Fiscal Policy

Fiscal policy refers to all the means which influence the income and expenditure of the Government. Since most of the government income comes from taxation and most of the government expenditure goes to public expenditure, these two viz. taxation and public expenditure are main fiscal policy instruments. Any government policy stance that influences the government taxation and government spending – would be termed as a fiscal policy.

Any changes in the level and composition of taxation and government spending can affect the economy because –

  • This can bring a change in the aggregate demand and the level of economic activity
  • This can bring a change in the pattern of resource allocation
  • It can bring a change in the distribution of income.

A welfare government tries to reallocate income by designing tax systems that treat high-income and low-income households differently.

Types of Fiscal Policies

There are three types of the Fiscal Policies viz. neutral, expansionary and contractionary.

Neutral Fiscal Policy

A neutral fiscal policy means that total government spending is fully funded by the tax revenue. The government takes a neutral fiscal policy stance when the economy is in a state of equilibrium.

Expansionary Fiscal Policy

An expansionary fiscal policy means that the government spending is more than tax revenue. Government needs to spend more than its revenue during the time of recessions.  This is because recession occurs when there is a general slowdown in economic activity. Recessions generally occur when there is a widespread drop in overall spending. Recessions may be triggered by various events, such as

  • financial crisis
  • External trade shock,
  • Adverse supply shock
  • Bursting of an economic bubble.

Governments usually respond to recessions by adopting expansionary fiscal policies, such as increasing money supply, increasing government spending and decreasing taxation. When the tax is decreased, there is more money left with people, who can spend more.

Contractionary fiscal policy

Contractionary fiscal policy occurs when government spending is lower than tax revenue. When the tax revenue of the government is more, the excess money can be used to pay the government debt.

Difference between Fiscal Policy and Monetary Policy

Fiscal policy deals with the taxation and expenditure decisions of the government. On the other side, the monetary policy deals with the supply of money in the economy and the rate of interest. The Fiscal Policy and the monetary policy are the main policy approaches used by economic managers to steer the broad aspects of the economy. In India as well as almost all countries, the government deals with fiscal policy while the central bank (RBI in India) is responsible for monetary policy.

Implications of Fiscal Policy on the Economy

Fiscal policy is composed of several parts such as taxation policy, expenditure policy, investment / disinvestment policies, debt and surplus management etc. Fiscal policy is an important constituent of the overall economic framework of a country and is therefore intimately linked with its general economic policy strategy. Moreover, fiscal policy has direct relation with the economic trends. The fiscal policy directly influences monetary policy. When the government receives more than it spends, it has a surplus. If the government spends more than it receives it runs a deficit.

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