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Fiscal Policy: Components, Types, Tools and Impact

April 3, 2024 1372 0

Introduction

Fiscal policy is the use of government spending and tax policies to influence economic conditions, especially macroeconomic conditions. Its primary goals are to:

  • Promote Economic Growth: By strategically allocating resources through spending and adjusting tax rates. 
  • Maintain Stability: Fiscal policy aims to keep inflation and unemployment under control.
  • Redistribute Income: Government spending on social programs and transfer payments can help address income inequality and improve the standard of living for disadvantaged groups.

Components of Fiscal Policy

  • Taxation Policy: This involves setting the rates and types of taxes that the government collects from individuals and businesses. 
  • Expenditure Policy: This involves deciding how much and in what areas the government spends its revenue.
  • Investment and Disinvestment Policy: This involves managing the government’s assets and liabilities, such as public sector enterprises, financial institutions, and sovereign wealth funds. 
  • Debt or Surplus Management: This involves borrowing or saving money to finance the gap between the government’s revenue and expenditure. 

Types of Fiscal Policy

  • Expansionary Fiscal Policy and Contractionary Fiscal Policy are the two distinct approaches to managing the economy through government spending and taxation.
  • Expansionary Fiscal Policy:
    • Purpose: Stimulating Economic Growth.
    • Tools:
      • Increase in Government Spending: The government allocates more funds to public projects, infrastructure, and social programs.
      • Tax Cuts: Reductions in taxes, especially for businesses and individuals, to increase disposable income and stimulate consumer spending.
    • Impact:
      • Boost Aggregate Demand: Direct injection of money into the economy, leading to higher consumer spending and business investment.
      • Job Creation: More job opportunities, helping to reduce unemployment.
      • Preventing or Ending Recessions: Used to counter the negative effects of economic contractions.
    • Examples: During the 2008 financial crisis, 

Contractionary Fiscal Policy:

  • Purpose: Controlling Inflation.
  • Tools: The government reduces its expenditure on public projects and programs.
    • Tax Increases: Raising taxes, especially on consumption or high-income individuals, to reduce disposable income and slow down spending.
  • Impact:
    • Reduce Aggregate Demand: Decrease in the overall demand for goods and services.
    • Control Inflation: Prevent the economy from overheating and experiencing unsustainable levels of inflation.
  • Stabilize the Economy: Maintain a balanced and stable economic environment.
  • Examples: This was seen, for instance, in the late 1970s and early 1980s when several countries, including the United States, used contractionary policies to combat high inflation.
S No. Type of Fiscal Policy Purpose Tools Impact
1 Automatic Stabilizers Automatically stabilize the economy without explicit government action Progressive Income Taxes. Unemployment Benefits Provides automatic support during economic downturns, contributing to economic stability
2 Discretionary Fiscal Policy Deliberate decisions to change government spending or taxation New Laws or Budget Changes Allow for conscious policy adjustments in response to economic conditions
3 Non-Discretionary Fiscal Policy Automatic changes in government spending or taxation Changes in tax revenues and government spending based on the economic cycle Involves automatic adjustments without the need for explicit government decisions
4 Progressive Taxation Addresses income inequality by taxing higher incomes more heavily Higher Average Tax Rate for Higher Incomes Helps reduce income inequality by placing a higher burden on those with higher incomes
5 Regressive Taxation May contribute to income inequality by taxing lower incomes more heavily Higher Average Tax Rate for Lower Incomes Can exacerbate income inequality as lower-income individuals bear a higher relative tax burden
6 Proportional Taxation Provides a uniform tax burden across different income levels Constant Average Tax Rate Ensures that the tax burden is proportionate to income, maintaining a consistent rate for all individuals
7 Structural Fiscal Policy Long-term policies addressing underlying economic issues Tax Reforms.

Changes in Public Spending

Aims to promote economic growth and stability over the long term
8 Temporary Fiscal Policy Short-term measures in response to immediate economic challenges Stimulus Packages.

Emergency Spending

Offers quick relief and support during economic crises, preventing prolonged downturns

Pro-cyclical and Counter-cyclical Fiscal Policy

Pro Cyclical Policy

Counter-cyclical Fiscal Policy

  • Definition: It  is one in which the government’s fiscal actions reinforce and exacerbate the existing economic conditions. In other words, during economic expansions, pro-cyclical policies tend to be expansionary, and during economic contractions, they tend to be contractionary.
  • Characteristics:
    • Expansionary During Booms: Pro-cyclical fiscal policies involve increasing government spending and reducing taxes during economic booms, which can contribute to overheating and inflationary pressures.
    • Contractionary during Recessions: Conversely, during economic downturns, pro-cyclical policies involve cutting government spending and raising taxes, which can deepen and prolong recessions.
  • Example:
    • If a government increases spending on public projects and cuts taxes when the economy is already booming, it may contribute to inflationary pressures and asset bubbles.
  • Definition: It is one in which the government’s fiscal actions work against the natural fluctuations of the business cycle. It involves using fiscal measures to stabilize the economy, mitigating the impact of economic booms and busts, for instance, an expansionary policy during a slowdown.
  • Characteristics:
    • Expansionary During Recessions: Counter-cyclical fiscal policies involve increasing government spending and reducing taxes during economic downturns to stimulate demand and job creation.
    • Contractionary During Booms: Conversely, during economic expansions, counter-cyclical policies involve cutting government spending and raising taxes to prevent overheating and control inflation.
  • Example:
    • If a government implements a stimulus package during a recession by increasing spending on infrastructure projects and cutting taxes to boost consumer spending, it’s employing a counter-cyclical fiscal policy.

 

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Conclusion

  • Fiscal policy is a powerful tool wielded by governments to manage economic conditions and achieve macroeconomic goals such as stable growth, low inflation, and full employment
  • The choice between expansionary and contractionary policies depends on the prevailing economic circumstances and policy objectives.
Related Articles 
Indian Economy: Evolution Basics of Money
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Indian Insurance Sector Financial Inclusion

 

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 Final Result – CIVIL SERVICES EXAMINATION, 2023.   Udaan-Prelims Wallah ( Static ) booklets 2024 released both in english and hindi : Download from Here!     Download UPSC Mains 2023 Question Papers PDF  Free Initiative links -1) Download Prahaar 3.0 for Mains Current Affairs PDF both in English and Hindi 2) Daily Main Answer Writing  , 3) Daily Current Affairs , Editorial Analysis and quiz ,  4) PDF Downloads  UPSC Prelims 2023 Trend Analysis cut-off and answer key

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 Final Result – CIVIL SERVICES EXAMINATION, 2023.   Udaan-Prelims Wallah ( Static ) booklets 2024 released both in english and hindi : Download from Here!     Download UPSC Mains 2023 Question Papers PDF  Free Initiative links -1) Download Prahaar 3.0 for Mains Current Affairs PDF both in English and Hindi 2) Daily Main Answer Writing  , 3) Daily Current Affairs , Editorial Analysis and quiz ,  4) PDF Downloads  UPSC Prelims 2023 Trend Analysis cut-off and answer key

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UDAAN PRELIMS WALLAH
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Quick Revise Now !
UDAAN PRELIMS WALLAH
Comprehensive coverage with a concise format
Integration of PYQ within the booklet
Designed as per recent trends of Prelims questions
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