Structure of Public Finance > Fiscal Policy

• "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 the policy of the government that deals with its revenue (income), expenditure (spending), and debt (borrowing) to achieve certain economic objectives.
In simple words: When the government decides how much to spend, how much to tax people, and how much to borrow — that is fiscal policy.
Fiscal policy affects the level of aggregate demand in the economy — how much people and businesses are willing to buy in total.

A Quick History

Before the Great Depression of 1930, monetary policy (controlled by the central bank) was the main tool for managing the economy. But during the Depression, monetary policy failed to revive employment and business activity. After this, the world recognised the importance of fiscal policy, largely thanks to the economist J.M. Keynes, who argued in his book The General Theory of Employment, Interest and Money that government spending and taxation are powerful tools to stabilise an economy.

The government uses three main tools (instruments) to implement fiscal policy:

(A) Government Expenditure
The government spends money in many ways:

• Building roads, dams, bridges and other public works
• Funding education and public welfare programmes
• Defence spending and maintaining law and order
• Providing subsidies to producers to encourage production

By increasing or decreasing any of these, the government can raise or lower aggregate demand in the economy.

(B) Taxation
A tax is a compulsory payment made to the government according to prescribed laws.
Taxes are of two types:

Disposable Income = Income − Taxes + Transfer Payments (like pensions or allowances)

(C) Public Debt and Deficit Financing

• Public Debt / Borrowing: The government borrows money from the public by issuing bonds or loans to finance its expenditure.
• Deficit Financing: In India, deficit financing means the government issues more currency to meet a budget deficit (when expenditure exceeds revenue). This increases the money supply in the economy.

Note: Too much deficit financing (printing money) can cause inflation, so it must be used carefully.

The government affects the economy in two specific ways:

1. Government Purchases (G): When the government buys goods and services, it directly adds to aggregate demand.
2. Taxes (T) and Transfers (TR): These change households' disposable income, which changes how much they consume.

The Consumption Function (with Government)
\[\begin{array}
{rrr} & C=\bar{C}+c\cdot Y_D & \mathrm{where} & Y_D=Y-T+\overline{TR}
\end{array}\]

• c = marginal propensity to consume (MPC) — the fraction of extra income that is spent
• T = lump-sum tax (a fixed tax, not dependent on income)
• \[\overline{TR}\] = government transfer payments (pensions, welfare)

Aggregate Demand with the Government:

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

Equilibrium Income (where Y = AD):

\[Y^*=\frac{1}{1-c}
\begin{pmatrix}
\bar{C}-cT+c\overline{TR}+I+G
\end{pmatrix}\]

The equilibrium level of national income is the sum of all autonomous spending, including government spending (G) and the effect of taxes and transfers.

When the government increases spending by an amount ΔGΔG, national income rises by a larger amount. This chain reaction is called the multiplier effect.

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

$Government\; Spending\; Multiplier=\; \backslash [\backslash frac\{\backslash Delta\; Y\}\{\backslash Delta\; G\}=\backslash frac\{1\}\{1-c\}\backslash ]$

Worked Example: If MPC = 0.8:
Multiplier =\[\frac{1}{1-0.8}=\frac{1}{0.2}=5\]
So if the government spends ₹100 crore more, the national income rises by ₹500 crore.

Why does this happen? The government's extra spending becomes someone's income → they spend part of it → that becomes someone else's income → and so on. The effect multiplies through the economy.

• Fiscal policy = government's decisions on spending + taxes + borrowing
• Instruments: (i) Public Expenditure, (ii) Taxation (Direct & Indirect), (iii) Public Debt & Deficit Financing
• Taxes reduce disposable income → reduce consumption → reduce AD
• Government spending directly raises aggregate demand
• Multiplier =\[\frac{1}{1-c}\]: a rise in G leads to a proportionally larger rise in Y
• Excess demand → Contractionary fiscal policy (↑ tax, ↓ spend, ↑ borrow)
• Deficient demand → Expansionary fiscal policy (↓ tax, ↑ spend, deficit finance)
• Keynes gave fiscal policy its modern importance after the Great Depression (1930)