business community to mop up surplus funds for
economic development. In USSR also, collective farms were heavily-taxed and agricultural
surplus were siphoned off by raising the prices of manufactures relating to farm products. The
Economic Bulletin for Asia and the Far East States observes, Taxation, therefore, remains as the

only effective financial instruments for reducing private consumption and investment and
transferring resources to the government for economic development.
It will be essential for the purpose to relay on both direct and indirect taxes. Their form and
magnitude should be determined in the light of the requirements of development.
We may discuss the role of Fiscal policy, in this connection, after Prof. Kurihara regards
Fiscal policy as a desiderate for underdeveloped countries, lacking in private initiative, private
voluntary saving and private innovation. He discusses the fiscal roles of government as an
additional saver, an investor, an innovator and an income-redistributors.
As an additional saver, the government should, maintain a persistent budgetary surplus
through (a) a decrease in the government average propensity to spend, (b) an increase in the
average propensity to tax, or (c) a decrease in the government average propensity to make
transfer payments. Prof. Kurihara observes, As for as under-developed economy is concerned,
budgetary surplus is the relevant position to be achieved and maintained. For it is as
supplementing deficient private saving that the fiscal role of government as a saver is to be
contemplated.
As an additional investor, the government can increases the productive capacity of the
economy and secure an accelerated rate of economic growth by changing the pattern of
investments and laying emphasis on capacity creating rather than on income-generating aspects;
by decreasing government consumption and thereby increasing government investment and by
raising the tax-rate which has the effects of decreasing private consumption expenditure and
hence of increasing that part of real income which is available for government investment.
As an innovator, the Government should spend on research and experimentation and
stimulate innovations and new techniques of production. This will reduce the costs of production
and encourage investment. Besides, the Government can encourage innovations by giving
subsidies and tax-relief to those firms and industries which may introduce them of their own.
The government has an important role to play as an income redistributors and for that
fiscal measures can go a long way in reducing economic inequalities. A broad-based and sleepy

progressive tax structure can serve as a potent weapon in the hands of the state to secure
equitable distribution of income and wealth. However, there is a limit to which taxation can be
carried for resource mobilisation. If the taxes are excessive they will adversely affect peoples
desire and ability to work, save and invest. This will obviously retard the pace of economic
development. To avoid such a situation, the gap in resources required for economic development
may be covered by mobilising savings through voluntary loans.
Financing of economic development through borrowings is not harmful it loans are used
for productive projects. Further, unlike taxes, borrowing is not harmful if loans are the public,
does not adversely affect peoples desire to work, save and invest as lending is voluntary and the
lenders not only get back the amount lent but also earn interest on it. Instead Public borrowing
may add to the incentive of the people to save and invest more as the lure of interest is there.
However, public borrowing is beset with certain limitations in under-developed countries
and as such much reliance cannot be placed on it. The general masses are poor and their
propensity to consume is very high and hence they have no lending capacity. The rich generally
do not like to lend to the government but instead divert their invisible resources into speculative
channels as they can earn more from there.
Besides, the absence of organised money and capital markets inadequate banking
facilities and lack of confidence in the financial and political stability in the governments of most
of the underdeveloped countries are some of the other obstacles in the way of public borrowing
programme.
Therefore, steps may be taken to remove these and other obstacles and all out efforts
must be made to educate people and persuade them to save more in the wider interest of the
community.
But if inspite of all this, adequate resources are not forthcoming, the government may
resort to compulsory borrowing. For financing economic development. In this connection,
Nurkse says, since individuals are interested not only in their consumption but also in the size of
their asset holdings, there is a case for forced loans as an alternative to taxation.

They may be little more than tax receipts and yet make a difference to the incentive to
work and to produce as was found during the war period when the un-spendable cash reserves
accumulated as a result of rationing made consumers feel much better off. Forced loans in place
of taxation would be a method of forced saving in form as well in substance.
Those people who spend the major portion of their income on conspicuous consumption
and divert their resources into unproductive channels or those who stand to be benefitted from
particular development projects may be forced to invest in government bonds.
But it may be noted that no democratic government can rely on forced loans except for a
short period and for certain specified projects. Ultimately, it is the voluntary lending by the
people that matters and the Government must be prepared to increase its domestic borrowing
when the income and saving of the people increase as a result of economic development and
make public borrowing an important tool of resource mobilisation.
Under the policy of Laissez. Faire when state was regarded as police state, the role of
public expenditure in the economic life of the people and community remained neglected. Its
effects on production and distribution were not take notice of and it was held that public
expenditure should be kept at the minimum level. But today, the pendulum has moved to the
other side.
Public expenditure is one the most potent weapons in the hands of the state to secure
economic development of the underdeveloped. In underdeveloped countries, there is lack of
basic facilities such as transport, power, irrigation, education etc. and also of basic and key
industries.
The availability of such facilities and provides by the private sector for want of resources
and entrepreneurial ability. Thus, public expenditure should aim at creating basic facilities and
establishing basic and key industries and encourage the development of agriculture and industry
by giving loans, grants, subsidies etc.
Thus a carefully and wisely planned public expenditure by creating social and economic
overheads can go a long way in creating necessary environment for the growth of the economy.

