Concept of Fiscal Policy

Fiscal policy is concerned with the revenue and expenditure of the government, which is careful as a powerful device for stabilization. It refers to the budgetary policy of the government. This has become an extremely important tool of the government to preserve economic stability, economic growth, high employment, and balance of payments equilibrium. The major components of fiscal policy are aspects of government expenditure, debt management and tax revenue. In the economy to attain economic stability above all aspects should be equilibrium. Fiscal policy is the package of government economic measure, which is attached to public expenditure, public revenue and public debt. Various economists have defined fiscal policy.

In the words of Prof. Musqrave, “Fiscal policy is concerned with those aspects of economic policy which arise in the operations of the public budget”. According to American Economic Association, “Fiscal policy should mean the policy which concerns itself with aggregate effects of government expenditure and taxation on income, production, employment”.

Similarly, Arther Smithies defines fiscal policy as, “A policy under which government uses its expenditure and revenue program to produce desirable effects and avoid undesirable effects on the national income, production and employment”.

In short, contemporary fiscal policy is an application of the principle of functional finance. It is used to actively function in accordance with the changing conditions of the economy, i.e. to control inflationary or deflationary tendencies. Thus it is the government policy related to public income, public expenditure and public debt to have beneficial effects and remove unbeneficial effects on the economy. There are mainly two types of fiscal policies i.e. expansionary fiscal policy and concretionary fiscal policy.

(i)   Expansionary Fiscal strategy: Fiscal policy is said to be expansionary when spending is higher than revenue. That is, it is the situation of budget deficit. In expansionary fiscal policy, government usually reduces the tax rate and or increases the administration spending, which leads the situation in which spending is greater than revenue.

(ii)  Reduction Fiscal Policy: Fiscal policy is said to be reduction when revenue is higher than spending. That is, it is the situation in which government budget is in surplus. In reduction fiscal policy, government usually increases the tax rate and or reduces the public expenditure so that income is greater than spending.

2          Purpose of Fiscal Policy

In modern times, the objectives of fiscal policy are as follows:

(i)   Best possible provision of Resources: One of the main objectives of fiscal policy in developing countries is to mobilize economic resources. It should be formulated so as to secure use and optimum allocation of economic resources like money, men and material. This means that government should not misuse resources and ensure maximum productive utilization of economic resources.

(ii) Perfection in fair allocation of Income: survival of inequality in income and wealth in developing countries is wide spread. It is undesirable from the point of view of social justice. The government should adopt suitable fiscal policy to reduce inequality of income and wealth. It should be designed to reduce the economic disparity between the rich and poor to the least. Fiscal policy is the power instruments to reduce income inequality by the appropriate tax rate.

(iii) Price constancy: Another important objective of fiscal policy is maintaining price stability. The price instability represents both inflationary and deflationary tendencies. But the negative effect of inflationary tendencies in developed countries. Deflation leads to decline in economic activity. Inflation affects adversely the fixed income groups. Fiscal policy should aim at securing price stability by counteracting inflationary and deflationary tendencies in the economy.

(iv) Economic increase: The vicious circle of poverty in developing countries is mainly caused by the deficiency of capital. In this context, according to Mlier and Baldwin, “The overall concern of the government’s fiscal policy should be directed towards maximizing savings, mobilizing them for production, investment and channel zing them into directions that will best secure the objectives of a balanced development program”. The basic objective of fiscal policy in developing countries is to accelerate the economic development through capital formation.

(v) Full service: In modern time, the ultimate objective of all government economic policy including fiscal policy is to provide and achieve full employment. An appropriate fiscal policy helps to maintain full employment. For this, the economy should maintain its growth rate in commensurate with the growth of population. The fiscal policy should be designed to ensure that the rate of increase in revenue, and the rate of increase in employment opportunities are much higher than the rate of growth of population


  1. Implication/Objectives of Fiscal Policy in Developing Countries

Fiscal policy plays a dynamic role in developing countries. The monetary policy alone ineffective due to the existence of underdeveloped money and capital markets, fiscal policy can be used as an important adjusts to monetary policy in accelerating the rate of capital formation. In modern time, optimum allocation of resources, price stability, equitable distribution of income, economic growth and development and creation of full employment are the basic objectives of fiscal policy.

The main objectives of fiscal policy in developing countries are related to accelerate economic development and proper utilization of resources. Generally, developing countries are facing low level of income, consumption, saving and investment. Due to low investment or capital formation, there will be further low income, consumption and saving. Thus the fiscal policy in developing countries aims to raise the rate and volume of saving by the help of tax and public expenditure policy.

The importance/significance of fiscal policy in development countries can be discussed under different heading.

(i)   Boost the Rate of funds Formation: One of the main objectives of fiscal policy is to increase the rate of capital formation. Capital formation is an important determinant of economic development. Saving and investment are the two components of capital formation. In the economy as the saving flow is the formal investment in the productive sector, the rate of capital formation increases. Economic development takes place rapidly when the rate of capital formation increases. The fiscal policy should be formulated in such a manner as to increase the rate of investment both in public and private sectors. This needs large amounts of financial resources, which can be obtained by raising the incremental saving ratio and curtailing conspicuous consumption and unproductive investment. Fiscal policy helps in the formation of capital in two ways:

(a) Fiscal policy expands investment in private and public sector through planning wise development. Specially, government invests in the economic sector. It helps to provide necessary means to invest in such sectors. It collects necessary amount for the progress of the physical capital formation and human capital formation.

