INSTRUMENTS OF SAMIHAH KHALIL
SCHOOL OF
FISCAL POLICY GOVERNMENT, UUM
WHY FISCAL POLICIES?
In economy, there are many situations where a market failure (arising
from externalities) and suggests how the government could correct
the failure and improve economic efficiency.
The intervention by the government was promulgated by British
economist John Maynard Keynes, aka Keynesian economics. This
theory basically states that governments can influence
macroeconomic productivity levels by increasing or decreasing tax
levels and public spending.
Fiscal instruments are the means by which a government adjusts its
spending levels and tax rates to monitor and influence a nation's
economy.
Fiscal policy explores the means and consequences of government
finance. We must analyze tax systems and such alternatives to taxes
as user charges for government-provided services and borrowing.
We also discuss the criteria used to evaluate systems of government
finance. In most cases, funds to pay for government-provided goods
and services are obtained in a way that is fundamentally different
from that used to finance goods and services in markets.
The particular method of finance that is either proposed for a
community or actually used can affect a number of important
economic and political variables.
CAN GOVERNMENT
FAILS?
Government failures. How? First, government policy has created
economic inefficiencies where significant market failures do not
appear to exist, but the intervention (such as antitrust laws and
economic regulations) have raised firms’ costs and generated
economic rents for various interest groups at the expense of
consumer welfare. Antitrust enforcement may be deterring
anticompetitive behavior, especially collusion, but this potentially
important benefit has not been verified empirically.
Information policies have also raised consumer prices and firms’
costs. A possible benefit of this intervention is that some products,
such as harmful drugs.
Second, in situations where market failures do exist, government
policy has either achieved expensive successes by correcting these
failures in a way that sacrifices substantial net benefits or in some
cases has actually reduced social welfare.
Government policy has wasted resources with its application of
command-and-control policies to correct externalities, particularly in
health, safety, and environmental policy. Efficient pollution taxes and
more extensive use of tradable permits could have reduced
automobile emissions, airplane noise, and air and water pollution at
much lower cost than current policies.
5 MAJOR FISCAL
INSTRUMENTS
BUDGET
TAXATION
PUBLIC EXPENDITURE
PUBLIC WORKS
PUBLIC DEBT
A. BUDGET
Given the politics of the budget process and the time constraints in
enacting annual budgets, the approach that many governments
actually use views budgeting as an “incremental process.”
There are three formulas of budget:
Annual budget
Cyclical balanced budget
Fully managed compensatory budget
Annual Balanced Budget
There should be balance in income and expenditure of the
government. Economists felt that automatic system is capable to
correct the evils.
Balance budget will not lead to depression or boom in the economy.
It is politically desirable as it checks extravagant pending of the state.
This type of budget assures full employment without inflation.
Normal principle behind government should increase the taxes to get
more money and reduce expenditure to make the budget balanced.
However, this principle is subject to certain objections
Balanced budget is not neutral and not well based. It can be
expansionary.
The assumptions of full employment and automatic adjustment are
too untenable in a modern economy.
Some economists argue that annually balanced budget involves lesser
burden of the taxes.
Cyclically Balanced Budget
A budget implies budgetary surpluses in prosperous period and
employing the surplus revenue receipts for the retirement of public
debt.
During the period of recession, deficit budgets are prepared that the
budget surpluses earlier are balanced with deficit. The excess of
public expenditure over revenues are financed through public
borrowings.
This budget stabilize level of business activity. During inflation – use
budgetary surplus to curb excessive spending, During recession – use
budgetary deficits with raising extra purchasing power
This policy is favored due:
The government can easily adjust its finances according to the needs;
This policy works smoothly in all times like depression, inflation,
boom and recession;
It ensures stability but gives no guarantee that the system will get
stabilized at the level of full employment
Fully Managed
Compensatory Budget
Policy that implies deliberate adjustment in taxes, expenditures,
revenues and public borrowings with the motto of achieving full
employment without inflation.
B. TAXATION
How taxes work? Greatly effect the changes in disposable income,
consumption and investment.
Anti-dep tax policy increases disposable Y, promotes C and I – more
fund available. E.g reduce in import duty, sales.
Ultimately result in increase in spending activities, increase Dd and
reduce the deflationary gap.
The same effect can be expected on personal and corporate taxes in
raising private I.
Only, the extent of Ue can be reduced is small and consumers and
investors are likely to postpone their spending in anticipation of
further fall in taxes.
