FISCAL POLICY (Pages 592-599, covering Chapter 49)

Meaning of Fiscal Policy

Fiscal policy refers to the use of government spending and taxation to influence the
economy's performance, especially regarding:

 Employment,

 Output,

 Income, and

 General economic stability.

The objective is to achieve economic growth without inflation and minimize unemployment.

Key Definition: Fiscal Policy involves the "adjustment of tax rates, public expenditure, and
public borrowing to achieve desirable economic objectives."

Objectives of Fiscal Policy

1. Full Employment: Fiscal policy is used to increase aggregate demand and stimulate
production and employment.

2. Economic Stability: Minimize cyclical fluctuations (booms and recessions) through

counter-cyclical spending.

3. Economic Growth: Allocate resources towards investment in public utilities,

infrastructure, education, and health.

4. Equitable Distribution of Income and Wealth: Through progressive taxation and

targeted public spending.

5. Capital Formation: Promote savings and channel them into productive investments.

6. Price Stability: Prevent excessive inflation or deflation.

7. External Stability: Correct balance of payments disequilibria by influencing

domestic income and spending.

8. Regional Development: Reduce regional disparities through public investment in

backward areas.
Instruments of Fiscal Policy

A. Taxation

 Direct taxes (e.g., income tax)

 Indirect taxes (e.g., GST, excise duties)

 Aimed at influencing disposable income, consumption, and savings.

B. Public Expenditure

 Government spending on goods and services to stimulate or restrain aggregate

demand.

C. Public Borrowing

 Government borrowing from the public to mobilize savings for development projects.

D. Deficit Financing

 Printing new currency or borrowing from the central bank to finance excess
expenditure.

Instrument Expansionary (During Contractionary (During

Depression) Inflation)

Taxation Reduce taxes to increase demand Increase taxes to reduce demand

Public Increase spending Cut back spending

Expenditure

Public Borrowing Increase borrowing from private Reduce borrowing

sector

Deficit Financing Increase to boost spending Decrease to control inflation

Crowding-Out Effect and Fiscal Policy

 When government increases its spending, it may "crowd out" private investment
because of higher interest rates.
  Increased demand for money raises interest rates, discouraging private sector
investment.

Diagram (described in book):

 IS curve shifts right.

 LM curve remains fixed.

 Higher income but also higher interest rate.

Thus, fiscal expansion might be partially offset by reduced private investment.

Types of Fiscal Policy

1. Expansionary Fiscal Policy

o Increase government spending,

o Decrease taxes,

o Increase budget deficit,

o Used during recession.

2. Contractionary Fiscal Policy

o Decrease government spending,

o Increase taxes,

o Reduce budget deficit or generate surplus,

o Used during inflation.

Fiscal Policy in Developing Economies

In developing countries, fiscal policy is designed to:

 Mobilize resources for development,

 Accelerate economic growth,

 Reduce income inequalities,

 Expand employment opportunities,

  Provide infrastructure for modernization.

Specific Features:

 Progressive Taxation:

o Rich taxed more to mobilize funds for development.

 Deficit Financing:

o Controlled to avoid hyperinflation.

 Priority to Public Investment:

o Especially in infrastructure, education, health.

 Social Welfare Expenditure:

o Healthcare, nutrition, housing schemes.

 Balanced Growth Focus:

o Remove regional disparities.

🔹 Limitations of Fiscal Policy

1. Time Lags: Recognition, decision, and implementation delays.

2. Political Constraints: Policy decisions often influenced by political considerations.

3. Inelastic Government Expenditure: Major part of budget (salaries, pensions,

interest) is non-discretionary.

4. Effects of Public Debt: Higher future tax burdens to repay debts.

5. Crowding-Out Effect: Increased public borrowing may reduce private sector

investment.

6. Risk of Inflation: If deficit financing is excessive.

7. Misallocation of Resources: If public investment decisions are inefficient.

8. Globalization Impact: Open economies face constraints on independent fiscal policy.

Summary Table

Aspect Fiscal Policy Focus

Objective Full employment, economic growth, equity

Instruments Taxation, Public expenditure, Borrowing, Deficit financing

Problems Time lags, crowding out, political pressure, inflation risk

Application More critical in developing countries

PUBLIC REVENUE: TAXATION, INCIDENCE, EFFECTS (Pages 452-455)

Public Revenue refers to the income or receipts of the government from all sources, primarily
for meeting its expenditure requirements to maintain public services and promote economic
development.

