UNIT IV

Fiscal Policy: PAPER 8B

Dr. Neelam Tandon

Journey from NIA to Fiscal Policy

Government Intervention to Provide Public Goods,

Overcome externalities, ensure efficient allocation of

resources and to enable distribution of income

Taxes and Subsidies incentivize private consumption (-/+)

What are the components of Fiscal Policy?

Aggregate Income / Aggregate expenditure, government

debts, total employment, overall economic growth,

inflation and total output: Fiscal Policy

Significance of Fiscal Policy: Great Depression 1930 /

Financial Crisis 2008/Pandemic 2020-21 / World

Recession

1. Rapid economic growth

2. Equitable distribution of income and wealth

3. Reduction of Poverty

4. Price Stability

5. Exchange Rate Stability

6. Full Employment

7. Balanced Regional Development

Tools to achieve economic goals: economic growth and

aggregate demand, output and employment

1. Public revenue Personal Income tax /Corporate Tax

2. Public expenditure: Revenue and Capital

3. Public debt : Short term /Long term

4. Deficit Financing

Demand Side driven Fiscal Policy is designed to

1. To change the price level

2. To change the timing and composition of government

expenditure

3. To alter the fiscal burden

4. Structure and frequency of tax payment

Objectives of Fiscal Policy

1. Achievement and maintenance of full employment

2. Maintenance of price stability

3. Acceleration of the rate of economic development

4. Equitable distribution of income and wealth

Objectives of fiscal policy priorities vary from country

to country and from time to time

Developed nations : Stability and Equality

Developing countries : Employment and equity

Challenge :Tradeoff between Economic growth and

efficiency to equitable distribution of Income

Automatic Stabilizers/ Non-Discretionary Fiscal

policy/”Built –in” Fiscal mechanism

Automatically reduce the Expansions and contractions

of the business cycle (fluctuations in GDP) through:

1. Change in the level of taxation: Personal Income Tax,

Corporate Income Tax

2. Change in the level of government spending :

Transfer Payments

It helps to

1. Increase GDP when GDP is falling (deficit AD)

Recession: Progressive taxation decreases and

transfer payments increases. It will increase

disposable income and incentivize investments,

increase employment and increase output .

2. Decrease GDP when GDP is increasing (Excess AD)

Economic Expansion : Progressive taxation increases

and transfer payments decreases. It will decrease

disposable income and reduce investments decrease

employment and decrease output and inflation gets

controlled

Automatic Stabilizers affect Yd directly and

consumption indirectly (induced) bring change in GDP

Discretionary Fiscal policy

Govt directly or indirectly influence the way resources

are used in the economy

GDP= C+I+G+(X-M) (X-M=NX)

Controlling G through taxes and subsidies Government

can influence C, I and NX

Instruments of Fiscal policy

1. Government Expenditure

Pump Priming versus Compensatory Spending

Government spending multiplier

a) The Keynesian economy’s planned expenditure

function, AD = C(Y – T) + I + G, and the equilibrium

condition that actual expenditure equals planned

expenditure.

An increase in government purchases from G to G’

shifts the planned expenditure function upward. The

new equilibrium is at point. The change in Y equals the

product of the government purchases multiplier and the

change in government spending:

Y = [1/(1 – MPC)]*G.

Because we know that the marginal propensity to

consume MPC is less than one, this expression tells us

that a one-rupee increase in G leads to an increase in Y

that is greater than one rupee .

2. Taxes

Tax Multiplier

An increase in taxes of T reduces disposable income Y – T by

T and, therefore, reduces consumption by MPC x T. For any

given level of income Y, planned expenditure falls. In the

Keynesian cross, the tax increase shifts the planned expenditure

function down by MPC x T.

Balanced budget multiplier

The amount by which Y falls is given by the product of

the tax multiplier and the increase in taxes:

Y = [-MPC/(1-MPC)]*T)

We can calculate the effect of an equal increase in

government expenditure and taxes by adding the two

multiplier effects that we used in parts a and b:

Balanced Budget Multiplier

Y = [(1/(1-MPC))*G] – [(MPC/(1-MPC))]*T

Because government purchases and taxes increase by the

same amount, we know that G = T.

Therefore we can rewrite the equation as:

Y = [(1/(1-MPC)) – (MPC/(1-MPC))]*G = G

This expression tells us that an equal increase in

government purchases and taxes increases Y by the

amount that G increases. That is, the balanced-budget

multiplier is exactly 1.

