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Introduction
Fiscal policy through variations in government expenditure and taxation profoundly affects national income, employment, output and prices. An increase in public expenditure during depression adds to the aggregate demand for goods and services and leads to. a large increase in income via the multiplier process; while a reduction in taxes has the effect of raising disposable income thereby increasing consumption and investment expenditures of the people. On the other hand, a reduction of public expenditured during inflation reduces raggregate demand, national income, employment, output and prices; while an increase in taxes tends to reduce disposable income and thereby reduces consumption and investment expenditures. Thus, the government can control deflationary and inflationary pressures in the economy by a judicious combination of expenditure and taxation programmes.
Objectives of lesson
Instruments of Fiscal Policy
1. Budgetary Policy
Budgetary Policy is also called Contracyclical Fiscal Policy. The budget is the principal instrument of fiscal policy. Budgetary policy exercises control over size and relationship of government receipts and expenditures. Lets see how this policy works in budget deficit and surplus budget.
(1) Budget Deficit—Fiscal Policy during Depression. Deficit budgeting is an important method of overcoming depression. When government expenditures exceed receipts,larger amounts are put into the stream of national income than they are withdrawn. The deficit represents the net expenditure of the government which increases national income by the multiplier times the increase in net expenditure. If the MPC is 1/2, the multiplier will be 2; and if' the net increase in government expenditure is Rs 100 crores it will increase national income to Rs 200 crores (= 100 x 2). Thus, the budget deficit has an expansionary effect on aggregate demand whether the fiscal process leaves marginal propensities unchanged or whether a redistribution of disposable receipts occurs .The expansionary effect of a budget deficit is shown diagrammatically in Figure
7.1.
Budget deficit may also be secured by reduction in taxes and without government spending. Reduction in taxes tends to leave larger disposable income in the hands of the people and, thus, stimulates increased consumption expenditure.This, in turn, would lead to increase in aggregate demand output, income and employment. This is illustrated in Figure 7.2, where C is the original consumption function. Suppose tax is reduced by ET, it will shift-the consumption upward to C.
Income will increase from OY to OY1.
(2) Surplus Budget—Fiscal policy during Boom: Surplus in the budget occurs when the government revenues exceed expenditures. The policy of surplus budget is followed to control inflationary pressures within the economy. It may be through increase in taxation or reduction in government expenditure or both. This will tend to reduce income and aggregate demand by the multiplier times the reduction in government or/and private consumption expenditure (as a result of increased taxes). This is explained with the aid of Figure 1, where the economy is at the initial equilibrium position E1. Suppose the
government expenditure is reduced by ∆G so that the total spending function C+I+G' shifts downward to C+I+G. Now E is the new equilibrium position which shows that the income has declined to OY from OY1 as a result of reduction in government expenditure by E1B. The fall in income Y1Y (=AE) > E1B the reduction in expenditure because consumption has also been reduced by BA.
There may be budget surplus without government spending when taxes are raised. Enhanced taxes reduce the disposable income with the people and encourage reduction in consumption expenditure. The result is fall in aggregate demand, output,income and employment. This is illustrated in Figure 7.3. C is the consumption function before the imposition of the tax. Suppose a tax equal to ET is introduced. The consumption function shifts downward to C1. The new equilibrium position is E1. As a result, income falls from 0Y to 0Y1.