Two Main Components:

 Tax Revenue (compulsory contributions)

 Non-Tax Revenue (fees, fines, profits from public enterprises, etc.)

Meaning of Taxation: Taxation refers to the compulsory contribution made by individuals

and institutions to the government without any direct return or benefit.

Features:

 Compulsory in nature.

 Paid without direct quid pro quo.

 Levied by government authority.

 Used for public purposes.

Definition: "A tax is a compulsory contribution imposed by a public authority irrespective of

the exact amount of service rendered to the taxpayer in return." (M.L. Jhingan)

Incidence of Taxation

Meaning: The incidence of taxation refers to the ultimate burden of a tax on the final
taxpayer, i.e., who actually bears the tax burden.

Important Terms:

 Impact of Tax: The initial burden when the tax is levied.

 Shifting of Tax: Movement of burden from the payer to another.

 Incidence of Tax: The final resting point of the tax burden.

Types of Incidence:

1. Formal Incidence: Who is legally bound to pay the tax.

2. Effective Incidence: Who actually bears the economic burden of the tax.
 3. Shifting:

o Forward Shifting: Shifting tax to consumers (raising prices).

o Backward Shifting: Shifting to suppliers (lowering input costs).

Type Explanation Example

Forward Seller passes tax burden to consumer Sales tax added to product
Shifting price

Backward Supplier bears burden by lowering Agricultural cess absorbed

Shifting supply price by farmers

Capitalization Tax reduced future earnings, Property tax reducing

impacting asset prices property value

Effects of Taxation

On Production

1. Effect on Ability to Work, Save, and Invest: High direct taxes reduce disposable
income and can discourage saving and investment.

2. Effect on Willingness to Work, Save, and Invest: Progressive taxes may demotivate
higher income earners.

3. Effect on Composition of Production: Heavy excise duties may discourage

production of luxury goods.

4. Effect on Allocation of Resources: Tax exemptions or concessions may shift

resources to priority sectors.

5. Effect on Capital Formation: If taxes discourage savings, it hampers capital

accumulation and economic growth.

On Distribution

1. Reduction of Income Inequalities: Progressive income taxes reduce the gap between
rich and poor.

2. Redistribution via Expenditure: Tax revenue used for welfare programs improves
the standard of living of lower-income groups.
 3. Correction of Externalities: Taxation on harmful goods (sin taxes) improves societal
welfare.

4. Inflationary and Deflationary Effects: Taxes influence aggregate demand,

impacting the price level.

Elasticity and Tax Burden Sharing

Elasticity (responsiveness of supply or demand to price changes) determines how the burden
of a tax is shared.

Scenarios:

 Demand Inelastic, Supply Elastic:

o Consumers bear a larger share of the tax burden.

 Demand Elastic, Supply Inelastic:

o Producers bear a larger share of the burden.

Graphical Analysis:

 If demand is more inelastic than supply, a greater portion of tax is shifted to

consumers.

 If supply is more inelastic, producers bear more burden.

Conclusion:

The party (consumer or producer) whose supply or demand is relatively more inelastic will
bear the greater burden of taxation.

Elasticity Situation Who Bears More Burden?

Demand Inelastic Consumer

Supply Inelastic Producer

Demand Elastic Producer

Supply Elastic Consumer

Effects of Taxation on Employment

  Tax-induced reduction in consumption or investment reduces effective demand,
leading to unemployment.

 However, productive use of tax revenue can create employment opportunities.

Counterview:

 If taxes are used for productive public expenditure, they may promote employment in
the long term.