Example : Government Multiplier

∆Y/ ∆G = 1 /MPS = 1/ 1-MPC

1. Assume that MPC is 0.6

a. What is the value of government spending?

b. what would be the impact of 50 billion increase in govt

spending on equilibrium GDP

c. what about 50 billion decrease in government spending

∆Y/ ∆G = 1 /MPS = 2.5

∆Y = 125 Billion

Example

If MPC =0 Multiplier will be

∆Y/ ∆G = 1 /MPS = 1/1 =1

Example : If Avg per capita income of a country

increases from 42,300 to 50,000 and per capita

consumption increases from 35,400 to 42,500 . What

will be the value of multiplier?

MPC= ∆C/ ∆Y

K= 1/ 1-MPC

The formula for KT is:

∆Y/∆ T = -MPC /1-MPC

Example

Tax multiplier is negative and, in absolute terms, one

less than government spending multiplier.

If MPC = ¾ then the value of KT = (-3/4)/ (1 – 3/4) = –

3. This means that an increase in taxes of Rs. 20 crore

results in a decline of income of Rs. 60 crore.

That is to say

60 = (-3/4)/(1 – 3/4). 20

In contrast, with an MPC = 3/4, the value of KG = 4.

Assume an increase in government expenditure of Rs.

20 crore.

Applying the formula for KG, we obtain:

∆ Y = 1/1 – MPC. ∆G

80 = 1/ 1 – 3/4. 20

∆Y/∆G = 80/20 = 4

Thus, KT is negative and its value is one short of KI or

KG.

Thus, KT is negative and one less than KI or KG.

The G-multiplier and T-multiplier are also called

fiscal multipliers as these multipliers are associated

with the fiscal activities of the government (i.e.,

changes in expenditure and taxation plans).

3. Public Debt

Internal

Market Loans: T-Bills and Bonds

Treasury bills or T-bills, which are money market

instruments, are short term debt instruments issued by

the Government of India and are presently issued in

three tenors, namely, 91 day, 182 day and 364 day.

Treasury bills are zero coupon securities and pay no

interest.

Small Savings : Public Borrowings through NSC ,

National Development Certificate

External

Bonds

Loan from International Market

4. Budget

Balance Budget Multiplier

Example :

What would be the impact on GDP if both government

spending and taxes are increased by 5 billion when the

MPC is 0.5?

∆Y/∆G = 1/ 1-MPC

∆Y/∆T = -MPC/ 1- MPC

What is the net result on the output?

Balanced Budget : No Effect on AD because

Leakages = Injections

Deficit Budget : +Net effect on AD because

Injections > Leakages from the government sector

Add National Debt = Total Past deficit- Total Past

Surplus

Surplus Budget : -Net Effect on AD because

Leakages > Injections from the government sector

Reduces National Debt

Increase savings

Reduces interest rates

Decreases international borrowings

Decreases current account deficit

Types of Fiscal policy

1. Expansionary or Recessionary Gap or

Contractionary gap : To Stimulate the economy

during recession or an anticipation of contraction of

business cycle (Actual Demand < Potential Output)

Actual AD < AD required at Full Employment

Declining real income or real GDP

Increasing unemployment

Decreasing AD

Slump in Economic Activity

Expansionary Fiscal Policy for Combating Recession

Classical Economist

Deficit Aggregate Demand : Wages would reduce hence

cost of production will reduce , Aggregate supply would

increase and economy will be back at Equilibrium.

But

Keynes

Wages are sticky downward: wages will not

accommodate to adjust unemployment. Hence recession

will persist for long time

According to J.M. Keynes, an increase in public

expenditure, will thus serve to uplift the economy from

the morass of depression.

Increase in public expenditure at such a time may take

two forms, first is Pump priming and second is

compensatory Spending.

The term pump priming implies that a certain amount of

public spending varying under different conditions will

have the effect of setting the economy on the way toward

full utilisation of resources on its own power without

further aid from Governmental spending.

Pump priming refers to increased private investment

through an injection of fresh purchasing power in the

form of an increase in public expenditure.

It was believed that such an initial public expenditure

may set in motion a process of recovery from the

condition of depression.

