7 Crucial Considerations of Fiscal Policy

Read this article to learn about the seven crucial considerations of fiscal policy during inflation and deflation.

(a) The Contra-Cyclical Budgetary Policy:

Recognition of the need of contra-cyclical budget means that we readily accept the necessity for the government cash-deficit in the periods of depression, and the acceptance of the fact that these deficits would be offset by revenue surpluses of the periods of inflation.

Such a budgetary policy implies the manipulation and managing of the budget with a view to ironing out cyclical fluctuations. It has become quite an important fiscal tool in recent years to fight the unusual situations of inflation and deflation.

The policy of managed budget may imply changing expenditures with constant tax rates or changing tax rates with constant expenditures or a combination of both. All these methods of budget management may be used to overcome depression or inflationary situations. This method became popular with the appearance of Keynes ‘General Theory’.

According to managed budget policy deliberate attempts are made to adjust revenues, expenditures and public debt to eliminate unemployment during depression. Under it, government should incur heavy expenditures on public works to remedy un-employment. In recent years, many advocates of managed budget policy have stressed tax adjustments.

There are others who favour unbalanced budgets to fight inflation or depression. An unbalanced budget during depression implies deficit spending by increasing government outlays. To make it more effective the government may finance its deficits by borrowing from the banks. During periods of inflation, unbalancing the budget implies a budget surplus by curtailing government outlays.

The government may utilize the budget surplus to retire the outstanding government debt. Thus, a surplus budget has deflationary effect on national income while a deficit budget tends to be expansionary. During depression when we need an increase in the flow of income stream deficit budgets are favoured. Conversely, in inflation when we need to check the overflow of income, surplus budgets are favoured.

Some argue that a balanced budget may be more important for the economy than unbalanced budget surplus or deficit. Such a view is based on the merits of balanced budget and on the assumptions that fiscal policy is unable to stabilize the economy. In favour of balanced budgets it is said that they compel the government to lay down strict priorities of expenditures on different projects and guards against the inflationary dangers.

Dernburg and McDougall express the opinion that a policy of sound finance based on balanced budget may not be really in order. They feel that the rising tax revenues that result from inflation may lead to additional government spending just at a time when the private sector of the economy is rather hard pressed to find sufficient resources—and it is really quite difficult to believe that business confidence is in the slightest degree increased by the so-called balanced budget or a policy of sound finance. A more sensible approach is not to balance the budget in each fiscal year but over the entire cycle—such cyclically balanced budgets to have a stabilizing effects on the economic system.

However, with the appearance of Keynes’ General Theory, an alternate budgetary policy called the fully managed budget policy has become popular. It assigns a secondary role to the budgetary balance. The stress is on maintenance of full employment and stable prices both during inflation and deflation. If there is depression in the economy resource is taken to budgetary deficits and in case there is inflation, surpluses are created.

However, there are many limitations of managed budget policy and the dangers of rising public debt which will result from the managed budget policy. Despite the merits of balanced budgets, managed budgets have been favoured as important tools of fiscal policy to influence the level of income, output and employment.

They also include compensatory budgets under which certain automatic stabilizers are built into the revenue and expenditure systems of the government. During recent years the idea of functional finance has come to be firmly rooted in government circles. There are now no more contenders of a balanced budget at all. However, following a contra-cyclical budgetary policy is not an easy task.

Predicting a recession or an inflationary boom is a difficult job, adjusting the budget to the fast changing economic conditions is still more difficult especially when budget is a political decision to be taken after a good deal of delay and discussion. Therefore, emphasis has also to be laid on individual items of the budget in order to make it more effective as a contra-cyclical weapon.

(b) Taxation:

The structure of tax rates has to be varied in the context of conditions prevailing in an economy. Taxes determine the size of disposable income in the hands of general public and, therefore, the quantum of inflationary gaps, given the supply of goods and services. During depression tax policy has to be such as to encourage private consumption and investment; while during inflation, tax policy must curtail consumption and investment.

