Macro Moves

Fiscal Policy: Meaning, Types, instruments, Importance and Effects

Created on 24 Dec 2022

Wraps up in 13 Min

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Updated on 22 Nov 2023

Shifts in taxation and alterations to the way the government spends its money are the most significant. Decreases in taxation and in the amount of money the government spends are beneficial to the economy. Because of this, the general public might be required to take out loans to cover a portion of the government's debt under certain circumstances.

The use of a tool known as fiscal policy is common practice among national governments, with the dual goals of fostering robust economic growth and reducing poverty levels. The current worldwide economic crisis has brought to the attention the function and objectives of fiscal policy. Governments worldwide have taken action to shore up floundering financial institutions, kickstart the economy, and soften the blow for those individuals who are the most vulnerable.

Toh aaiye deviyo aur sajjano shuru karte hai, yeh adbhut khel policy.

What is Fiscal Policy?

Taxation, public spending, and public borrowing are all components of what is collectively referred to as "fiscal policy," - an umbrella word that encompasses all of these aspects of government action towards the economy. To put it another way, it's the tactic of employing taxation and spending by the government to bring about sustained economic growth. Monetary policy is managed by the central bank, while fiscal policy is largely up to interpretation by national governments.

Bigg boss chahte hai fiscal policy economic equilibrium sambhale.

The two most important levers that governments use to exert influence on the economy are monetary policy and fiscal policy.

Monetary policy is typically steered in the direction that is desired by central banks. The ability of the market to supply and demand money is impacted by a variety of factors, including but not limited to interest rates, bank reserve requirements, the sale and purchase of government assets, and the value of the currency. After all, kya kijiyega inn paiso ka?

Nevertheless, governments can influence fiscal policy by adjusting tax rates, levels of expenditure, and interest rates on borrowing.  It is a vital factor for preserving the health of the economy. A robust fiscal plan is essential:

  • to protect the purchasing power of the currency, 
  • bring the rate of inflation under control, and 
  • increase employment.

There are two ways in which the government can influence the economy: 

  • The imposition of taxes, which has an impact on individuals' abilities to save and spend money
  • Through the actions of individuals with regard to their own spending and saving patterns. 

Whether or not it is the government's intention, the money it spends on things like public works projects and social welfare programmes will have some kind of impact on the economy.

Types of Fiscal Policies 

There are primarily two distinct approaches to fiscal policy, known as expansionary and contractionary. 

Expansionary fiscal policy

It is possible to adopt an expansionary fiscal policy to the economy when it is in a weak phase, such as during a recession, periods of high unemployment, or other weak stages of the business cycle. The major purpose of this initiative is to act as a catalyst for economic growth and improvement. The government must decide between a number of different choices, some of which include raising expenditure levels, lowering tax rates, or doing both at the same time.

Customers that have a greater amount of money available for purchasing will likely spend more of it, leading to a rise in economic activity. This is the objective that we want to achieve through the implementation of a fiscal plan that is more expansive. 

When there has been a decrease in private demand, governments usually turn to fiscal policy that is expansionary in an attempt to stimulate the economy. This is due to the fact that private demand is one of the primary contributors to economic growth.

So, when the times go, economic growth, aap danger zone me hain, the government goes, expanddd and groww!

Contractionary fiscal policy

If there are indications that inflation could reach an unacceptably high level, the governing body may opt to cut spending to curb the economy's growth. A contractionary fiscal strategy is the very opposite of an expansionary fiscal approach. One example of a contractionary fiscal plan is raising taxes with the intention of decreasing public spending.

When taxes are increased, consumers see a reduction in their post-tax income. This has the effect of diminishing the stimulative impact of consumer spending, which in turn slows down the expansion of the economy.

The rate of economic expansion will not exceed 3% on an annual basis, on average, so long as there are policies in place that are restrictive both in terms of monetary and fiscal policy. If economic growth continues at a rate that is higher than this, the country faces the possibility of experiencing inflation, possibly even a recession.

