Unit 3 Aggregate Demand, Supply and Fiscal Policy Chapter 29 Fiscal Policy.
3.fiscal policy
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Fiscal PolicyThe most important instrument of government intervention in the economy is fiscal or budgetary policy. fiscal policy is essential in the matter of
Overcoming Recession or Inflation Promoting and Accelerating Economic Growth.
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‘Fisc’ means State Treasury
Fiscal policyFiscal policy
Fiscal policy is the government programme of making discretionary Fiscal policy is the government programme of making discretionary
changes in changes in The pattern and level of its expenditure, The pattern and level of its expenditure, TaxationTaxation BorrowingsBorrowings
To Achieve To Achieve Intended Economic Growth, Employment, Income Equality
and Stabilization of the Economy on a Growing Path.
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Fiscal policy is also called Budgetary Policy The essence of fiscal policy lies in the budgetary operations of the The essence of fiscal policy lies in the budgetary operations of the
Govt.Govt.
Two sides of the Govt budget are – Two sides of the Govt budget are – Receipt and ExpenditureReceipt and Expenditure Receipts - inflow ( flow of money from private sector to Govt.sector) Tax revenue Non tax revenue Borrowings including Deficit Payment
Expenditures Payments/outflow – flow of money from Govt to Private
Sector Payment for goods and services Interest and loan payments Subsidies Pensions grand in –aid and so on.
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Govt using its statutory power to change the magnitude and composition of inflows and outflows
magnitude and composition can be altered by – Making changes in taxation– Govt spending– Borrowing
Fiscal Instruments
Fiscal Instruments are the variables that government changes it. Fiscal policy is implemented through instruments.
Target Variables
Variables that are intended to be changed to achieve the intended results
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Fiscal Policy Instruments
Budgetary surplus and deficit Govt expenditure Taxation – direct and indirect Public debt Deficit financing
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Budgetary Balance Policy Balanced budget – expenses = revenue
Deficit budget – Govt.spending> expected revenue
Surplus budget - Govt.spending> expected
revenue
Balanced, Deficit, Surplus budgets affect the economy
in different ways and in different directions.
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Govt. Expenditures Govt. expenditures means the sum of public spending on purchase of
goods and services, public investment, transfer payments
Size and composition of GE is a matter of Govt. direction
GE is an injection into the economy
It adds to the AD (C + I)
Effect GE depends on Way of Govt. financing Multiplier effect of the GE.
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Taxation Direct –
• taxes on personal income
• Corporate income
• Wealth and property
Indirect tax –
• on production
• Sale of the goods and services
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Public Borrowings Borrowings include both internal and external
To finance their budget deficit
Internal Borrowing- Borrowing from public by means of bonds & treasury ( transfer of
purchasing power from the public to the Govt)- From central bank (straightaway an injection into the economy)
External Borrowing- Borrowing from foreign Govt- International organization i.e. IMF and WB- Market borrowing
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Target Variables Disposable income
Aggregate Consumption expenditure
Savings and investment
Imports and exports
Level and structure of prices
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Fiscal Policy and Macroeconomic Goals
Fiscal policy for economic growth
Fiscal policy for Employment
Fiscal policy for Stabilization
Fiscal policy for economic equality
Fiscal policy for external balances
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Fiscal Policy and Economic Growth
Given the Manpower
Technology
Natural Resources
The growth rate of a country depends on the
Rate of Savings
Investment.
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Therefore fiscal policy in this regard is To create conditions for increase in private savings
and investment
To enhance investment in the public sector.
To promote savings
reducing rate income tax
giving tax incentives for savings
giving incentives to promote private savings
giving concessions to promote private investment
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Incentives/concessions may be one of the following
Tax holiday
High depreciation allowance
Rebate for capacity expansion
Investment subsidies
Exception of import duties on capital imports
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These measures often prove to be inadequate to promote savings and investment due to,
Low level of per capita income and high rate of
MPC
A small fraction of population with taxable income
Inadequate growth infrastructure and social
overhead Capital
Because of these reasons savings and investment may
inadequate.
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The Government is required, under these conditions to
play the role of a prime mover
This requires Expansion of the public sector and Enhancement of the public sector investment.
To accomplish these things huge amount of resources
is need.
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Tax is a suitable means of source of income.
progressive taxation of personal and cooperate income
taxation of all kinds of consumer goods
taxation of luxury goods at a prohibitive rate
imposition of extraordinary high duty on imports of
consumer goods.
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Fiscal policy for Employment
According to Keynesian theory of employment
All fiscal measures that accelerate the pace of
economic growth promote employment but
This proposition does not hold under all conditions.
Developed countries try to maintain full employment
Developing countries try to create more
employment opportunities.