But public expenditure can achieve its wider objective of development only it conforms to
certain well-defined principles of public expenditure.
The expenditure on the armed forces must not be overdone and other wasteful and
excessive expenditure on administration must be avoided. Public enterprises must conform to the
principle of economic efficiency so that costs fall and profits increase.
Care should be taken that public expenditure does not adversely affect peoples desire to
work, save and invest and for that people should not be provided with direct money help but with
goods and services in the form of free education, free medical facilities etc. This will go a long
way in increasing the efficiency and productive capacity of the people. Thus public expenditure
can play an important role in economic development.
Dr. R.N. Tirpathy, in his book, Public Finance in Under-developed Countries has
suggested the following methods which the government may adopt to increase the volume of
domestic savings to meet the financial requirements of economic development:
(i) Direct physical controls.
(ii) Increase in the rate of existing taxes.
(iii) Imposition of new taxes.
(iv) Surplus from public enterprises.
(v) Public borrowing of a non-inflationary nature.
(vi) Deficit financing.
The process of economic development inevitably leads to inflationary pressures in the
economy because it generates additional effective demand without an immediate and
corresponding increase in the production of consumption goods.
Direct physical controls can be used most effectively to curtail consumption and check
socially undesirable investment and thereby releasing resources for economic development.

Though direct physical controls are not compatible with maintenance of democratic freedom and
may be difficult to administer in an underdeveloped economy yet they are a necessary adjunct to
a developmental fiscal policy.
To meet the financial requirements of economic development, the imposition of a new
variety of taxes both direct and indirect becomes indispensable in absence of sufficient voluntary
savings. In some countries profits made in public enterprises bring the government closer to
economic realities and enable it to measure the efficiency and taxpaying capacity of their
counterparts and in the private sector.
It is desirable that the government herself starts highly profitable enterprises and utilises
the surplus from them for economic development. But the scope for any large surplus from
public enterprises in under developed countries is limited due to high cost of production, in the
initial stages of economic development and also because of limited number of such enterprises.
A mild dose of deficit financing is very useful for the employment of unemployed
economic resources but its scope is limited in underdeveloped countries because of its
inflationary impact resulting from the lags in the supply of consumer goods.
Similarly, public borrowing cannot be expected to bring in adequate resource in the
absence of properly developed capital markets in most of the underdeveloped countries. Besides
a vigorous programme of public borrowing may push up interest rates and affect investments
adversely.
Of all methods, therefore, main reliance has to be placed on taxation for the mobilisation
of resources for economic development. Besides, fiscal policy in the shape at fiscal concessions
such as investment and depreciation allowances, provisions of finance and foreign exchange, taxholiday, development rebates subsides etc., can contribute materially to the growth of investment
in the private sector of the economy. Thus the first role of fiscal policy is to make available for
economic development maximum resources consistent with minimum current consumption.

Optimum Pattern of Investment:

An underdeveloped country can ill-afford the diversion of her limited resources into
socially undesirable channels. The fiscal measure can be used to secure the pattern of investment
which is in conformity with the criteria of social marginal productivity.
High taxes on land value increments on capital gains and other windfalls should be
imposed to prevent the flow of funds into unproductive channels such as land, buildings,
inventories and other investments of speculative nature.
The tax system can provide positive inducement to productive and socially desirable
investment in the private sector. This can be done by differential rates of taxation and the grant of
tax exemption in selected cases.
Investment in economic and social overheads, viz. transport, power, soil conservation,
education public health, technical training facilities etc., is of vital importance for attaining
optimum pattern of investment because the provision of these basic facilities is essential for
speeding up development.
Such an investment widens the extent of the market; helps reduce cost of production and
raise productivity by creating external economies. Private enterprise cannot be expected to
provide such basic facilities as the investment involved in them is very huge and they are low
yielding and slow yielding projects.
Therefore, Governments of under-developed countries should take upon themselves the
responsibilities to the execution of these basic facilities. However, such projects should be
financed through taxation and not with borrowed funds because they do not yield direct returns
necessary for the repayment of these debts.