Compensatory Fiscal Policy
The compensatory fiscal policy aims at continuously compensating the economy against chronic tendencies towards inflation and deflation by manipulating public expenditures and taxes. It, therefore, necessitates the adoption of fiscal
measures over the long-run rather than once-for-all measures at a point of time. When there are deflationary tendencies in the economy, the government should increase its expenditures through deficit budgeting and reduction in taxes. This is essential to compensate for the lack in private investment and to raise effective demand, employment output and income within the economy. On the other hand, when there are inflationary tendencies, the government should reduce its expenditures by having a surplus budget and raising taxes in order to stabilise the economy at the full employment level. The compensatory fiscal policy has two approaches:
(1) Built-in stabilisers
(2) Discretionary fiscal policy
(1) Built-in Stabilisers:
The technique of built-in-flexibility or stabilisers involves the automatic adjustment of the expenditures and taxes in relation to cyclical upswings and downswings within the economy without deliberate action on the part of the government. Under this system, changes hubs budget are automatic and hence this technique is also known as one of automatic stabilisation. The various automatic stabilisers are corporate profits tax, income tax, excise taxes, old age, survivors and unemployment insurance and unemployment relief payments. As instruments of automatic stabilisation, taxes and expenditures are related to. national income. Given an unchanged structure of tax rates, tax yields vary directly with movements in national income, while government expenditures vary inversely with variations in national income. In the downward phase of the business cycle when national income is declining, taxes which are based on a percentage of national income automatically decline,thereby reducing the tax yield. At the same time, government expenditures on unemployment relief and social security benefits automatically increase. Thus, there would be automatic budget deficit which would counteract deflationary tendencies.
On the other hand, in the upward phase of the business cycle when national income is
rising rapidly, the tax yield would automatically increase with the rise in tax rates. Simultaneously, government expenditures on unemployment relief and social security benefits automatically decline. These two forces would automatically create a budget Surplus and are, thus, inflationary. Built-in stabilisers have certain advantages as a fiscal device.
(i) built-in stabilisers serve as a cushion for private purchasing power when it falls and lessen the hardships on the people during deflationary period.
(ii) they prevent national income and consumption spending from falling at a low level.
(iii) there are automatic budgetary changes in this device and the delay in taking administrative decisions is avoided
(iv) automatic stabilisers minimise the errors of wrong forecasting and timing of fiscal measures.
(v) they integrate short-run and long-run fiscal policy.
Limitations
The effectiveness of built-in stabilisers as an automatic compensatory device depends on the elasticity of tax receipt, the level of taxes and flexibility of public expenditures. The greater the elasticity of tax receipts the greater will be the effectiveness of automatic stabilisers in controlling inflationary and deflationary tendencies. But the elasticity of tax receipts is not so high as to act as an automatic stabilizer.
Second, with low level of taxes even a high elasticity of tax receipts would not be very significant as an automatic stabiliser during a downswing.
Third, the built-in stabilisers do not consider the secondary effects of stabilisers on after-tax business incomes and of consumption spending on business-expectations.
Fourth, this device keeps silent about the stabilising influence of local bodies, state governments and of the private sector economy.
Fifth, they cannot eliminate the business cycle. At the most, they can reduce its severity.
Sixth, their effects during recovery from recession are unfavourable.
(2) Discretionary Fiscal Policy :
Discretionary fiscal policy requires deliberate changes in the budget by such actions as changing tax rates or government expenditures or both. It may generally take three forms:
(i) changing taxes with government expenditure constant,
(ii) changing government expenditure with taxes constant, and
(iii) variations in both expenditures and taxes simultaneously.
First, when taxes are reduced, while keeping government expenditure unchanged, they increase the disposable income of households and businesses. This increases private spending. But the amount of increase will depend on whose taxes are cut, to what extent, and on whether the taxpayers regard the cut temporary or permanent. If the beneficiaries of tax cut are in the higher middle income group, the aggregate demand will increase much. If they belong to the lower income group, aggregate demand will not increase much. If they are businessmen with little incentive to invest, tax reductions will not induce them to invest. Lastly, if the taxpayers regard tax reductions as temporary, this policy will again be less effective. So this policy is more effective in controlling inflation by raising taxes because high rates of taxation will reduce disposable income of individuals and businesses thereby curtailing aggregate demand.
The second method is more useful in controlling deflationary tendencies. When the government increases its expenditure on goods and services, keeping taxes constant, aggregate demand goes up by the full amount of the increase in government spending.
On the other hand, reducing government expenditure during inflation is not so effective
because of high business expectations in the economy which are not likely to reduce
aggregate demand.
