Understanding Macro Economy - Fiscal Policy

Macroeconomic variables of a country keep changing dynamically with the level of economic activity in the country and around the globe. Say, a country is undergoing a recessionary phase, what is it that the government of a country needs to do in order to move the country out of the recession? How does the government of a country cope up with slowing demand or an inflationary scenario or a slowdown in the industrial production? What is it that gives a country its economic stability and what does its government do when macroeconomic variables undergo significant adverse changes? If you seek answers to these questions, read on to find out the combat instruments with which the government of a country is equipped with to develop the economy and maintain its stability. The government of a country uses fiscal instruments and monetary tools to achieve its economic objectives. We will elaborate on fiscal policy here.

Its all about the Government's income and expenditure Fiscal policy deals with the revenue and expenditure policy of the country. Direct and indirect taxes are the largest source of revenues for a government. Other receipts include charges, fines and borrowings. However, in borrowings there is a liability on the government to repay back the money along with the regular interest payments. Government expenditure can be of revenue nature or of capital nature. However revenue expenditure is not very fruitful and productive in achieving the economic objectives. Salaries of Government employees and interest on borrowings are two key revenue expenditures of our Government - and both are not really productive in nature. Government expenditure may be planned or non planned. Non plan expenditure may be in the form of interest payments, subsidies, defense expenditure etc. Expenditure that is incurred on developmental activities like infrastructure, redevelopment etc is productive and helps in achieving the economic objectives. Much of the economic growth depends on the allocation of resources which should be judicious and effectively managed. Fiscal policy helps moderate economic cycles Fiscal policy has a considerable influence on the aggregate demand and price stability of an economy. Its main objectives are to develop the economy, maintain price stability, maintain the balance of payments, equitable distribution of income and wealth, capital formation, ensure full employment and increase the GDP of the country. It is important for the government of a country to devise a policy which allocates financial resources effectively so that fiscal deficit remains within reasonable levels. Expansionary policy helps an economy come out of a recession The fiscal policy is the key to maintaining a macroeconomic stability. If there is a slowdown in industrial production or a there is a creeping recession, the government uses its fiscal tools of taxes and government expenditure to bring aggregate demand to an equilibrium level. In the aftermath of the 2008 global crisis, the Indian government cut down excise duties and service tax, to lower prices of goods and services and thus spur more consumption. In the 2012 Union Budget, the Government restored these taxes to the pre 2008 levels, after it saw that consumption demand was restored, and as a measure to increase revenue to finance its various subsidies. During recessionary phases, Governments typically resort to an expansionary fiscal policy where they increase their own spending, often by borrowing money (and thus run up deficits) in an effort to promote more economic activity, generate new investments in the economy and put more money in the hands of the consumer through all these developmental activities, which in turn consumers can spend and thus increase aggregate demand. This cycle of activity, triggered by Government spending, helps pull an economy out of a recessionary phase. In recent times, we saw China do this very successfully in the post 2008 period. Attempts by some European countries to do the same however did not yield similar results as the incremental money in the hands of consumers was used to pay back large personal debt rather than spend more - which meant that consumption demand remained weak and growth continued to be anaemic, even while the Government's fiscal deficit (excess of spending over income) soared. Contractionary policy helps check excesses of a boom period On the flip side, when the economy is suffering from soaring inflationary worries, the government uses its weapon of contractionary fiscal policy. The main objective here is to reduce the aggregate demand which would then cool down the prices. The government does so by reducing the government expenditure and increasing the taxes. Higher taxes bring down the levels of disposable income of individuals and income of Corporates. This leads to lesser consumption and lesser investment and brings down the elevated aggregate demand. Lower Government expenditure also reduces overall economic activity in the economy and reduces the amount available for spending by consumers. A macroeconomic equilibrium again sets in. Fiscal deficit While the fiscal policy can be used for expanding the economy and maintaining its stability, a high fiscal deficit is not desirable. Fiscal deficit is the difference between the government revenues and expenditure excluding borrowings. This deficit is financed with public borrowings or external debt. The option of deficit financing also exists (printing excess money) but the amount of debt that can be monetized is limited, as otherwise it would lead to high inflation in the economy. Therefore, a high fiscal deficit means large borrowings both from the public as well as external. However, large borrowings from the market can lead to 'crowding-out' of private investment as there would be less liquidity in the market which would make the funds expensive for private investment. Not only does high fiscal deficit makes funds expensive, it also increases the debt burden on the government which leads to lesser money remaining for essential public expenditure. All this makes it imperative for the government to devise its fiscal policy in a manner which would lead to an increase in GDP but would not burden the government with a high fiscal deficit. Increasing direct taxes, indirect taxes on account of higher industrial production, decrease in non plan expenditure etc are some ways of improving mobilization of resources. In the Indian context, finding a way to reduce various subsidies on fuels and fertilizers can help reduce our deficit in a big way. And of course, preventing tax evasion is of utmost importance for an economy. Balancing its receipts and expenditure effectively for continuous economic development is what makes fiscal policy a powerful tool for a country.