The raising of collective compulsory saving through taxation for such development
programmes is now widely recognised. Thus fiscal measures should be directed to secure the
optimum pattern of investment so as to accelerate the pace of economic development of the
underdeveloped countries.
To Counteract Inflation:

The process of economic development in underdeveloped countries inevitably leads to

inflationary pressures as a result of the imbalances between the demand for and supply of real
resources.
The pressure of wages on prices, structural rigidities of their economic systems, market
imperfections and bottle- necks impede the supply of goods and services and prices start rising.
Inflation feeds on itself and if it goes out of control, it ruins the entire economy and all progress
comes to standstill.
That is why economic growth and stability are regarded as joint objectives for
underdeveloped countries to pursue. Today the choice is not between economic growth and
stability but only over the inter-relations ups between them and over the policies necessary to
achieve them.
The fiscal measures should be used to counter act the inflationary pressures by reducing
over a effective demand for the attainment of this objective. The tax structure should be so
devised that it mops up a major portion of the rise in money income.
For that, greater reliance should be placed on progressive direct taxes and commodity
taxes, the yield of which changes more than in proportion to changes in tax base. Special antiinflationary taxes on excess profits, capital gains and other windfalls including taxes on articles
of conspicuous consumption may be imposed.
Besides, the fiscal policy of the Government should extend to the removal of structural
rigidities, market imperfections and imposition of physical controls including subsidies and

protection to essential consumer goods industries. However, if inflationary pressures go on

mounting, capital levy on cash balances and liquid assets may be imposed.

Alternative Fiscal Policies for Curbing Inflation:

The inflationary situation may basically be caused by the condition of excess demand,
when the spending on consumption and investment goods and the foreign spending on the goods
of home country, aggregate together, exceed the full employment output. This implies that true
inflation starts only after full employment. But actually, inflationary pressure are felt even before
full employment on account of the bottle necks and rigidities of factor supply and the pushes of
wages, profits and costs.
The fiscal remedies of inflation are discussed below:

(i) Reduction in Government Spending and no Change in Tax Rates:

Such a fiscal policy will give rise to budget surplus and drain out the purchasing power of
the people. Tins will set a reverse process of government expenditure multiplier in motion and
bring about a contraction in national income and employment and a consequent mitigation of
inflationary phenomenon.
(ii) Reduction in Government Spending and Increase in Tax Rates:
This set of fiscal measures is likely to be made effective than the previous one since an
increase in tax rates coupled with a reduction in government spending will create a larger budget
surplus and consequently a larger reduction will be affected in national income and employment.

(iii) Rigid Government Spending and Increasing Tax Rates:

Sometimes the Government spending is rigid as for instance during the period of war the
reduction in aggregate spending can be affected. In this case, only through an increase in tax
rates. This results, in a reduction in private disposable incomes and hence private consumption
and investment expenditures fall which can check inflation. It was through such a policy that the
United States during the period of Second World War could siphon of purchasing power by a
measure sufficient to finance more than 48 percent of the cost of war out of tax proceeds.
(iv) Reduction in Government Spending and an Equivalent Reduction in Taxes:
Just as an increase in government expenditure and an equivalent increase in tax revenues
raises the national income through the operation of the balanced budget multiplier, similarly a
decrease in government spending and equivalent decrease in tax revenue brings about a
reduction in national income and expenditure on account of its reverse operation.
If these fiscal changes result in a redistribution of income between the beneficiaries of
government expenditure and tax payers in such a way that it results in reduction in government
expenditure. A balanced budget multiplier greater than unity will in this situation have an antiinflationary impact upon the economy.
This discussion clearly brings out the fact that variation in taxes is the most crucial
instrument of an anti-inflationary fiscal policy. There is a controversy about the relative antiinflationary impact of income-tax and consumption tax of an equal yield.
The latter is sometimes conceived as more effective, since it results entirely in reducing
consumption. The income tax, on the contrary, falls partly upon consumption and partly upon
savings, to the extent income-tax reduces savings, if will not help in curtailing inflationary
pressure.
To Promote Economic Stability:
The underdeveloped countries are susceptible to economic instability resulting from
deficiency of effective demand in the short-run and fluctuations in demand for their products in

the world market. Underdeveloped countries mainly export agricultural and mineral products the
demand for which is generally less elastic.
On the other hand these countries import capital goods and finished manufactured
articles, the demand for which is elastic. When the prices of export goods fall in the international
markets the terms of trade becomes unfavourable, foreign exchange earnings decline and
national income falls which produces depression effects on the economy.
The under-developed countries cannot push their, exports to take advantage of the fall in
prices because their capacity to produce more is limited. Similarly, when the prices of the exports
rise due to the boom conditions in the world-markets, the increase in export earnings does not
lead to increased output and employment but instead it is dissipated in conspicuous consumption
and speculative investment which further generate inflationary pressure in the economy.
Fiscal measures can be used to offset the effects of international cyclical fluctuations in
the prices of exports. For example, in booms heavy export and imports duties may be imposed
export duties to neutralise the windfall gains arising from the rise in world market prices and
import duties to discourage conspicuous consumption.
The earnings from such export and import duties should be used for capital formation. In
periods of depression on the other hand, subsidies may be given to encourage exports and
government should directly intervene to maintain the level of effective demand through public
work programmes etc.
Thus, contra-cyclical fiscal policy should be followed to mitigate the effects of
international cyclical movements and all out efforts should be made to develop all sectors of the
economy so as to reduce an excessive dependence on the primary sector alone. Hence a welldevised fiscal policy can go a long way in promoting economic stability.