The third method is more effective and superior to the other two methods in controlling inflationary and deflationary tendencies. To control inflation, taxes may be increased and government expenditure reduced. On the other hand, taxes may be increased and government expenditure be raised to fight depression.
Limitations
The discretionary fiscal policy depends upon proper timing and accurate forecasting. First, accurate forecasting is essential to judge the stage of cycle through which the economy is passing. It is only then that appropriate fiscal action can be taken. Wrong forecasting may accentuate rather than moderate the cyclical swings. Economics is not an exact science in correct forecasting. As a result, fiscal action
always follows after the turning points in the business cycles. Second, there are delays in propert timing of public spending. In fact, discretionary fiscal policy is subject to two time lags .First, there is the "decision lag," the time required in studying the problem and taking the decision. The lag involved in this process may be too long. Second, once the decision is taken, there is an "execution lag." It involves expenditure which is to be allocated for the execution of the programme. In a country like USA it may take two years and less than a year in the UK. Third, certain public works projects are so cumbersome that it is not possible to accelerate or slow them down for the purpose of raising or reducing public spending on them.
Crowding Out and Fiscal Policy
The term crowding out refers to the reduction in private expenditure caused by an increase in government expenditure through deficit budget via a tax cut or increased money supply or bond issue. An increase in government expenditure raises
aggregate demand, national income and interest rates thereby reducing private investment. This is called the crowding effect of fiscal policy.
The Keynesians and monetarists differ on the effects of budget deficit on the crowding out effect. The main difference between the two arises from the fact that the Keynesians emphasise on "first-round" (short-run) effect which show "once-for-all shift" of the IS curve, whereas the monetarists emphasise the "ultimate (long-run) effects.
The Keynesian crowding out theory states that when the government resorts to deficit financing by issuing new bonds, its spending increases. National income rises. If the money supply is held constant people will need more money for business which will raise the rate of interest. A higher rate of interest will crowd out (reduce) private investment spending. These are the first-round effects which are explained in Figure
7.4 where E1 is the initial equilibrium position.
The rise in government expenditure financed by issuing bonds shifts the IS1curve rightward to IS2 on a "once-for-all" basis and it cuts the LM curve at point E2. Since the money supply is constant, E2 is the new equilibrium level of the economy. The multiplier process raises the income level from Y1 to Y2 and the interest rate from R1 to R2. Higher interest rate crowds out a certain amount of private investment. The Keynesians hold that a deficit financed by printing notes (money creation) is more expansionary than bond-financed. But they do not believe that the reduction in private expenditure caused by a higher interest will completely offset the increased government expenditure.
In other words, the crowding out of private investment will not be full. Thereason for this is that a high interest rate has dual effects. First, it reduces private spending. Second, a high interest rate leads people to economise on cash balances. They, therefore, divert idle cash holdings for transactions purposes. That is why crowding out of private investment is only partial. On the other emphasizes hand, Friedman the ultimate effects of a budget deficit( whether bond-financed or money financed) by taking account of the wealth effect. When the government increases its expenditure by selling bonds in the market, their buyers feel themselves wealthier than before. The reason is that they expect to have more resources available for consumption and other purposes in the future. As a result, they tend to increase the demand for money which shifts the LM curve leftward. This analysis assumes that bonds issued by the government are considered on wealth. Further, both the demand for money and expenditure on consumption are positively related to wealth.
Suppose the government increases its expenditure with bond-financed budget deficit. As a result the public expenditure on buying bonds also increases.
The rise in public expenditure shifts the IS1 curve rightward to IS2. In Figure 7.5 first-round effect raises the level of national income from Y1 to Y2 given the LM schedule. The increase in national income, in turn, raises the demand for money and the purchase of government bonds by the public further raise the demand for money due to the wealth effect. As the LM1 curve shifts leftward to LM2 and the IS2 curve shifts rightward to IS3, so that the ultimate equilibrium is established at the initial level of income Y1.