Neutral Fiscal Policy

When the economy of a country is operating at its optimal level, fiscal policy that is neutral is typically utilised. Therefore, the government's expenditure is paid by the department of tax income under a neutral fiscal policy, which will have no effect on the levels of economic activity.

Drawbacks of Expansionary Policy

One common criticism of such an approach is that it leads to ever-increasing deficits. Government deficits, according to non-supporters, can slow growth and lead to unpopular budget cuts. There is widespread disagreement among economists about how well expansionary fiscal policies work. 

They say that the private sector is unable to compete with government spending. There is also general support for expansionary policies, which worries some economists. It is politically challenging to roll back stimulus spending. Low taxes and increased government expenditure are popular with the people regardless of whether or not they promote economic growth. 

Because of the political pressures they encounter, politicians tend to engage in a pattern of deficit spending that can be justified, at least partly, on economic grounds.

Consequences of unchecked economic growth are possible. Inflation and asset bubbles are the results of wage growth. The economic system can be severely damaged by high inflation and the possibility of widespread defaults when debt bubbles collapse. Because of this danger, governments (or their central banks) often try to do the opposite and slow down the economy.

Components of Fiscal Policy

Fiscal Policy Elements Can Be Divided Into

  • Government Receipts
  • Public Accounts of India
  • Government Expenditures

Government Receipts

Government receipts include tax income, interest and dividends from investments, cess, and payments for government services. All receipts to the government are accounted for here. What pays for government expenditures is taxable income.

Both revenue and capital are considered to be types of government receipts.

All monetary contributions to the government that increase debt or decrease assets are classified as capital contributions. In contrast, all monetary contributions to the government that do neither are classified as revenue contributions.

Revenue Receipts

  1. Revenue receipts are earnings that neither increase nor decrease assets.
  2. Tax and non-tax revenues are two categories that fall under the umbrella term "revenues."
  3. Taxes can be broken down into two categories: direct taxes and indirect taxes.
  4. Interest and dividends on government investments, cess and other payments for government services, income from licences, permits, fines, penalties, etc., are all non-tax revenue streams.

Capital Receipts

  1. Capital receipts refer to the various methods the government can collect money to use for its operations. The government may take on debt or sell off assets as one of these options. Capital inflows are also known as cash flows.
  2. As the government must eventually pay back all loans, credits, and other forms of debt, including interest, these transactions are classified as debt receipts.
  3. The government also receives funds that are not considered debt and hence do not require repayment.
  4. Loans from the public, foreign governments, and the Reserve Bank of India (RBI) represent a key element of capital receipts, which account for over 75% of total budget collections.

Public Accounts of India (Public Debt)

Those flows associated with transactions in which the Indian government only acts as a banker are recorded in the country's Public Account.

This fund was established by the provisions of Article 266(2) of the Constitution. It considers the flows associated with transactions in which the government is only operating in the capacity of a banker.

Examples: provident funds, minor savings, etc. This money is not the property of the government; instead, they are obligated to be returned to the people who are legally entitled to possess them in future. As a result, the Parliament is not obligated to approve before any expenditures are made from the public account.

Government Expenditure

Two types of government spending are distinguishable:

Revenue expenditures

  1. They are costs incurred quickly and paid off quickly, usually within a year.
  2. Revenue expenditures are the same as operating costs since they cover the government's basic operating needs (OPEX).
  3. Routine repair and maintenance expenses are also considered revenue expenditures because they are required to keep an asset in operating condition without significantly enhancing or extending the asset's useful life.
  4. In contrast to the typically one-off nature of capital expenditures, revenue expenditures can be considered ongoing costs.
  5. Money spent on salaries, wages, utilities, rents and taxes on government-owned property, etc.