Main Objectives of Fiscal Policy in India

The Indian Constitution gives the balanced fiscal policy framework for the country. India
constitutes federal form of government which is having divided responsibility of imposing taxes
and spending between the central and the state governments. The Indian constitution provides
for the formation of a Finance Commission (FC) every five years which provides medium term
guidance on all the fiscal matters. It is with help of report of the FC that the central taxes are
delegated to the state governments. The Constitution also says that for every financial year, the
government shall prepare its proposal of taxation and spending execution and place them before
the legislature for legislative debate and approval. This is known as the Budget. Both the central
and the state governments have their own budgets. The various objectives of Indian fiscal
policy.
Development by effective allocation of Resources
The primary objective of fiscal policy is to produce rapid and sustainable economic
growth and development. By Mobilization of Financial Resources this objective of economic
growth and development can be attained. Both the central and the state governments in India
have been empowered to mobilize financial resources in order to bring effective financial
planning and its uses. In India financial resources are mobilized by following three means
:-Taxation : Through fiscal policies, the government generated revenue. It aims to allocate
resources by means of direct taxes as well as indirect taxes. Direct taxes involves income tax
which each working citizen of India pays form his salary.Public Savings : By reducing
government expenditure and increasing surpluses of public sector enterprises is one of the
emerging tool of fiscal policy. Hence financial resources can be mobilized well through public
savings. Private Savings : With the help of effective fiscal policy such as tax benefits, the

government can bring resources from households and private sector. Resources can be allocated
and managed through government borrowings by means of loans from domestic and foreign
parties,

treasury

bills,

issue

of

government

bonds,

deficit

financing

etc.

Expenditure of Financial Resources

The central and state governments have worked to make efficient allocation of financial
resources. These resources are utilized mainly to increase production of necessary and desirable
goods and discourage socially undesirable goods. The central theme of fiscal policy includes
development Activities which are expenditure on railways, infrastructure, etc. While other part
of non-development activities includes expenditure on interest payments defense, subsidies, etc.
Planning is made systematically at end of every financial year and action is taken accordingly.

Reduction of Income and Wealth inequalities

Fiscal policy by reducing income inequalities among different sections of the society
leads to strive equity or social justice. The direct taxes play crucial role in this, income tax are
charged on all salaried person which is directly proportion to the income of the person. More the
person earns more he is entitled to pay tax. Hence direct tax applied more on the higher income
groups as compared to lower income groups. Likely indirect taxes are also more in the case of
semi-luxury and luxury items than that of necessary consumable items. In this way government
generates good amount of revenue which is on significant proportion is implemented on Poverty
Alleviation Programmes which improves the conditions of poor people in society and
consequently

leads

to

reduction

Price Stability and Control of Inflation

of

income

and

wealth

inequalities.

One of the major objective of fiscal policy is to have stabilize price and control inflation.
Inflation and price instability have hazardous impact on over all economy. If inflation increses at
high rate in any country then it can finally lead to overall collaspe of country. Hence, the
government being particular about this and always tries to control the inflation by various means
such as bringing reduction in fiscal deficits, introduction of tax savings schemes, induce correct
use

of

financial

resources,

etc.

Employment Generation
The government is inducing every possible effort for increasing employment throughout
the country with help of effective fiscal measure. Direct and indirect employment are one of the
outcome of various investments in infrastructure of the country. Small-scale industrial (SSI) units
are encouraged to bring in more investment by providing lower taxes and duties which
consequently creates more employment. Government of India in order to solve problems in rural
areas initiated various rural employment programmes to generate employment and cope up with
increasing poverty. Likely, self employment schemes have been taken up in order to generate
employment

for

persons

in

the

urban

areas

who

are

technically

qualified.

Balanced Regional Development

Balanced regional development is very important for any nation. Government key
responsibility is to see that all states and its sub units whether urban or rural develop equally and
no part of country be away from development. So fiscal policy planning occupies larger portion
for regional development. Government in order to accomplish its aim provides various incentives
such as Finance at concessional interest rates, Cash subsidy, Concession in taxes and duties in
the

form

of

tax

holidays

etc

for

setting

up

projects

in

backward

areas.

