FISCAL POLICY

GROUP 1: ANOOP VIJAY SIMON SHREYA SHOBHIT

Macroeconomic Policy Objectives

Macroeconomic policies or Stabilization policies are policies by the government to achieve the following main objectives: Sustain GDP growth (maintain full employment), and Control inflation (maintain reasonably stable price level) Macroeconomic Policy instruments:

Fiscal Policy, and

Monetary Policy

Fiscal Policy
fisc means state treasury. fiscal policy refers to the use of state treasury or government finances to achieve the macroeconomic goals Fiscal policy is also called BUDGETARY POLICY. The tax and expenditure policies together constitutes fiscal policy of the government Budget / spending plan

Fiscal Policy Instruments:

Tax policies Government expenditure policies

Fiscal Policy - Theories behind

Keynesian Argument
Under Economic Depression
Keynesian Theory:
Low AD Low prices

Y = AD = C + I + G + X M
Low income Low production

Low wages

Fiscal Policy
Keynesian Argument

Govt. interference by: Increasing spending or

Cutting taxes or Increasing transfer payments Income rises

AD=C+I+G+(X-M)

Potential GDP

E E

AD AD

Potential GDP

45o

4000

5000

Output, Income

Recessionary GDP gap

AD-AS framework
Price level
AS

P1

P0

AD1 AD0

Y0

Y1

Real GDP

Fiscal Policy (Keynesian Argument)

Under Excess Demand Large govt. spending & tax cut, along with strong consumer spending causes inflation

Therefore, Govt. should either reduce spending or raise taxes.

Fiscal Policy (Keynesian Argument)

Under External Shocks (like Oil price rise) Creates a dilemma A situation of both high unemployment and high inflation called stagflation Keynesian argument does not work. Deficit seems to be a permanent part of fiscal scene Reducing deficit the goal of fiscal policy

Kinds of Fiscal Policy

How does Fiscal Policy work? There are two elements to the working of fiscal policy: i) Non-discretionary Fiscal Policy (Also called Automatic Stabilization Fiscal Policy) ii) Discretionary Fiscal Policy (Also called Compensatory Fiscal Policy)

Automatic Stabilization Policy

Means automatic adjustment in the net taxes in response to rise and fall in GNP (economic growth)

When the economy begins to contract (GNP declines), tax revenue falls and governments transfer payments increase automatically
When the economy expands (GNP rises), tax revenue increases and government transfers fall automatically In this kind of fiscal policy, the government adopts a tax system and an expenditure program linked to GNP and unemployment Also called non-discretionary fiscal policies

Discretionary Fiscal Policy

Economies do not work as expected under automatic fiscal policy regime Such regime are more suitable for mature and developed economies Discretionary fiscal policy is the most common form

Ad hoc changes are made in the government expenditure and taxation at the discretion of the government
Discretionary changes are taken (in taxation, govt. expenditure and public debt) to achieve certain specific objectives For example, changes in tax rates or tax base or tax system to reduce inflationary pressure

Compensatory Fiscal Policy

Compensatory Fiscal Policy is a form of Discretionary Fiscal Policy

A deliberate budgetary action by the govt. to compensate for the deficiency in or excess of AD
Usually in the form of surplus budgeting or deficit budgeting

During depression, taxes are reduced and govt. spending goes up (deficit budgeting)
Surplus budgeting is adopted during the period of high inflation rate that caused by excessive demand Govt. keeps its expenditure lower than its revenue, introducing higher rate of taxation

Budget
Government budget is the Annual Financial Statement of the government about its all planned expenses and revenues Two sides of the budget: Receipts and Expenditure
Receipts include all tax and non-tax receipts, capital receipts, and borrowings

Expenditures include revenue and capital expenditures (also classified as Plan and Non-plan expenditures)

Government Receipts
Govt.s own Receipts

Revenue Receipts

Capital Receipts

Tax Revenues

Non-Tax Revenues

Recovery of Loans

Public Sector Disinvestment

Government Receipts
Taxes are the major source of revenue for the govt. Major categories of taxes: personal income tax; corporate tax; customs duties; union excise duties, VAT, services tax Non-tax revenues includes interest and dividend received from its various investments, especially from the public sector undertakings, fees, etc. Also includes revenue from lotteries and user charges Revenue Receipts = Taxes + Non-tax Revenues

Capital receipts = recovery of loans + public sector disinvestments

Total Receipts = Revenue Receipts + Capital Receipts

Government Expenditure
Govt.s Total Expenditure

Revenue Expenditure

Capital Expenditure Expenditure on Roads, Dams, etc..

Consumption Expenditure

Interest Payments

Transfer Payments

Government Expenditure
Government expenditures are classified into three different ways A) Revenue and Capital Expenditure

B) Plan and Non-Plan Expenditure, representing new and existing works under Indias Five Year Plans
Both plan and non-plan expenditure will have elements of revenue and capital expenditures C) By departments, i.e., development and non-development expenditure under various departments of the government

Components of both revenue and capital expenditure will find place in these development and non-development expenditures

Government Deficit
Government deficit (usually called fiscal deficit) arises because total govt. expenditure exceeds govt.s own receipts

Fiscal deficit can be incurred either due to revenue deficit or deficit on capital account
This deficit is financed through borrowing, either from domestic sources or from external sources Domestic sources include market borrowings (by floating bonds, etc.) and other liabilities like PFs, etc. External sources can be bilateral or multilateral

Monetized Deficit: When the deficit is being financed from borrowing from the Central Bank (RBI), it is called monetized deficit
So called because it results in an increase in money supply MD is a part of Fiscal Deficit Government debt: When the fiscal deficit accumulated over the years, it is the stock of the debt Called government debt or public debt or national debt Primary Deficit = Fiscal Deficit interest payments

It is the difference between govt.s current expenditure (total expenditure interest payments), minus govt.s total receipts

Fiscal Deficit
Definition
The difference between the total expenditure of Government and revenue receipts of government and capital receipts which are not in the form of borrowing constitutes Gross Fiscal Deficit Essentially, it is the difference between what the government spends and what it earns.

Fiscal Deficit = {Revenue Receipts + Capital Receipts (Non-debt)} Total Expenditure (Revenue + Capital Expenditure)

Implications of High Fiscal Deficit

1. Money supply growth: When debt is monetized, it leads to increased high-powered money
With the introduction of Ways and Means Advances (WMA), the component of debt monetized is limited, therefore, no strong impact on money supply

2. Inflation: Unproductive govt. expenditures increases AD but not the production or supply

Implications of High Fiscal Deficit

3. Crowding-out of Private Investment: Continued market borrowing to meet fiscal deficit leads to high interest rates This may crowd-out private sector investment, which is more efficient than government investment. So, growth suffers.

4. Crowding-out of Exports: High interest rate attract more capital from abroad, appreciating domestic currency against foreign currencies, crowding-out exports 5. Crowding-out Essential Public Expenditure on health, education, and other social welfare
Large amount of money is spent for debt servicing

Complementarity Between Public and Private Investment The Crowding-in Effect

Mainly a Keynesian view

Complementarity or Crowding-in occurs because public expenditure enhances the productivity of private investment
E.g.: investment in infrastructure and public goods, increased demand for private goods through demand for inputs and ancillary services, etc.

The overall relationship is not definitive

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