Capital Expenditure

  1. When a government spends money, it invests in its future, usually to keep or grow its operations and tax base.
  2. Long-term assets, purchased with capital expenditures, have a lifespan of more than a year and often have a useful lifespan of many decades.
  3. Fixed assets, like machinery and computers, are frequent recipients of capital budgets. Capital expenditures, therefore, usually are bigger than revenue expenditures. Large purchases of assets are typically not used up in the current fiscal year, but there are exceptions.
  4. The purchase of equipment for manufacturing, supplies for a business, furnishings for a government office, money spent on infrastructure, and so on are all capital expenditures.

Who Handles Fiscal Policy in India?

The country's Union Finance Minister makes the decisions about India's fiscal policy at the national level. Governments can steer their economies in the direction of their choosing by exercising control over tax income and public spending.

A surplus is produced when tax money and other funds are used to fund the activities of the government, whereas a deficit arises when spending is greater than revenue. To cover any additional expenses, the government will have to take out loans, either from financial institutions in the country or from financial institutions in other countries. The country's foreign exchange reserves or newly printed money can also be utilised by the government.

When the economy is doing poorly, the government could decide to invest more money in initiatives like public works projects, social programmes, and other industries that are geared toward boosting business.

The purpose is to encourage business investments, free up some of the money owned by the people so that it can be spent elsewhere, and promote the availability of monetary resources that can be utilised more productively. Alternatively, the government can reduce the amount of money it collects from businesses and individuals by lowering the tax rates they impose on those groups.

The Significance of India's Fiscal Policy 

India's fiscal policy is mainly responsible for the rising levels of capital formation in both the public and private sectors. The fiscal strategy places a significant emphasis on the collection of taxes as a method of bringing in the huge sums of money necessary to finance its variety of activities.

One additional benefit of fiscal policy is an increase in the savings rate. The spending policies of the government foster expansion in the private sector. The difference of income and wealth is something that should be reduced or evened out as one of the goals of fiscal policy.

The following are the primary goals of India's fiscal policy:

  1. Growth of the economy: The use of fiscal policy helps to keep the economy expanding at a rate that is consistent with particular economic goals.
  2. Stability of prices: This aspect of monetary policy ensures that the overall cost of living in the nation is kept under control, even when inflation rates are unacceptably high.
  3. Full employment: It seeks to reach full employment or near full employment to recover from low economic activity. Full employment is often referred to as working at full capacity.

The Most Recent Update Regarding India's Fiscal Policy

The emphasis on the Development of Financial Institutions (DFIs) has been signalled in the Union Budget 2021 in pursuing long-term infrastructure construction to restore the economy.
It has been suggested in the Union Budget 2021 that a Dispute Resolution Committee (DRC) be established, which will be able to assist in providing prompt relief to taxpayers who are involved in tax disputes.

Instruments of Fiscal Policy

The fiscal policy is implemented by the government of a country using the following tools that it implements on the macroeconomic scale.

Capital Expenditure: The word "capital expenditure" indicates the amount of money a government spends on infrastructure projects like constructing new buildings, roads, and hospitals. The country's entire capital stock rises as a result of these investments. In addition, it affects a nation's overall output. Increased public investment in infrastructure like this also raises a nation's capital stock. A nation's overall productivity will rise as a direct result of the increase in the number of investments, made possible by the significant incentive that such facilities provide for investment.

Current Government Spending: In the current budget, the government allocates funds to supply staple goods and services. Examples of such services include the military, hospitals, and schools. The extra money is being put in to boost the nation's productivity in the workplace.

Transfer Payments: Transfer payments are monetary benefits provided by the federal government to private entities or persons outside the traditional tax system. Transfer payments ensure that those with low incomes receive a minimum acceptable standard of living. They also provide policymakers with opportunities to influence the distribution of wealth. As a result, they cover things like child support and welfare.

These advantages include retirement payments from the government, help with rent or mortgage payments, income supplements, and tax credits. It should be clear that these payments are not included in GDP because they are not linked to any specific input into production.

How Does Fiscal Policy Affect People/businesses?

Businesses, whether they are privately or publicly held, are susceptible to the immediate repercussions of an economy's monetary policy, regardless of whether such repercussions take the shape of expenditures or taxes. The following is a list of some of the potential effects that monetary policy may have on your modest enterprise.