Reducing the Deficit in the Balance of Payment

Fiscal policy aims to encourage more exports by means of various fiscal measures such
as exemption of central excise duties and customs, exemption of income tax on export earnings,
exemption of sales tax etc. The foreign exchange is also protected by giving import substitute

industries fiscal benefits, applying customs duties on imports etc. The problem of balance of
payment is solved since foreign exchange received by means of exports and saved by way of
import substitutes. With the help of this method the adverse balance of payment is rectified either
by

applying

duties

on

imports

or

by

providing

subsidies

to

export.

Capital Formation
The aim of fiscal policy in India is also to improve and increase the rate of capital
formation so as to increase the overall economic growth. An underdeveloped country is badly
trapped with the problem of increasing poverty which is mainly an outcome of capital
deficiency. In order to defeat poverty and increase the capital formation generation, the fiscal
policy must be systematically prepared to encourage savings and decrease spending.

Increasing National Income

National income growth of any country shows its efficiency and overall development.
Any activities of development closely have impact on national income. If production and
services within a country increases the overall national income also increases. National income is
calculated by addition of contribution from all the sectors in a country. So government with the
help of fiscal policy tries to increase capital formation which in turn increases GDP, per capita
income

and

national

income

of

the

country.

Development of Infrastructure
Development of infrastructure is the core element that is seen in fiscal policy.
Infrastructure development benefits is enormous, it help to provide boost in all the sector of the
economy. So government always see which area needs new or further infrastructural
development and accordingly investment is put in from the revenue to bring desired result.

Wrap up

The fiscal policy is the first step towards efficient and profound nation. It is a jest and
planning of all the sect oral development along with it carter the need of common people and
inducing the social justice. Its a great tool in the hands of government and if effective fiscal
policy is applied then the growth of any nation is inevitable. The proper investment in different
program and policy can bring great results in the long terms. In context of developing nation the
importance of fiscal policy is just too much because a developing nation have limited resources
and many responsibility and needs that require urgent attention. So mobilization of recourses
towards most urgent requirement is the prerequisite of any developmental action. India has
achieved to utilize benefit with help of fiscal policy but certain gaps in the implementation is still
exists which need a corrective measure to bring over all sustainable economic growth.

Improved Growth Effects of Fiscal Policy

In general, the increases in government revenue that occur as a result of economic growth
allow the government to employ policies that promote more jobs and swell benefits in kinds. In
this regard, fiscal consolidation can be rather regressive and less distributive although mixed
outcomes have been presented in some cases. In a comprehensive study, Carrere and De Melo
(2012) provided a cross country analysis of the correlation between fiscal policy and growth for
118 developing and 22 high income OECD countries during the period of 19722005. The study
found that a growth event is more likely to occur when there is a fiscal event. In the case of a
typical developing country, the probability of an occurrence of a fiscal event is high for the
bottom half of the incomedistribution, but the probability that this fiscal event is followed by a
growth event is higher for the third quartiles. This findings are consistent with the view that the
success of a growthoriented fiscal expenditure plan for developing countries depends on their
institutional environment. Mertens and Ravn (2013) estimate the dynamic effects of changes in
taxes in the U.S. by distinguishing between the effects of changes in personal and corporate
income taxes. The result suggests different types of taxes should be distinguished when
estimating their growth impacts. European Commission (2013) reported that fiscal devaluation
has only a limited and short-lived expansionary effect on employment and GDP. The fiscal
devaluation has a regressive effect to workers regardless of types of changes in the VAT rate. Tax

swap cannot be the substitute for structural reforms needed for addressing causes of external
imbalances and poor growth. The repeated use of consumption tax will eventually grind down
the credibility of the government and minimize the effectiveness of the reform. Kuttner and
Posen (2002) investigated the effectiveness of Japanese fiscal policy over the 1976-1999 period
by analyzing real GDP, tax revenues and public expenditures. The expansionary fiscal policy, in
form of tax cuts or increased public expenditure, does stimulate the economy substantially. The
results implied that a tax cut multiplier is 25% higher for a four-year horizon than that of public
spending. Historical data showed that Japanese fiscal policy was contractionary in the 1990s
leading to a significant variation in growth. Most increases in public debt were associated with
declining tax revenues from the recession. The effects of fiscal policy responses in 118 episodes
of banking crisis in advanced and emerging market countries is examined by Baldacci et al.
(2009). Timely countercyclical fiscal measures shorten the length of crisis episodes by
stimulating aggregate demand. Fiscal expansions that support government consumption are more
effective in decreasing crisis duration than those based on public investment or income tax cuts.
Devereux et al. (2013) studied how Pigouvian levies on bank liabilities associated with systemic
risk have affected European banks capital structures. In a related study, Gndr and Nistor
(2012) empirically studied the relationship between FDI and fiscal policy and found that fiscal
policy affects the competition environment and is a crucial factor affecting FDI. Brzozowski and
Gorzelak (2010) provided evidence on the impact of balanced budget and debt rules on the
degree of fiscal policy volatility. Motivated by previous studies, which showed a negative and
robust correlation of fiscal policy volatility and long run growth, they tried to identify the
possible determinants of such a correlation. They concluded that fiscal rules have a significant
impact on fiscal policy volatility, but depending on the target, public debt or fiscal balance, the
rules will increase or decrease policy volatility. A sound fiscal policy stimulates both FDI and
economic growth, which in turn indirectly improves income inequality. The increases in
government revenues that occur as a result of economic growth allows the government to
implement policies that are conductive to business environments, promote more jobs and
increase the benefit in kinds.
Financial Consolidation Effects of Fiscal Policies