If a little water is poured into a pump to prime it, it

may then supply an endless flow of water. In the same

way it was thought that once the Government spends

some money the flow of economic life would continue

smoothly forever. The pump priming theory appears to

be too optimistic. But it has been found that if

Government expenditure are curtailed, the level of

incomes again falls.

However, public spending in the U.S.A. during the

period of 1933-38, did not have very successful pump-

priming effects though it showed some success as a

compensatory device i.e. the national income and

employment were prevented from falling, but

permanent recovery was not generated.

Compensatory spending on the other hand, refers to that

Government expenditure which is undertaken with the set

idea of compensating for the decline in private

investment.

Private investment, as is well-known suddenly declines at

a time of depression, and despite best efforts on the part

of Government does not respond in the upward direction.

At such time, there is no alternative before the

Government except to resort to public investment to

take-up the slack of private investment. Since public

investment at such a time has to compensate for the

decline in private investment, it has to be necessarily

on a large scale to have an effective impact on the

employment.

Government increases government expenditure leading to

budget deficit, private investment increases, output

increases, employment increases. Because if the tax rate

will reduce disposable income. Budget deficit is financed

through borrowings or through Monetization

Impact of Government Expenditure depends on: MPC

(fiscal multiplier)

Expansionary Fiscal policy will be successful only with

Accommodative monetary Policy

Money demand Increases: Interest rate increases but

money supply does not increase then it will affect

private investment.

If interest rate remain unchanged; private investment

will not be affected and government expenditure will

increase income and employment

Example

Suppose the model is given by:

Y = National income

T = Taxes = 0.3Y

C = Consumption = 200 + 0.9 (Y – T)

I = Investment = 600

G = Government spending = 1,000

X = Exports = 600

Y = Imports = 0.1 (Y – T)

Step 1. Calculate the initial equilibrium for this

economy (where Y = AD).

Y=200 + 0.9(Y – 0.3Y) + 600 + 1000 + 600 – 0.1(Y –

0.3Y)

Y – 0.63Y + 0.07Y = 2400

0.44Y = 2400

Y = 5454

Step 2. Assume that the full employment level of

output is 6,000. What level of government spending

would be necessary to reach that level?

Since initial output is 5,454, GDP needs to be

increased by 6,000 – 5,454 = 556.

What increase in government spending (while

incorporating the spending multiplier) will achieve

this?

To answer this question, plug in 6,000 as equal to Y,

but leave G as a variable, and solve for G. Thus:

6000 = 200 + 0.9(6000 – 0.3(6000)) + 600 + G + 600 –

0.1(6000 – 0.3(6000))

Step 3. Solve this problem arithmetically. The answer

is: G = 1,240. In other words, increasing government

spending by 240, from its original level of 1,000, to

1,240, would raise output to the full employment level

of GDP.

Thus a Keynesian expansionary fiscal policy,

increasing government spending by 240, would correct

the recessionary gap in this example.

2. Contractionary : To refrain the economy during

inflation or an anticipation of expansion of business

cycle

Increase in consumption

Increase in investment expenditure

Increase in government expenditure

Leads to inflationary pressure

Increase in the general price level

AD reduction

1. Decrease government spending: Money demand

decreases

2. Increase in Personal income tax and/or Corporate tax

: reduces disposable income, reduces private

investment , reduces future investment in anticipation

of lower profits

3. 1+2 in various combinations

Example

Suppose the model is given by:

Y = National income

T = Taxes = 0.3Y

C = Consumption = 200 + 0.9 (Y – T)

I = Investment = 600

G = Government spending = 1,000

X = Exports = 600

Y = Imports = 0.1 (Y – T)

Step 1. Calculate the initial equilibrium for this

economy (where Y = AD).

Y=200 + 0.9(Y – 0.3Y) + 600 + 1000 + 600 – 0.1(Y –

0.3Y)

Y – 0.63Y + 0.07Y = 2400

0.44Y = 2400

Y = 5454

Step 2. Assume that the full employment level of

output is 5,000. What level of government spending

would be necessary to reach that level?

Since initial output is 5,454, GDP needs to be

decreased to 5,000 – 5,454 = - 454.

What decrease in government spending (while

incorporating the spending multiplier) will achieve

this?

