Structure of Public Finance > Fiscal Policy

Fiscal policy refers to the government's adjustment of its spending levels and tax rates to monitor and influence the economy.

It deals with three elements:

• Public expenditure
• Public revenue
• Public debt (public borrowing)

Historically, the role of fiscal policy gained prominence after the Great Depression of the 1930s, when economists realised the limitations of monetary policy in reviving business activity and employment. J. M. Keynes emphasised fiscal policy as an important tool for managing economic activity.

• "Fiscal Policy is the policy concerning the revenue, expenditure and debt of the government for achieving definite objectives." -Prof. Dalton 
• "Fiscal policy involves alterations in government expenditures for goods and services or the level of tax rates. Unlike monetary policy, these measures involve direct government entrance into the market for goods and services (in case of expenditure) and a direct impact on private demand (in the case of taxes)." – Prof. Gardner Ackley
• "We define fiscal policy to include any design to change the price level, composition or timing of government expenditure or to vary the burden, structure or frequency of tax payment." – G.K. Shaw
• Fiscal policy includes those "Changes in government expenditure and taxation designed to influence the pattern and level of activity." – Harvey and Johnson
• Fiscal Policy includes those "Changes in taxes and expenditure which aim at short run goals of full employment, price level and stability." – Otto Eckstein
• Fiscal Policy is defined as the policy under which the government uses the instruments of taxation, public spending and public borrowing to achieve various objectives of economic policy.

• Fiscal policy plays a role in influencing income, production, employment, and the overall level of economic activity.
• It is used to stabilise output and employment (based on the Keynesian approach).
• Keynes advocated using fiscal policy as a tool to manage economic activity through changes in government expenditure and taxation.

• When the government increases spending by an amount ΔG, national income rises by a larger amount. This chain reaction is called the multiplier effect.
• A change in government spending leads to a multiplied change in equilibrium income.
• The concept is discussed in the context of aggregate demand and equilibrium income.

\[Y^*=\frac{1}{1-c}\left(\overline{C}- cT+c\overline{TR}+I+G\right)\]

\[\Delta Y=\frac{1}{1-c}\Delta G\]

or

\[\frac{\Delta Y}{\Delta G}=\frac{1}{1-c}\]

A. Government Expenditure

Types of government expenditure are listed as instruments of fiscal policy.

Examples include:

• Expenditure on public works programmes (roads, dams, bridges, etc.)
• Expenditure on education and public welfare programmes
• Expenditure on defence and maintenance of law and order
• Expenditure on subsidies to encourage production

B. Revenue Instruments

• Taxation — A key instrument of fiscal policy on the revenue side.
• Public Debt (Public Borrowing) — Borrowing by the government from the public.
• Deficit Financing — In India, deficit financing refers to issuing more currency to meet the budget deficit.

Types of Taxes

Direct Taxes

• Levied directly on income and property.
• Burden cannot be shifted.
• Examples: Income Tax, Gift Tax, Wealth Tax.

Indirect Taxes

• Levied on goods and services.
• Burden can be shifted to others.
• Examples: Sales Tax, Excise Duty, Customs Duty.

\[C=\overline{C}+cYD=\overline{C}+c(Y-T+\overline{TR})\]

where,

\[Y_D=Y-T+\overline{TR}\]

\[AD=\overline{C}+c(Y-T+\overline{TR})+I+G\]

\[Y=AD\]

or

\[Y=\overline{C}+c(Y-T+\overline{TR})+I+G\]

Fiscal policy is one of the measures used to correct both deficient demand and excess demand.

Correction through Fiscal Policy

To correct Deficient Demand

• Increase government expenditure.
• Reduce taxes.

To correct Excess Demand

• Reduce government expenditure.
• Increase taxes.

• Fiscal policy involves government expenditure, public revenue, and public debt (public borrowing).
• Its primary goal is to influence income, production, employment, and stabilise economic activity using the Keynesian approach.
• A budget can be surplus, deficit, or balanced depending on government revenue and government expenditure.
• Key instruments include government expenditure, taxation, public debt (public borrowing), and deficit financing.
• Fiscal policy corrects deficient demand (by increasing government expenditure or reducing taxes) and excess demand (by reducing government expenditure or increasing taxes).
• Government spending creates a multiplier effect on equilibrium income.