26. Fiscal Policy

What is Fiscal Policy?

Fiscal policy refers to government strategies involving changes in taxation and public spending to influence a nation’s aggregate demand (AD) and overall economic performance. It is a key macroeconomic tool used to:

• Stimulate economic growth during a recession
  

• Control inflation
  

• Reduce unemployment
  

• Promote economic stability
  

Aggregate Demand (AD) is calculated as:
AD = C + I + G + (X – M)
Where:
C = Consumption
I = Investment
G = Government Spending
X = Exports
M = Imports

Fiscal policy is often used alongside monetary policy, although governments may prefer monetary tools for short-term stabilization.

Types of Fiscal Policy

A. Expansionary Fiscal Policy

• Used during economic downturns to boost demand.
  

• Involves:
  

  • Increasing government spending (G)
    

  • Reducing taxes (T)
    

• Effects:
  

  • Higher disposable income leading to increased consumer spending
    

  • Increased employment and output
    

  • Can result in a budget deficit due to higher spending or lower tax revenue

B. Deflationary (Contractionary) Fiscal Policy

• Used to reduce inflation or prevent the economy from overheating.
  

• Involves:
  

• Decreasing government spending
  

• Increasing taxes
  

• Effects:
  

• Reduces consumption and investment
  

• Helps reduce the budget deficit and control inflation
  

Government Budget Concepts

• Budget: The balance between government revenue (mainly taxes) and expenditure.
  

• Budget Surplus: Government revenue is greater than spending.
  

• Budget Deficit: Government spending exceeds revenue.
  

• National Debt: The total amount the government owes from accumulated deficits.
  

Objectives of Government Spending

1. Stimulate Economic Growth
Increase aggregate demand to boost output and employment during economic slowdowns.

2. Correct Market Failures

a. Provision of public goods (e.g., defense, roads)

b. Support for merit goods (e.g., healthcare, education)

c. Regulation to address externalities and monopolies

3. Promote Equity
Funding welfare programs, pensions, public housing, and education for vulnerable populations.

4. Service the National Debt
Pay interest on previous borrowings.

Taxation: Types and Roles

A. Types of Taxes

1. Direct Taxes
   Levied directly on income or wealth. Examples include:
   

   • Income tax
     

   • Corporation tax
     

   • Capital gains tax
     

   • Inheritance tax

2. Indirect Taxes

   Levied on spending, goods, or services. Examples include:

   • VAT/GST (value-added tax)

   • Excise duties (alcohol, fuel, tobacco)

   • Customs duties (tariffs on imports)

3. Local Taxes

   Levied by local governments to fund services such as waste management, education, and emergency services.
   Examples:
   

   • Council tax
     

   • Business rates

B. Classifications by Structure

• Progressive Tax: Takes a larger percentage from high-income earners.
  

• Proportional Tax: Same percentage applied to all income levels.
  

• Regressive Tax: Takes a larger percentage from low-income earners.

Adam Smith’s Canons of Taxation

• Equity – Those who can afford more should pay more.

• Economy – The cost of collecting taxes should be minimal.

• Transparency – Tax rules should be clear and understandable.

• Convenience – Taxes should be easy to pay.

Principles of Modern Taxation

• Flexibility: The tax system should adapt to economic changes and government goals.

• Automatic Stabilizers: Tax revenues naturally rise during booms and fall during recessions, helping moderate economic cycles.

• Efficiency: Taxes should not significantly distort economic decisions or reduce market performance.

Purpose of Taxation

• Raise Revenue to fund public services and infrastructure.

• Redistribute Income from high-income groups to lower-income individuals.

• Discourage Demerit Goods like alcohol and tobacco.

• Correct Externalities through taxes on polluters or harmful goods.

• Protect Domestic Industries using tariffs and import duties.

• Stabilize the Economy by influencing consumption and investment.

The Multiplier Effect

An increase in government spending can lead to a larger final increase in real GDP. This occurs because the initial injection leads to increased income, which causes further rounds of consumption and investment.