Fiscal policy is the government’s policy for managing its budget i.e. revenues (taxes) and expenditures i.e. government spending to influence the economy and meet its economic goals. The budget is said to be balanced when the government’s revenues equal its expenditures. It is said to be in deficit when expenditures are more than the revenues and in surplus when revenues exceed expenditures.
During a recession the government usually runs a budget deficit as its tax collection decreases and it increases its spending to spur demand and economic growth. Conversely during a boom period, the budget is usually in surplus as tax collection increases and the government reduces its spending to decrease demand and control economic growth to rein in inflation.
Fiscal policy in co-ordination with monetary policy is used for stabilizing the economy over the business life cycle. Fiscal policy is distinguished from monetary policy in that fiscal policy is administered by law of the legislature and is concerned with taxation and government spending, while monetary policy is administered by central banks and deals with supply of money and credit in the economy and interest rates.
You can read about all about monetary policies here below
Objectives of fiscal policy
The objectives of the fiscal policy are
- to influence demand and level of economic activity,
- to influence savings and investment and
- distribution of income.
Tools of fiscal policy
Government spending are of three types;
Transfer payments are payments like social security benefits, unemployment insurance benefits. This helps in redistribution of wealth. The government taxes someone to pay someone else.
Current spending: Government spending for purchasing of goods and services on a routine basis is called current spending.
Capital spending: Capital spending is government spending on infrastructure such as roads, bridges, schools and hospitals.
Government spending helps to spur demand and facilitate economic growth, provide a minimum standard of living. Infrastructure development boots future productivity.
Government’s revenue comes mainly from taxes. Taxes are of two types, direct and indirect. Direct taxes are income tax, wealth tax, estate taxes, corporate taxes, social security taxes and capital gains taxes. Indirect taxes are sales taxes, value added taxes, excise taxes, custom duties and levies.
Taxes help in social causes like discouraging the use of harmful products like tobacco, cigarettes and liquor through indirect taxes. Indirect taxes are also a quick source of additional revenue for the government.
On the other hand, direct taxes, transfer payments and capital spending take time to implement, thus delaying the effect of fiscal policy.
Announcement of fiscal policy may have significant effects on expectations. For example, the announcement of increase in taxes in future will immediately reduce current consumption and thus demand. Conversely, reduction is taxes are less effective. Reduction in taxes may not immediately increase demand. Even so, reduction in taxes has more effect on people with low incomes than people with high incomes.
Changes in government spending have multiplier effects on demand. People whose incomes increase from an increase in government spending spend more which in turn increases the income and spending of others. The magnitude of effect from the changes in government spending is determined by the tax rate and marginal propensity to consume.
Let’s take an example. When the government’s spending increases by 100, the incomes of some people increase by 100. Supposing the tax rate is 25%, they will pay 25 in taxes. Now their disposable income is 100-25 = 75. Again suppose the marginal propensity to consume is 80%, therefore they will spend 75*80% = 60. This 60 that they spend will increase someone else’s income by 60, on which they will pay 25% tax i.e. 15. Their disposable income would be 45 of which they will consume 45*80% = 36. And so on and so forth. Therefore the total demand that an 100 increase in government spending will generate is finite and will end somewhere. This is called the fiscal multiplier.
The fiscal multiplier determines the total potential increase in demand from an increase in government spending and is given as;
Fiscal multiplier = 1 / 1 – MPC (1 – t)
Hence in our example where the tax rate is 25% and the MPC is 80%, the fiscal multiplier is 2.5.
Point to be noted is that, the fiscal multiplier is inversely related to the tax rate and directly related to the MPC. This can be intuitively understood. When the tax rate is high the disposable income is lower and therefore spending is lower and lower with each person in the chain. Similarly, when MPC is higher people spend more of their disposable incomes and demand is more.
Balance budget multiplier
To balance the budget and offset the 100 increase in spending, the government could increase taxes by 100. The increase in taxes by 100, would reduce the disposable income and consumer spending by 100*MPC, i.e. 100*80% = 80 and so on. The overall decrease in demand from a 100 increase in taxes is given by,
Hence in our example, demand will decrease by 100*0.80*2.5 = 200
The net impact on demand of a fiscal policy move of 100 increase in spending and a simultaneous 100 increase in taxes will be 250 – 200 = 50. Therefore we can say that the budget multiplier is positive.
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In the next post we proceed to next installment on fiscal policy where will discuss the implementation aspects of fiscal policy…..bye for now…
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For solved examples please refer to the CFA Institute books or CFA study notes. The problems can be easily solved using the CFA institute approved financial calculators. Please refer to the CFA exam policy and CFA calculator guide.
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