To answer this question, plug in 5,000 as equal to Y,

but leave G as a variable, and solve for G. Thus:

5000 = 200 + 0.9(6000 – 0.3(6000)) + 600 + G + 600 –

0.1(6000 – 0.3(6000))

Step 3. Solve this problem arithmetically. The answer

is: G = ---- . In other words, decreasing government

spending by-----, from its original level of 1,000, to------

, would decrease output to the full employment level of

GDP.

Thus a Keynesian contractionary fiscal policy,

decreasing government spending by-----, would correct

the expansionary gap in this example.

Fiscal policy and Long Run Economic Growth

Short term: Price Stability and Employment through

AD

Long Term : Economic growth and development

through AS

Long Term : Infrastructure , Well designed tax policy ,

ecosystem of startup and R& D , Investment and

structural reforms

Fiscal policy and Reduction in unequal distribution of

Income and Wealth

Future earnings of the country = f( National Fiscal

policy) to achieve Equity & Social justice

Progressive Direct Tax reduces government

expenses

Differential Indirect Tax : Luxurious / white goods

to consumer goods

Poverty alleviation Prog

Subsidized Health Care, Insurance , Education ,

Housing

Selective Infrastructure provision : PLI , SEZ

Social Security Scheme : Pension Fund , Jan Dhan

Yojana

Subsidized Production of mass consumption

Public production and /or grant subsidies

Enhancing human capital employability

Marginal tax and Progressive tax system defines

savings, investment and employment , production

efficiency

Limitations of Fiscal Policy

Lags

1. Recognition Lags: Need for policy change

2. Decision Lag: Evaluate possible policy measures

and decision for the most appropriate policy measures

3. Implementation Lag: Legislation and

implementation

4. Impact lag: Outcomes are not effective and visible

Mismatch between Policy initiation and Economic

health of the country

Operational problems of changing government

spending and taxation policies

Inelastic expenses of the government : Capital

projects midway / Defence

Long gestation period project and short term

project collusion

Determination of accurate policy intervention is

difficult due to domestic and international uncertain

factors

Tradeoff of different fiscal policy objectives

Deficit financing and spill over impact

Spiral Fiscal Debt

Huge disparity between public and private

investment

Crowding Out

Government spending substitutes Private Spending

Fiscal Multiplier impact reduces

Long term growth gets adversely affected

Govt borrows money from the market through

Bonds and T- Bills to meet its expenses. This results

in increase in interest rate. It increases cost of

investment and reduces private investment.

Rapid growth of public spending Productivity shifts

from Pvt to govt

Fiscal policy becomes ineffective.

During deep recession crowding out is not possible

Important Government economic policy tool: Government Budget

Budget

Estimates 2021-2022*

Actuals@ upto

May 2021

% of Actuals to Budget Estimates

Rs. Rs. Current COPPY**

1 Revenue Receipts 1788424 349977 19.6% (2.2%)

2 Tax Revenue (Net) 1545396 233565 15.1% (2.1%)

3 Non-Tax Revenue

243028 116412 47.9% (2.8%)

4 Non-Debt Capital Receipts

188000 4810 2.6% (0.4%)

5 Recovery of Loans 13000 815 6.3% (5.6%)

6 Other Receipts 175000 3995 2.3% (0.0%)

7 Total Receipts (1+4) 1976424 354787 18.0% (2.0%)

8 Revenue Expenditure

2929128 415000 14.2% (17.4%)

9 of which Interest Payments

809701 88573 10.9% (11.1%)

10 Capital Expenditure 554108 62961 11.4% (13.4%)

11 of which Loans disbursed

40374

2646 6.6% (36.6%)

12 Total Expenditure (8+10)

3483236 477961 13.7% (16.8%)

13 Fiscal Deficit (12-7) 1506812 123174 8.2% (58.6%)

14 Revenue Deficit (8-1) 1140704 65023 5.7% (67.6%)

15 Primary Deficit (13-9) 697111 34601 5.0% (440.3%)

Note :- Fiscal deficit figure shown in monthly accounts during a financial year is not necessarily an indicator of fiscal deficit for the year as it gets impacted by temporal mismatch between flow of not-debt receipts and expenditure up to that month on account of various transitional factors both on receipt and expenditure side, which may get substantially offset by the end of the financial year.

*Financial Year runs from "April to March"

**COPPY : Corresponding Period of the Previous Year

@ Actuals are unaudited provisional figures.

@@ 1 Crore = 10 Millions