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Fiscal measures should accelerateFiscal measures should accelerate Economic growth Promote employment
Some conditions not increase economic growth Capital intensive or labour saving technology does
not increase employment
In this situation Govt. intervene through fiscal policy
as follows Govt should discourage use of labour – saving
Technology Encourage the use of labour absorbing technology
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In this case Govt may take following fiscal measures
heavy taxation on capital – intensive good
giving subsidization for labour intensive goods
heavy duty on imports of capital intensive
technology
Concessions in customs for the import of input for
labour intensive products
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Fiscal Policy for stabilizationFiscal policy for stabilization can take any of the two forms of
fiscal policy
automatic stabilization policy discretionary policy
Automatic stabilization policy means adopting a fiscal system with built – in flexibility of tax revenue and government spending.
Built – in flexibility means automatic adjustment in the
government expenditure and tax revenue in response to rise
and fall in GNP.
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Automatic Stabilization Policy
If GNP increases tax revenue also increases because household income increases no need to government expenditure
If GNP decreases tax revenue also decreases Because household income decreases So Govt. will increase its expenditures
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Discretionary Fiscal PolicyIt means ad hoc changes – happening when necessary
and not planned in advance
So, here Govt. make changes in the
level and pattern of taxation
size and pattern of govt. expenditures
size and composition of public debt
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Fiscal policy for Economic Equity
Economic Disparity beyond a level is socially,
economically and politically undesirable.
Both taxation and expenditure measures are
used to reduce income and wealth gap between the rich and poor……
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Fiscal Policy – Tax Measures Taxation on personal income
corporate income at progressive rate
Imposition of wealth and property tax
Taxation of high price and luxury goods at
higher rate
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Fiscal Policy – Govt. Expenditures
Spending on projects which increase the earning
capacity of the lower income people
Ex: Free Education , Medical Facilities
Reallocating capital expenditures to enhance employment opportunities for unemployed and under employed people.
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Fiscal Policy – Govt. Expenditures
Financial aid for unemployed people for their self – employment
Giving unemployed relief and unemployment insurance.
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Tax and expenditure measures make two – way attack on
economic disparity.
Tax measures limit the growth of incomes in th high – income groups and transfer a part of rich people’s income to the Govt. treasury
Which enhances government resources to help poor
Expenditures increase incomes in low-income groups
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Fiscal policy for External Balances External imbalances arise - when external
payment obligations exceed the foreign exchange
earnings.
This gap arises mainly due to decreasing trade
balance or current account deficits
Current account deficit increase mainly due to he widening gap between imports and exports
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Tax policy can be used as an effective tool of
resorting the external balance.
Imposition of heavy import duty – especially on the import of consumer goods
Subsidization of exports These measures work efficiently only when
both imports and exports are price – elastic In the absence of a high – price elasticity,
these measures may not work
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Kinds of Fiscal Policy
Variety of fiscal policies have been suggested by the
economists and used by the policy makers in different
countries under different circumstances to achieve
specific macroeconomic goals.
Automatic Stabilization Fiscal policy Compensatory Fiscal Policy Discretionary Fiscal Policy
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Automatic Stabilization Fiscal policy
Automatic stabilization policy means adopting a fiscal
system with built – in flexibility of tax revenue and
government spending.
Built – in flexibility means automatic adjustment in
the government expenditure and tax revenue in
response to rise and fall in GNP.
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Tax revenue increases and government expenditure decreases automatically, with an increase in GNP
Tax revenue decreases and government
expenditure increases automatically, with an
decrease in GNP
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Compensatory Fiscal Policy Compensatory Fiscal Policy is deliberate
budgetary action taken by the government to compensate for the deficiency in aggregate demand and excess of aggregate demand.
During the period of depression – the Govt is
required to boost up the aggregate demand The government compensatory fiscal actions may
be – reduction in tax and increase in
Govt.expenditure.
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This kind of fiscal action (Deficit budgeting)
increases AD
AD leads first to the rise in price level It adds to the producer’s profit without any
increase in costs. This creates an optimistic environment So opportunity and incentives to invest increases This push up the level of employment and output
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During the period of high rate of inflation surplus budgeting policy is adopted.
Inflation is caused by excessive demand So Govt. lowers the expenditure level Increase the tax level Higher taxes reduces the disposable income as
result aggregate demand decreases Further, cut in the Govt. expenditure reduces the
AD Therefore, two side attack on the AD helps
reducing the demand pressure and thereby, the inflation.
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Discretionary Fiscal Policy Ad hoc changes in the Govt. expenditure and
taxation System In Discretionary Fiscal Policy, the Govt. makes
deliberate changes in
Level and pattern of taxation
Size and pattern of its expenditure
Size and composition of public debt. The discretionary changes in these fiscal instruments
are made with the view to achieving certain specific
objectives.
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During recession/depression period Fiscal Policy helps to
increase demand Govt increase its expenditures Spending more on public works to increase employment Increase subsidies to producers of consumer goods Lowering tax to stimulate consumption and investment
During period of inflation Fiscal Policy helps to
Reduce demand Govt reduce its own expenditures Reducing private investment by imposing tax –
consumption or investment.