- jaro education
- 14, July 2024
- 6:00 pm
The fiscal policy in India is a fundamental component of economic management and guides economic development. It is a crucial tool used by policymakers to accomplish various macroeconomic goals and promote sustainable growth. Recent fiscal policy of India involves a wide range of taxation, spending, and borrowing decisions.
Understanding Fiscal Policy: A Key Tool for Economic Management
Fiscal policy refers to using government taxation and spending to influence the economy. It is essential for achieving macroeconomic goals such as job growth, controlling inflation, and reducing unemployment. By altering the economy’s total demand, it impacts economic activity. The government can adjust spending levels or modify tax rates to achieve its desired financial outcomes.
Various policy tools, including changes in transfer payments, tax rates, and government spending, are used to implement fiscal policy. The effectiveness of it depends on several factors, such as the timing of implementation, the extent of the policy measures, and the overall health of the economy.
Table of Contents
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How does Fiscal Policy operate?
Fiscal policy relies on two main instruments: taxes and government spending. When the economy is sluggish, it suggests that people are not investing money in purchasing goods. To address this, the government may reduce taxes, putting more money into the hands of consumers. With more disposable income, people are likely to spend more on goods and services, which boosts demand and creates more job opportunities.
Conversely, if the economy is overheating and citizens are overspending, the government can raise taxes to reduce consumer demand and help stabilise the economy. This policy’s essential goal is to maintain a balanced approach, ensuring economic stability and growth.
Tools of Fiscal Policy
The government employs several primary fiscal policy tools to manage the economy:
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1. Public Expenditure
Public expenditure encompasses subsidies, transfer payments (including welfare programs), public works projects, and government salaries. By adjusting its spending, the government can directly impact economic activity. For instance, increasing government spending can boost demand, leading to higher output and employment.
2. Taxation
The government influences economic activity through its taxation policies. Reducing taxes leaves individuals and businesses with more income to spend and invest, which can stimulate economic growth. Conversely, increasing taxes can help cool down an overheated economy by reducing disposable income and curbing excessive demand.
3. Public Borrowing
Public borrowing is the government’s process of financing expenditures that exceed tax revenues. The government raises funds from domestic or international sources through instruments like bonds, National Savings Certificates (NSC), and Kisan Vikas Patra. Public borrowing is commonly used to finance public services, infrastructure projects, and welfare programs and effectively manage fiscal policy.
Various Types of Fiscal Policies
Different types of fiscal policies are as follows:
1. Contractionary Fiscal Policy
Contractionary fiscal policy involves cutting government spending or raising taxes, resulting in tax revenue exceeding government spending. This approach reduces aggregate demand in the economy, slowing economic growth and alleviating inflationary pressures.
2. Expansionary Fiscal Policy
Expansionary policy stimulates the economy, especially during recession periods when national income growth is insufficient to maintain the current living standards of the population. This approach involves tax cuts and increased government spending to boost economic growth and reduce unemployment rates. However, this method could be more sustainable in the long term, as it can lead to a budget deficit. Therefore, it should be used with caution.
3. Neutral Fiscal Policy
A neutral fiscal policy balances government spending with tax revenue, meaning that all tax revenue is fully utilised for government spending. This approach ensures that the overall budget has a neutral effect on the level of economic activities.
Objectives
1. Full Employment
The primary goal of this policy
in a developing economy is to achieve and maintain full employment. Even if full employment is not attainable, the focus is on minimising unemployment and achieving near-full employment. The state should invest significantly in social and economic infrastructure to create more job opportunities and enhance the economy’s productive efficiency.2. Price Stability
Price fluctuations affect various societal groups, including consumers, labourers, employees, agriculturists, producers, and traders. Rising prices can negatively impact the general public.
Fiscal policy aims to stabilise prices by addressing price increases or decreases. This can be achieved through subsidies or tax reductions to mitigate the impact of rising prices.3. Accelerating Economic Development
The policy should aim to accelerate economic growth in a developing economy. Proper use of fiscal measures such as taxation, public borrowing, and deficit financing is essential to ensure that production, consumption, and distribution are not negatively affected. These measures should promote overall economic growth, raising national and per capita income.4. Optimum Allocation of Resources
Fiscal measures like taxation and public expenditure significantly influence resource allocation across various sectors. Public spending through subsidies and incentives can direct resources toward desired areas. For example, tax exemptions and concessions can attract resources to favoured industries, while high taxation can deter resources from specific sectors.
5. Equitable Distribution of Income and Wealth
A welfare state should ensure social justice through equitable income and wealth distribution.
Fiscal policy is an effective tool for achieving this goal in developed and developing countries. A progressive tax system is particularly useful in realising this objective. Additionally, public expenditure can help redistribute income from the wealthy to the poorer sections of society.6. Economic Stability
Economic stability is another critical aim of sound fiscal policy, encompassing the maintenance of full employment with relative price stability. The policy should curb inflation and avoid deflation. This policy pursues twin objectives of economic growth and stability. Measures should boost growth while controlling inflationary pressures. It also helps stabilise the economy against short-term international cyclical fluctuations, which often favour developed economies at the expense of developing ones.
7. Capital Formation
Fiscal policy aims to increase investment rates in both the private and public sectors. Developing countries often have low capital formation rates due to unemployment and low per capita income, perpetuating the cycle of poverty. It should reduce undesirable consumption and encourage savings to increase capital formation.