According to Friedman, the rise in interest rate to R reduces private investment so that bond-financed government expenditure crowds out private investment. But the total expenditure remains unchanged and fiscal policy has no expansionary effect on national income.
If the budget deficit is money-financed, it will have an expansionary effect. This is because the increase-in-money supply is greater than the wealth effect on the demand for money. In this case, the LM1 curve shifts rightward to LM2 as shown in Figure 7.6. The increase in government expenditure shifts the IS1 curve rightward to IS2. The first-round effect raises the level of income from Y1 to Y2 .
According to Friedman, in a money financed deficit, the money stock continues to grow and the LM curve continues to shift to the right causing falling interest rates. In this case, the LM schedule exerts a dominance influence on subsequent changes in income than the IS
schedule. The ultimate (long-run) equilibrium is shown with the shifting of the IS2 curve rightward to IS4 and also of the LM2, curve rightward to LM4 so that Y4 equilibrium income level is established. The rate of interest has fallen from Y2 E2 to Y4 E4. Thus, money-financed deficit is expansionary and it does not crowd out private investment.
Blinder and Solow have criticised Friedman's crowding out model of debt-financed deficit for ignoring interest payments on outstanding debt. They point out that the government has not only to finance the budget deficit, but also interest payments on outstanding debt. They have shown that if private expenditure and demand for money are subject to wealth effects, then the IS and LM curves will be shifting from period to period and the short
-run equilibrium will differ from the long-run equilibrium depending upon whether the budget is bond-financed or money-financed.
The short-run and long-run equilibrium situations in the case of bond-financed budget deficit are shown in Figure 7.7(A). The rise in government expenditure as a result of bond-financed deficit shifts the IS1 curve rightward to IS2. This shift is due to both the increase in government expenditure and rise in private expenditure following the wealth effect of bonds. LM1 curve shifts leftward to LM2 as a result of wealth effect which increases the demand for money. This raises the short-run equilibrium level of income from Y1 to Y2.
In the long-run, bond-financing is more expansionary than money-financing. This is because when "deficits are bond-financed, income must rise sufficiently to produce tax receipts (at given tax rates) that not only match the increased government expenditure on goods and services, but also cover the interest payments on the
increased government debt. If deficits are, on the other hand, financed by the creation of money, long-run equilibrium is established when income has merely risen sufficiently to produce tax revenues that each match the increased expenditure on goods and services." Figure 7.7(A) shows the bond-financed situation. When in the long-run the IS2 curve shifts to IS6 and the LM2, curve to LM6, the new equilibrium level of income is set at Y6. The money-financed situation is shown in Panel (B) where in the long-run the IS’2 curve shifts to IS’6 and LM'2 curve to LM’6 and the new equilibrium is established at Y’6 income level. As is clear from the two figures, Y6 income level is greater than Y’6 level.
The above analysis shows that the long-run effect of increased bond-financed government deficit is more expansionary' but it crowds out private investment because the rate of interest rises sufficiently high. But the money-financed deficit though less expansionary than the former, it does not crowd out private investment through wealth effects.
Conclusion
Budget deficit may also be secured by reduction in taxes and without government spending.Reduction in taxes tends to leave larger disposable income in the hands of the people and, thus, stimulates increased consumption expenditure. If the budget deficit is money-financed, it will have an expansionary effect. Despite the higher multiplier effect of government spending as against changes in tax rates, the latter can be operated more promptly than the former. Emphasis has, thus, shifted to taxation as the best fiscal device for controlling cyclical fluctuations. Thus, when the turning point of a business cycle is already underway, discretionary fiscal action tends to strengthen the built-in-stabilizers. The term crowding out refers to the reduction in private expenditure caused by an increase in government expenditure through deficit budget via a tax cut or increased money supply or bond issue. An increase in government expenditure raises aggregate demand, national income and interest rates thereby reducing private investment. This is called the crowding effect of fiscal policy.
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