Anti- inflationary tax policy
Gov should not retain the same tax structure but help to wipe off
the excessive purchasing power and consumer. Raise expenditure tax
and excise duty, in extent not to retard new investment. Windfall gains
tax is good in this case.
C. PUBLIC EXPENDITURE
Effective government tool with appropriate variation can have more
direct effect upon level of economic activity than even taxes.
G have multiple effect upon income, output and employment (like
investment does).
G during Inflation. There are excessive aggregate spending,
including I + C. Therefore, G should be reduced via some
government activities, postpone or abandon. E.g. reduction in
unproductive channels but it is politically.
G during Depression. G is helpful to lift the economy out of morass
of stagnation. Demand is deficient as a result of sluggish private C +
I.
How much G is needed? Equivalent to deflationary gap. The
multiplier and acceleration effect will neutralise the depressing effect
of lower C + I and stimulate the path of recovery.
D. PUBLIC WORKS
According to Keynes General Theory, public works prog is the most
significant anti-depression device.
First device, Public works on infrastructure building create
employment. Also called as capital expenditure.
Second device, Transfer payment such as interest on public debt,
subsidy, pension, relief payment, SSN pay, Ue schemes etc.
Public works are supported as anti-
depression device on the following grounds:
They absorb unemployed workers
They increase purchasing power, improve Dd for C
They help to create economically and socially useful capital assets
roads, buildings, training centers etc.
They provide strong incentive for industries growth which are
generally hit by depression
They do not have an off setting effect upon private investment
because these are started at a time when private investment is not
forthcoming (e.g. after war).
They help to maintain the moral and self respect of the work force
and make use of the skill of Ue people.
HOWEVER, THERE ARE
LIMITATIONS AND
PRACTICAL DIFFICULTIES:
Difficult forecasting. Prediction of accurate forecasting is very
difficult. The effectiveness of public works rests upon this.
Timing of public works. Due to lack of accurate forecasting, proper
timing is neither feasible nor possible which can undermines the
significance of stabilisation effect of public works instrument.
Delay in starting. A long term prog requires proper planning with
regard to finance and engineering. We do not want clumsy, shoddy
an slow moving public works which actually are that took place.
Scarcity of resources, Limited scope of employment, Misallocation
of resources, Burden of public debt, Political considerations, Control
over public works, Effect on private enterprises, and Cost of price
maladjustments.
E. PUBLIC DEBT
Government borrows for many reasons.
Public debt is a sound fiscal weapon to fight against inflation and deflation.
It can be device to generate wealth
Borrowing from Non-Bank/Public is through sale of bonds, money flow
either out of C, S or I or hoarding. As a result there is debt operation on
national income. Attractive bonds will curtail C, then borrowings are likely
to be non inflationary.
Bonds purchase from savings are non-inflationary. Has the govt not been
borrowing, it can be channelled to private investment –just a diversion of
funds but similar quantitative effects on national income.
But, if the bonds are purchased buy non bank by drawing upon hoarded
money (money collected and kept in hide), there will be net addition to the
circular flow of spending.
Borrowing from banking
system
During depression, such borrowings are highly effective because banks have
excessive cash reserves and private businesses are not willing to borrow
they consider it unprofitable.
When unused cash is lent out to gov, it causes a net addition to circular flow,
raise national Y and emp.
Contrary, this source dry up almost completely in times of boom. Dd is high
during inflation period since profit expectation is high in business. Banks
have less cash reserve and difficult to lend to gov.
Therefore, banks reduce private lending. This lead to fall in I, G increases.
As the G is off-set by a reduction in I, there will be no net effect upon
national income and employment.
In nut shell, borrowings from banking have desireable effect only in
depression and is undesirable or with neutral effect during inflation period.
Printing money
Printing money is another method of public expenditure for
mobilising additional resources by gov. new money brings new
circular flow, therefore this form of public borrowing is highly
inflationary. Effective during depression.
Likely to be inflationary in nature. But, generally, there are small
balances over and above what is required for normal day to day
requirements. Thus, this produce minimum significant result.
However, with the use of digital money, disruption to economy will
be anticipated.
References:
1. David Hyman (2010) Public Finance. A contemporary application
of theory to practice. 10th edi. Cengage Learning, USA.
2. Clifford Winston (2006). Government failure vs Market failure.
Microeconomics Policy Research and Government Performance.
AEI-Brookings, Washington, D.C.