When introducing fiscal policy options, a key challenge is how to fiscal policy generates
economy growth which in turn indirectly improves income inequality. A central concern lies on
how to leverage fiscal policy for more inclusive growth while minimizing fiscal constraint.
Fiscal consolidation is creation of contraction strategies for minimizing deficits and preventing
the accumulation of more public debt. Larch (2012) finds that to run deficits across the cycle, so
called deficit bias, is predominantly attributed to the common poolproblem especially for
developed and middle-income countries, which externalizes the costs for society as a whole
thereby overspending. According to the study, the relationship between income distribution and
fiscal performance is indirect. He concludes that failing to address issues of income distribution
may lead to unfavorable sustainability outcomes. The Rada and Kiefle (2013) study of dynamics
in income distribution and economic activity for a panel of 13 OECD countries, show that
contractionary monetary policy, R&D spending and more financialization, shift from production
to finance, have a negative effect on the labors welfare. OECD (2013) reported that fiscal
consolidation would make governments policy goals elsewhere more complicated. Fiscal
consolidation would slow the process of global rebalancing, undermine long-term growth and
aggravate income inequality. The report recommended an implementing of consolidation
strategies that minimize these adverse sideeffects. Cottarelli and Jaramillo (2013) discussed the
ongoing debate as to trade-off between fiscal policy and economic growth. Stabilizing public
debt-to-GDP shows a penalizing effect to potential growth, which in turn would make it harder to
sustain high public debt over the longer run. Thus, lowering public debt over time is inevitable.
In the short-run, however, front-loaded fiscal adjustment is likely to hurt growth prospects,
which would delay improvements in fiscal indicators, including deficits, debt, and financing
costs. Bouvet (2010) used data from 197 European regions between 1977 and 2003 and found
that, while income inequality has been decreased within richer countries, convergence criteria of
the single market exacerbated regional inequality in poorer EU countries. Bertola (2010) argues
that Europes EMU had a relatively petite impact on income inequality due to its less munificent
social policies. Conducting independent fiscal policies and enforcing income redistribution
schemes became more difficult for National governments. In a recent study, Agnello and Sousa
(2012) assess the impact of fiscal consolidation on income inequality. A panel analysis of 18
industrialized countries from 1978 to 2009 shows significant rises income inequality during
periods of fiscal consolidation. In addition, while fiscal policy driven by spending cuts seems to

be detrimental for income distribution while, tax hikes have an equalizing effect. The fiscal
consolidation program shows quantitative impacts on income inequality. When consolidation
plans represent a small share of GDP, the income gap widens, affecting households at the bottom
of the income distribution. Considering the linkages between banking crises and fiscal
consolidation, they found that the income gap effect is amplified when fiscal adjustments take
place after the resolution of such financial turmoil. In the short-run, front-loaded fiscal
adjustments are likely to hurt growth prospects, which would delay improvements in fiscal
indicators, including deficits, debt, and financing costs. A number of studies addressed that the
relationship between income distribution and fiscal performance is indirect. Income inequality
rises during periods of fiscal consolidation. The income gap widens, strongly affecting
households at the bottom of the income distribution.
Other Views on Effects of Fiscal Policies
There are other effects than inequality and growth from fiscal policy and its
consolidation. The Ardagna (2007) study looked at an economy that contained unionized labor
markets and heterogeneous agents. Changes in macroeconomics and distributional consequences
in response to the various fiscal policy implementations are examined. The author suggested that
when employment in the private sector and capital stock fall, the economy contracts. Simulations
implied that debt financed policy initiatives increases public employment, and 14 wages and
unemployment benefits increases workers utility in the short-run. The negative effect of
expansions in public employment are mitigated if public spending enters the production function.
In another study, Benetrix (2012) studied the impact of fiscal shocks in a panel of 11 EMU
countries and provided empirical evidence on the effects of different types of spending on real
wages. The result shows that an increase in government spending raises the real wage with
variable impact depending on the spending type. Atkinson and Leigh (2010) used taxation data to
create the distribution of top incomes covering five Anglo-Saxon countries of relatively similar
backgrounds and tax systems. They find that a reduction in the marginal tax rate on wage and
investment incomes increase the share of the top percentile group. Pealosa and Turnovsky
(2011) examined how changes in tax policies affect the dynamics of distributions of wealth and
income. They investigated the impact of recent tax changes in the U.S. and Europe. Tax changes
that affect working hours will affect wealth and income distributions, which in turn will either