Summary Table: Taxation, Incidence, and Effects

Aspect Description

Taxation Compulsory payment for public needs

Incidence Final resting place of the tax burden

Forward Shifting Tax passed onto consumers

Backward Shifting Tax burden shifted to suppliers

Production Effects Discourage or encourage certain industries

Distribution Reduce inequalities, finance welfare programs

Effects

Elasticity's Role Determines division of tax burden

PUBLIC EXPENDITURE (Pages 592-594 — embedded under fiscal instruments and
effects)

Public Expenditure refers to the expenses incurred by the government to perform its essential
functions and promote economic and social welfare.

It includes spending on:

 Defence,

 Law and order,

 Education,

 Public health,

 Infrastructure development,

 Social security, and

 Economic development programs.

Definition: “Public expenditure means the expenses of public authorities—central, state, and
local bodies—on the various activities undertaken for the welfare of the society.”

🔹 Objectives of Public Expenditure

1. Maintenance of Law and Order: Police, judiciary, and internal security systems.

2. Defence of the Country: Military spending, border protection.

3. Provision of Social and Economic Overheads: Transport, communication,

irrigation, power, and other infrastructure services.

4. Promotion of Economic Growth: Spending on development programs, industry,

agriculture, and services sector.

5. Reduction of Income Inequalities: Welfare schemes, subsidies, social security.

6. Provision of Public Goods: National defence, street lighting, lighthouses (non-

excludable and non-rival goods).

7. Provision of Merit Goods: Education, healthcare.

 8. Stabilisation of Economy: Anti-cyclical fiscal policy to smooth out economic
fluctuations.

Classification of Public Expenditure

Public expenditure can be classified under various heads:

1. Revenue and Capital Expenditure

Type Meaning Examples

Revenue Expenditure that does not create assets Salaries, pensions, subsidies
Expenditure or reduce liabilities

Capital Expenditure that creates assets or Infrastructure projects, loan

Expenditure reduces liabilities repayments

2. Developmental and Non-Developmental Expenditure

Type Meaning Examples

Developmental Expenditure promoting Education, health, agriculture

economic growth development

Non- Administrative and maintenance Police, defence, interest

Developmental costs payments

3. Plan and Non-Plan Expenditure (earlier classification in India)

Type Meaning Examples

Plan Expenditure Spending linked to five-year plans Infrastructure, education

Non-Plan Regular government expenses Salaries, subsidies, defence

Expenditure

Note: Post-2017, India moved to Revenue and Capital classification.

Effects of Public Expenditure

On Production

1. Increase in Productive Capacity: Public investment in infrastructure boosts

production capabilities.
 2. Promotion of Employment: Government spending generates direct and indirect
employment.

3. Stimulating Demand: Increased public spending leads to higher aggregate demand.

4. Encouragement to Private Investment: Public investment in infrastructure

complements private sector activity.

5. Development of Strategic Industries: Heavy industries and defence sectors receive

targeted support.

On Distribution

1. Reduction in Income Inequalities: Social welfare programs redistribute resources.

2. Provision of Free or Subsidized Services: Education, healthcare, food subsidies to

the poor.

3. Social Insurance and Social Security: Old-age pensions, unemployment benefits,

maternity benefits.

4. Rural and Regional Development: Focused expenditure in underdeveloped areas.

On Economic Stability

1. Counter-cyclical Tool:

o During depression: Increase public expenditure.

o During inflation: Curtail or reorient expenditure.

2. Price Stability: Expenditure programs can moderate inflationary/deflationary trends.

3. Investment in Public Works: Construction of dams, bridges creates employment and

stabilizes economy.

Important Table: Effects of Public Expenditure

Aspect Effect

Production Increases productive capacity, stimulates investment

Distribution Reduces inequalities, promotes social welfare

Stability Smooths business cycles, ensures price stability

Role of Public Expenditure in Developing Economies

1. Acceleration of Economic Growth: Building infrastructure (roads, dams, power

plants).

2. Expansion of Social Overheads: Education, healthcare, sanitation.

3. Poverty Alleviation: Rural employment schemes, subsidies.

4. Reducing Regional Imbalances: Targeted expenditure in backward areas.

5. Human Capital Formation: Investment in skill development, health, and education.

6. Creation of Basic Industries: Steel plants, heavy machinery production units.

7. Market Expansion: Infrastructure improves market access and efficiency.

8. Capital Formation: Public sector investment enhances total capital stock.