8. Attraction of Foreign Investment
Fiscal incentives, such as customs duty exemptions and excise duty concessions, attract foreign investment, bolstering domestic production and foreign exchange earnings.
These two fiscal policy objectives are complementary, achieving economic stability and growth.
The Cyclicality of Fiscal Policy
The cyclicality of fiscal policy refers to adjusting government expenditures and taxes in response to economic conditions and fluctuations in economic growth. There are two main types of cyclical budgetary policies:
1. Counter-Cyclical Fiscal Policy
Counter-cyclical policy involves taking actions that oppose the direction of the economic or business cycle. For instance, the government typically adopts expansionary budgetary policies during a recession or economic slowdown. These entail increasing expenditures and reducing taxes to stimulate demand, thereby aiding economic recovery. By boosting consumption potential, these measures help mitigate the effects of the recession.
2. Pro-Cyclical Fiscal Policy
Pro-cyclical policy involves actions that reinforce the business cycle by being expansionary during economic prosperity and contractionary during recessions. However, pursuing a pro-cyclical fiscal policy is often considered risky as it can exacerbate macroeconomic volatility, dampen investment, impede growth, and disproportionately affect the less affluent segments of society. For example, implementing contractionary fiscal policies during a recession, such as reducing government expenditure and increasing taxes, can further dampen consumption potential, exacerbating the economic downturn.
Evolution of Fiscal Policy and Institutions in India (2014-2024)
Between 2014 and 2024, India witnessed significant shifts in fiscal policy and institutions under the government. Significant changes included:
- The introduction of the Goods and Services Tax (GST).
- The abolition of the Planning Commission.
- Revisions to the Fiscal Responsibility and Budget Management Act.
Fiscal prudence initially emphasised deficit reduction but later saw increased off-budget borrowing.
Key fiscal trends
- Fiscal deficits were initially reduced but later increased, with significant off-budget borrowing.
- Factors contributing to this included disappointing revenue collection and economic slowdown.
- Welfare expenditure was used strategically for electoral gains, emphasising direct benefit transfers and schemes like PM-KISAN.
- Intergovernmental transfers saw changes, including increased devolution to states but reduced central contributions to centrally sponsored schemes.
On fiscal policy and growth strategy
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- The government shifted towards using fiscal policy to promote growth, employing instruments like production-linked incentives (PLIs), increased capital expenditure, and corporate tax cuts.
- Capital expenditure saw a notable rise, particularly in infrastructure sectors, aiming to stimulate economic activity.
Looking ahead
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- The government aims for fiscal consolidation, targeting a primary surplus in the medium term.
- Fiscal consolidation is expected mainly through cuts in revenue expenditure.
- Efforts to increase revenue, including tax and non-tax sources, are crucial, along with potential privatisation initiatives.
- Off-budget borrowing practices are discouraged for fiscal transparency despite most government debt being held domestically.
Key Differences Between Monetary and Fiscal Policy
Monetary and fiscal policy represent distinct tools wielded by policymakers to influence economic activity. While both are instrumental in shaping the economic landscape of a country, they operate in different spheres and address varied aspects of economic management.
Here are the key differentiating points between monetary and fiscal policy.
| Factors | Monetary Policy | Fiscal Policy |
|---|---|---|
| Definition | Monetary policy is a set of measures enacted by the central bank to regulate the money supply and manipulate interest rates within an economy. | Fiscal policy pertains to the government's management of tax revenues and spending decisions to steer the economy in a desired direction. |
| Managed By | Central banks are entrusted with the responsibility of formulating and executing monetary policy. | It is formulated and executed by the Ministry of Finance or equivalent government entities. |
| Measures | The focus of monetary policy lies in determining the prevailing interest rates and influencing the availability of credit within the economy. | Unlike monetary policy, it revolves around decisions related to government spending, taxation, and borrowing. |
| Focus Area | Monetary policy aims to ensure stability within the economy, particularly by controlling inflationary pressures. | The primary focus of fiscal policy is on fostering economic growth and stability through the strategic allocation of government resources. |
| Impact on Exchange Rates | Changes in interest rates, as influenced by monetary policy, can impact exchange rates, with higher interest rates generally leading to an appreciation of the domestic currency. | It typically has no direct impact on exchange rates, as it primarily deals with fiscal measures rather than monetary ones. |
| Targets | Inflation is often the primary target of monetary policy, with central banks aiming to achieve a predetermined inflation rate conducive to economic stability. | While fiscal policy does not have a specific target akin to inflation in monetary policy, it aims to address various economic challenges, including unemployment and income inequality, through fiscal interventions. |
| Impact | The effectiveness of monetary policy is evident in its influence on borrowing and lending activities, affecting investment, consumption, and overall economic activity. | It's impact is felt primarily through its influence on the budget deficit, as well as its role in shaping public investment, taxation levels, and overall economic demand. |
Conclusion
Fiscal policy in India serves as a vital tool for economic management, encompassing a range of measures aimed at achieving macroeconomic stability, promoting inclusive growth, and addressing societal challenges. Through strategic decisions on taxation, government spending, and borrowing, policymakers endeavour to steer the economy towards desired objectives such as full employment, price stability, and equitable distribution of income and wealth. While fiscal policy operates in conjunction with monetary policy, its focus on government interventions distinguishes it as a crucial driver of economic development and welfare. Moving forward, maintaining fiscal prudence and transparency will be essential for sustaining growth and addressing emerging economic imperatives.
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