FISCAL POLICY

INTRODUCTION:
FISCAL policy is the use of government spending and taxation to influence the
economy. Governments typically use fiscal policy to promote strong and sustainable growth
and reduce poverty. The role and objectives of fiscal policy have gained prominence in the
current crisis as governments have stepped in to support financial systems, jump-start
growth, and mitigate the impact of the crisis on vulnerable groups. In the communiqu
following their London summit in April, leaders of the Group of Twenty industrial and
emerging market countries stated that they are undertaking unprecedented and concerted
fiscal expansion. What do they mean by fiscal expansion? And, more generally, how can
fiscal tools provide a boost to the world economy? Historically, the prominence of fiscal
policy as a policy tool has waxed and waned. Before 1930, an approach of limited
government, or laissez-faire, prevailed. With the stock market crash and the Great
Depression, policymakers pushed for governments to play a more proactive role. More
recently, countries scaled back the size and function of government, with markets taking on
an enhanced role in the allocation of goods and services. Now, with the financial crisis in
full swing, a more active fiscal policy is back in favor.

OBJECTIVES OF FISCAL POLICY:

To mobilise resources for Economic Growth
To promote growth in Private Sector
Equitable distribution of Income and wealth
Restrain inflationary forces in the Economy

TOOLS OF FISCAL POLICY:

Introduction 2:
Fiscal policy can play a significant role in economic growth. In the short term, countercyclical fiscal expansion can help support aggregate demand and growth during cyclical
downturns. Conversely, fiscal contraction can cool down an economy that is growing at an
unsustainable pace and thus faces the risk of overheating. Advanced economies in particular
have a long history of using taxes and government spending to smooth the business cycle. At
the same time, fiscal policy can also have a major impact on medium- and long-term
economic growth. This is especially true in developing economies where the private sector is
relatively weak and underdeveloped. Public spending on physical infrastructure, such as
roads, ports, and power plants, affects the productivity of all firms and industries, and the
entire economy. Likewise, public spending on education fosters human capital, a vital
ingredient to long-term growth. Taxes can harm growth because they distort economic
incentives and behavior; for example, corporate income taxes have a negative impact on
investment. But generally, different taxes vary in the extent of their distortionary impacts.
In developing Asia, as in the rest of the world, fiscal policy can influence both shortand long-term growth. The region has very limited experience in using fiscal policy for
counter-cyclical purposes than advanced economies. Nevertheless, during the global
financial and economic crisis in the period 20082009, developing Asias governments
forcefully unleashed large fiscal stimulus programs that helped the region stave off
recession. More broadly, in much of the region, the primary strategic objective of fiscal
policyand of public policy in generalhas been to foster long-term economic growth.
The prioritization of growth was perfectly understandable in light of developing Asias low
income levels in the past. A tradition of fiscal prudence laid the foundation for
macroeconomic stability in large parts of the region which, combined with large public
investments in physical infrastructure and human capital, brought about sustained rapid
growth. Different components of public spending will likely have different impacts on
growth; for example, spending on health care is likely to have a bigger effect than spending
on military equipment.

How does fiscal policy work?

When policymakers seek to influence the economy, they have two main tools at their
disposalmonetary policy and fiscal policy. Central banks indirectly target activity by
influencing the money supply through adjustments to interest rates, bank reserve
requirements, and the sale of government securities and foreign exchange; governments
influence the economy by changing the level and types of taxes, the extent and composition
of spending, and the degree and form of borrowing. Governments directly and indirectly
influence the way resources are used in the economy. The basic equation of national income
accounting helps show how this happens: GDP = C + I + G + NX. On the left side is gross
domestic product (GDP)the value of all final goods and services produced in the economy
(see Back to Basics, F&D, December 2008). On the right side are the sources of aggregate
spending or demandprivate consumption (C), private investment (I), purchases of goods
and services by the government (G), and exports minus imports (net exports, NX). This
equation makes it evident that governments affect economic activity (GDP), controlling
G directly and influencing C, I, and NX indirectly, through changes in taxes, transfers, and
spending. Fiscal policy that increases aggregate demand directly through an increase in
government spending is typically called expansionary or loose. By contrast, fiscal policy
is often considered contractionary or tight if it reduces demand via lower spending.
Besides providing goods and services, fiscal policy objectives vary. In the short term,
governments may focus on macroeconomic stabilizationfor example, stimulating an ailing
economy, combating rising inflation, or helping reduce external vulnerabilities. In the longer
term, the aim may be to foster sustainable growth or reduce poverty with actions on the
supply side to improve infrastructure or education. Although these objectives are broadly
shared across countries, their relative importance differs depending on country
circumstances. In the short term, priorities may reflect the business cycle or response to a
natural disasterin the longer term, the drivers can be development levels, demographics,
or resource endowments. The desire to reduce poverty might lead a low income country to
tilt spending toward primary health care, whereas in an advanced economy, pension reforms
might target looming long-term costs related to an aging population. In an oil-producing

country, fiscal policy might aim to moderate procyclical spendingmoderating both bursts
when oil prices rise and painful cuts when they drop.