1. Slower growth: When that equilibrium is upset and demand, along with prices, falls, a contractionary fiscal policy may kick in to prevent inflation. 

2. Investment opportunities: As a result of government spending, additional chances for investment will present themselves to businesses. This typically takes place during times of expansionary fiscal policy, which sees an increase in the amount of money entering the economy from the government.

3. Taxation changes: Your company could be subject to multiple levels of taxation, including local, state, and federal, depending on where it is located. Consider the taxation practises of both your state and municipal governments, as well as how these practices interact with the fiscal policies of the federal government.
The taxation levied on future generations can also be influenced by fiscal policy. Spending by the government that results in larger deficits will eventually require an increase in taxation to cover the cost of the interest accrued on those deficits. On the other hand, when there is a surplus in the government's coffers, eventually, taxes will need to be reduced.

4. Unemployment rates: Reducing unemployment to a manageable level should be one of the primary focuses of fiscal policy. For instance, the government may reduce tax rates to put more cash back into the hands of consumers. As a consequence of this, customers have more money to spend, and businesses could have to contend with higher demand.

Fiscal policy goals

Spending on public asset creation like roads, trains, and other infrastructural works, public health and safety, encouraging education, payment of salaries, subsidies, pensions, etc, are all examples of possible goals of a fiscal strategy.

Its secondary purpose is to encourage businesses to expand their operations with economic impacts on a national level.

A government's short-term priority may be macroeconomic stabilisation, which could involve raising taxes and decreasing spending in times of inflation or cutting taxes and increasing spending in times of a poor economy.

In the long run, it may promote sustainable growth and lessen poverty. The confidence of private investors will rise due to an effective fiscal strategy, and they will then be encouraged to expand, bringing in investment and increasing demand.

Moreover, it seeks to achieve this objective by imposing direct taxes on those with higher incomes and subsidising the spending of low-income households. The populace receives subsidies for necessities like food and gasoline, while the wealthy pay more through indirect taxes on things like imported vehicles and cosmetics.

The greatest strategies to tackle policy changes

It is important for owners of businesses to seek the advice of financial professionals before acting rashly in response to even the tiniest signs of a shift in the economy. If your company does not already have a chief financial officer, you might consider hiring a certified public accountant (CPA) or a financial management company. 

You will be able to make appropriate judgements regarding expenditures, pricing for your products and services, benefits packages, and other aspects of your company that the monetary policy may impact if you get the assistance of an expert.

The significance of maintaining close monitoring of fiscal policy

The area of economics known as fiscal policy is a complex subfield. Within it, political parties frequently disagree about the most effective way for the country to move forward. The executive and legislative branches have a hand in formulating fiscal policy by voting on several options that influence taxation and spending by the government. Because even the tiniest businesses are affected, even indirectly, by these decisions, it is critical to stay abreast of the latest developments in the economy. These effects might be positive or not.

What is the key distinction between monetary policy and fiscal policy?

For the government to achieve its economic goals for the county, it employs both monetary policy and fiscal policy. Monetary policy is often overseen and administered by a nation's central bank.

The Reserve Bank of India, sometimes known as the RBI, is in charge of monetary policy in India. The primary concerns of monetary policy are economic units, exchange rates, and interest rates. On the other side, the government addresses issues with taxation and spending by the Central Government in accordance with the fiscal policy.

The Bottom Line

There is no way to stop the growth in unemployment. The cost of living goes up in tandem with the rising prices of goods and services. Your financial situation is also directly influenced by the stance that the government takes on taxation. When the government does things like cut income taxes, for example, individuals have more disposable income to purchase products and services.

The administration of public finances is an essential component of the economic framework. To a significant extent, it contributes to the acceleration of the rate of capital formation in India's public as well as private sectors. The purpose of utilising fiscal policy by governments is to affect the level of aggregate demand that exists within the economy, with the end objective of accomplishing particular economic goals such as price stability, economic growth, and full employment.

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