(b) Fiscal policy encourages unproductive investment to mobilize it in productive sector. Making the tax-free, low tax rate, subsidy, reduction policies etc do this. It helps in reducing unnecessary consumption and will increase capital formation rate, from unproductive sector to productive sector through the mobilization of resources.

(ii)  Funds draft: Resources are limited in developing countries. The aim of economic development can be obtained only if the limited resources are utilized optimally. The available resources should be mobilized rationally and effectively. Fiscal policy plays a central role for resource mobilization in the economy. The fiscal policy is more effective means for resource allocation and mobilization than any other means. In this context, according to Okun and Richardson, “The main task of fiscal policy underdeveloped countries is to make available adequate saving for financing economic development from excessive low production and prepare the environment for increasing significantly the private investment activities”.

(a)  Fiscal policy provides tax facilities in order to increase saving and in investment. Government may increase the tax rate and give priority for the public sector for investment.

(b)  Saving of public enterprises is mobilized in public investment.

(c)  Fiscal policy can be the means for mobilizing the investment and resources of agriculture to the productive sector such as trade industry, tourism, etc. then after the available saving from agriculture should be maintained in the form of tax to the economic development.

(iii) Support in service prospect: Fiscal policy plays a vital role to make conditions of full employment and offer with higher living standards. Fiscal policy therefore should aim at increasing employment opportunities and reducing unemployment. For this, government expenditure on economic and social overheads should be incurred to generate employment. Government should increase productive competence in the economy. Government can encourage labour-based small industries by reducing tax or by providing subsidies. Likewise, government can increase local community development programs involving more labour and requiring less capital per head. Government should give greater emphasis to the family planning performance to control the high growth of population that is the major reason of population growth. For this reason, above-mentioned fiscal measures can help to increase employment.

(iv) Effective Role in counteracting increase: Creeping inflation is required for the initial stage of economic development but higher inflation is dangerous in the economy. Inflation creates uncertainties, which are the barrier for investment and economic growth. That’s why fiscal policy can play an effective role in counteracting inflation. In this context, according to Henry C. Murphy, fiscal policy is an effective in counteracting inflation in developing countries as it is in industrial countries. The following are the effective roles in counteracting inflation:

(a)  Curtail Government Expenditure without Changing Tax Rate: This increases the saving of government budget and reduces the purchasing power of public. These are the forces which influence or increase the inflation will be declined.

(b)  Curtail Government Expenditure with the Increase in Tax Rate: This helps to increase the rate of saving and reduce the purchasing power of public. In this, aggregate demand will be decreased which help in controlling inflation.

(c)  Fixed in Government Expenditure with adds to the in Tax Rate: Sometimes, government expenditure cannot be controlled. In such situation, inflation can be controlled by increasing tax rates with the help of reducing purchasing power of public.

(d)  Limit in Government Expenditure and Reduce Tax Rates in Equality: If the government expenditure and tax rate is disparity is reduced, the income between the beneficiaries of government expenditure and the class of taxpayers will be redistributed. This process reduces the net propensity to consume and reduces more in the national income than government expenditure. Through this, the multiplier value of balanced budget will be greater than the unity and the effects occur against inflation.

(e)  Increase in Government liability: Government may increase public debt and pull public saving that reduce purchasing and demand. This helps in controlling inflation.

(v)  Reduction of Income Inequality and Wealth Distribution: In underdeveloped countries, inequality of income and wealth distribution widely spread. This inequality is socially injustice and economically helpful. Until the problem of such inequalities exists in the economy. There will be hardly developed of economy and social welfare. That’s why inequality of income exists and wealth distribution should be reduced. For this, fiscal policy plays very important role.

(a)  Implementation of progressive tax system. To reduce income inequality, government has to impose high tax rate to the rich people and low tax rate or free tax to the poor people.

(b)  Levy tax on the basis of class of consumption pattern: Government should levy taxes at high rates on the luxurious goods and services, which there should be lower tax rates on the goods and services that are consumed by poor people.

(c)  Increase facilities to the poor class: Basic facilities should be increased to make easier life for poor class than the rich class.

(d)  Expenditure on human capital for poor people: Government should spend a lot of money on physical capital and human capital development. Such expenditure provides job opportunities for the poor people by developing human capital on them.

(vi) Correct Adverse Balance of Payment: Fiscal policy helps to correct adverse balance of payment. This policy discourages the import and encourages the exports of the economy. For this, government should reduce the taxes of imports and increase the tax of exports goods, subsidies and other facilities.

(vii) Economic constancy: One of the most serious problems of developing countries is economic instability. Generally they are affected by inflationary tendencies. Fiscal policy adopts the various methods to maintain economic stability. Contra-cyclical fiscal policy should be adopted to offset the effects of fluctuations in world market prices thereby to promote economic stability in the economy. During the inflation, government can increase direct tax and reduce the government expenses to control the inflation. On the other hand, the government can increase public expenditure and decrease tax rate to control the deflation. During depression period, government should make deficit budget and surplus budget policy will be made in the period of prosperity. From this stability will be maintained.


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