reinforce or offset the redistributive impact of taxes. Considering financing government

expenditure, they found that with policies that reduce the labor supply and output, they also lead
to a more equal distribution of after-tax income. Beetsma et al. (2013) studied budgetary
planning and implementation in the Netherlands over the period 1958-2009. The key findings are
related to: planned surplus variability across terms, trend-based budgeting planning process,
positive association between expected growth and public debt and how strict the budget plans
will be. Kenworthy and Smeeding (2013) by analyzing U.S. data found that actual changes in tax
or transfer policy did not raise inequality, government transfers and economic growth but merely
kept up with inflation. Policies that redistribute income in favor of only one particular type of
worker are found to be detrimental to the workers as a group. While tax changes that affect
working hours will affect wealth and income distribution, which in turn will either reinforce or
offset the direct redistributive impact of taxes. Some studies showed that tax changes or transfer
based policies had little effect on stemming the rise in inequality. Government transfers only
keep up with the level of inflation, rather than making any contribution to economic growth.
Fiscal Policy in Asia
Historically in Asia, the role of fiscal policy has been to facilitate economic growth by
providing basic infrastructure while safeguarding macroeconomic stability. A tradition of fiscal
prudence was instrumental in Asias past success, along with public investments in growth
conducive physical and human. (ADB, 2014) Jomo (2006) argues that both rapid growth and
structural change have reduced poverty in a number of East Asian economies. Income inequality
has been low in Korea and Taiwan, but has risen in recent years. Contrary to Kuznets
hypothesis, the cases of Korea and Taiwan suggest that lower inequality can be complementary
to rapid growth in early stages. In Thailand, Malaysia and Indonesia, despite different policies,
poverty has declined, while income inequality trends have varied. With openness and sustained
rapid growth, China has experienced increased inequality despite considerable poverty reduction.
These suggest that inequality tends to worsen with economic liberalization in the absence of
redistribution. Using the Atkinson inequality measure of income distribution, Sato and Fukushige
(2010) analyze the impact of Chinas income inequality on total income inequality among
ASEAN countries. They found that China's domestic income inequality worsened income
inequality among East Asian countries from the 1980s, and this effect became even more

prominent 15 from 1990. The growth of China's per capita GDP had an equalizing effect on
income distribution initially, but was reversed around 1997. Although economic growth of China
has improved income inequality it has had a more equalizing effect overall. The ADBs (2012)
research on financing Asian higher education for inclusive growth, have traditionally dominated
debates on measures of financing higher education. Privatization of education is a pivotal
component of the analysis. The study deliberately links the financing of higher education to
questions of equity. Any higher education system that fails to cultivate the breadth of talent in
society is sacrificing both quality and efficiency. The failure to make progress on inclusive
growth is resulting in lower growth and higher inequalities. This issue is further emphasized in
the ADB Outlook (2012) report suggesting that Asias rapid growth in recent decades has led to a
significant reduction in extreme poverty, but it has also been accompanied by rising inequality in
many countries. Since the income inequality coexists with non-income inequality, it contrasts
with the growth with equity characteristics. Since technological progress has favored capital
over labor, the declining labor income share has resulted in rising inequality. In many Asian
countries income inequality is due to uneven growth and unequal access to opportunity. Claus et
al. (2012) assesses the impact of fiscal policies on income inequality in Asia. In order to discuss
the role and effectiveness of taxation and government expenditure on income distribution, it
conducts analysis over the 1970-2009 periods. Even though tax systems tend to be progressive,
government expenditures are a more effective tool for redistributing income. Both social
protection spending and government expenditure on housing appear to increase income
inequality. Rodgers and Zveglich (2012) examine gender inequality in labor markets in Asia and
the Pacific, with a focus on the structural drivers of womens labor force participation. In Asias
lower-income countries, economic necessity is an important push factor behind womens
employment. China and Taiwan have been successful in conducting policies to support women in
market-based activities. Kar and Saha (2012) conducted analysis on recent Latin America studies
and argued that as the size of the informal economy grows, corruption is less harmful to
inequality. They investigated if the Latin American environment applies to cases for developing
countries in Asia where corruption, inequality and shadow economies are large. Both the
corruption and risk guide indices are sensitive to a number of important macroeconomic
variables. Although corruption increases inequality in the absence of the shadow economy, the
income inequality tends to fall as there are larger shadow economies in South Asia. Balakrishnan

et al. (2013) assesses how pro-poor and inclusive Asias recent growth has been, and what factors
have been driving these outcomes. It finds that while poverty has fallen across the region over
the last two decades, inequality has increased. Compared to other regions and to Asias own past,
the recent period of growth has been both less inclusive and less pro-poor. A number of fiscal
policies are suggested to broaden the benefits of growth. These include increase in spending on
health, education, and social safety nets; labor market reforms to boost the labor share of total
income; and to make financial systems more inclusive. Yoshida et al. (2014) reviews different
projection methods and estimates the global poverty rate of 3 percent by 2030. The study argues
that accelerating growth is not enough and that sharing prosperity is essential in order to end
extreme poverty in one generation. Cornia and Martorano (2013) focus on the income inequality
changes that have taken place in a few representative developing regions during the last 30 years.
While inequality rose in the majority of the countries in the 1980s and 1990s, the last decade was
characterized by divided inequality trends. With contrasting the experience of virtuous regions
and non-virtuous regions, the difference in inequality trends was likely due to institutional
factors and public policies. Tests conducted confirmed that a reduction in inequality levels is
possible if appropriate macroeconomic, labor, fiscal and social policies are adopted by
governments. In many Southeast Asian economies, market liberalization policies and sustained
economic growth platforms have led to both declines in poverty levels and variations in
inequality trends. For some countries increased inequality levels have been experienced despite
considerable poverty reduction. Several studies showed that income inequality tends to worsen
with economic liberalization, especially in the absence of effective provisions for redistribution
systems. Some suggested that a reduction in inequality levels is possible even during an
economic liberalization process, given appropriate policies are adopted by governments.
Balancing Act
The idea, however, is to find a balance between changing tax rates and public spending.
For example, stimulating a stagnant economy by increasing spending or lowering taxes runs the
risk of causing inflation to rise. This is because an increase in the amount of money in the
economy, followed by an increase in consumer demand, can result in a decrease in the value of
money - meaning that it would take more money to buy something that has not changed in value.

Let's say that an economy has slowed down. Unemployment levels are up, consumer
spending is down and businesses are not making substantial profits. A government thus decides
to fuel the economy's engine by decreasing taxation, which gives consumers more spending
money, while increasing government spending in the form of buying services from the market
(such as building roads or schools). By paying for such services, the government creates jobs and
wages that are in turn pumped into the economy. Pumping money into the economy by
decreasing taxation and increasing government spending is also known as "pump priming." In
the meantime, overall unemployment levels will fall.
With more money in the economy and fewer taxes to pay, consumer demand for goods
and services increases. This, in turn, rekindles businesses and turns the cycle around from
stagnant to active. If, however, there are no reins on this process, the increase in economic
productivity can cross over a very fine line and lead to too much money in the market. This
excess in supply decreases the value of money while pushing up prices (because of the increase
in demand for consumer products). Hence, inflation exceeds the reasonable level.For this reason,
fine tuning the economy through fiscal policy alone can be a difficult, if not improbable, means
to reach economic goals. If not closely monitored, the line between a productive economy and
one that is infected by inflation can be easily blurred.
And When the Economy Needs to Be Curbed
When inflation is too strong, the economy may need a slowdown. In such a situation, a
government can use fiscal policy to increase taxes to suck money out of the economy. Fiscal
policy could also dictate a decrease in government spending and thereby decrease the money in
circulation. Of course, the possible negative effects of such a policy in the long run could be a
sluggish economy and high unemployment levels. Nonetheless, the process continues as the
government uses its fiscal policy to fine-tune spending and taxation levels, with the goal of
evening out the business cycles.
Who Does Fiscal Policy Affect?
Unfortunately, the effects of any fiscal policy are not the same for everyone. Depending
on the political orientations and goals of the policymakers, a tax cut could affect only the middle

class, which is typically the largest economic group. In times of economic decline and rising
taxation, it is this same group that may have to pay more taxes than the wealthier upper class.
Similarly, when a government decides to adjust its spending, its policy may affect only a
specific group of people. A decision to build a new bridge, for example, will give work and more
income to hundreds of construction workers. A decision to spend money on building a new space
shuttle, on the other hand, benefits only a small, specialized pool of experts, which would not do
much to increase aggregate employment levels.
The Bottom Line
One of the biggest obstacles facing policymakers is deciding how much involvement the
government should have in the economy. Indeed, there have been various degrees of interference
by the government over the years. But for the most part, it is accepted that a degree of
government involvement is necessary to sustain a vibrant economy, on which the economic wellbeing of the population depends.

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