During depression, a general reduction in corporate and income taxation has been favoured by many economists like Prof. A.H. Hansen, M. Kalecki, and R.A. Musgrave on the ground that low taxes will leave higher disposable incomes with people for higher consumption, low corporation taxation will encourage ‘rich enterprise’ and ‘venture capital’, thereby promoting more investment. But there are others who express grave doubts about the supposed stimulating effect of modified taxation or investment.

It has been argued that even a heavy reduction in taxes does not alter an entrepreneur’s decisions. Mr. Kalecki expressed the view that the policy of reducing taxes and increasing consumption or stimulating private investment is no solution for the unemployment problem because in that case income-tax will have to be continuously lowered. However, it cannot be denied that in the short period it is wise to encourage private investment by manipulating business tax rates and to encourage consumption by lowering sales tax and excise duties.

During inflation, on the other hand, not only should the existing tax structure be retained, but also new taxes are levied to wipe off the surplus purchasing power. Caution, however, should be taken not to raise the taxes as high as to stifle new investment or to generate a business recession. Expenditure tax and excise duties are anti-inflationary in character. During inflation fiscal authority should aim at levying such taxes as reduce current incomes and particular demands for commodities rather than aggregate demand.

Redistributive taxation is perhaps the best measure for raising and stabilizing the consumption function. The term redistributive taxation implies the construction of a very progressive tax structure, that is taxing the low spending in high-income groups at high rates, while taxing the high spending middle and low income groups at low rates with a view to raising consumer spending. Thus, experience has shown that manipulation of tax rates is a more powerful and effective anti- cyclical weapon than interest rates.

(c) Public Debt:

A sound programme of public borrowing and repayment, popularly called public debt is a potent fiscal weapon to fight inflation and deflation and to bring about economic stability and full employment. The government borrowing may assume the form of borrowing from non-bank public, borrowing from banking system, drawing from treasury and printing of money. Borrowing from the non-bank public through the sale of bonds and securities curtail consumption and private investment and may be non-inflationary in effects.

Borrowing from the banking system are effective during depression, when banks have got excess cash reserves and the private business or investing community is in no mood to borrow from banks. Thus, the unused cash lying with banks can be lent to the government, which in turn, will cause a net addition to the circular flow and raise national income. Withdrawing of balances from treasury are inflationary in nature but these balances are likely to be small to be of any importance in the economic system.

However, the printing of new money is net addition without any liability and is highly inflationary. During war, borrowing becomes necessary and inflationary pressures become strong. In a period of inflation, therefore, public debt has to be managed in such a way as to reduce the money supply in the economy and to curtail credit expansion. New borrowing shall have to be altogether avoided. Rather the government will do well to retire debt through a budget surplus.

During depression, on the other hand, taxes are reduced and public expenditures are increased through budget deficits, which are financed by borrowings from the public, commercial banks or the central bank of the country. The borrowing of idle funds will have no adverse effects on consumption or on investment. During depression, it is very difficult to retire debts.

Actually, it pays to accumulate debt during depression and redeem it during a period of expansion. Along with this the monetary authority (the central bank) must aim at low bank rate to keep the burden of debt low. Thus, public debt becomes an important tool of anti-cyclical phenomena.

(d) Public Spending:

The most important type of fiscal policy is the policy of public expenditure to stimulate production, income and employment. Now-a-days government expenditure forms a highly significant part of the total expenditure in the economy and a reduction or expansion in it causes significant variations in the total income; it is instrumental in adjusting consumption and investment to full employment level. As such, modern government resort to what is called contra-cyclical budgeting, that is adjusting expenditure to lessen the severity of booms and depressions.

The principal cause of inflation in country is the excessive aggregate spending. During inflation, therefore, the best policy is to reduce government expenditure to control inflation by giving up those schemes which are justified during deflation and by postponing the construction of various types like school buildings, hospitals, parks, etc.

While expenditures are reduced, attempts are made to increase revenues to generate a budget surplus. It is true that there is a minimum beyond which it may not be possible to reduce government spending (say on account of political, warlike and military considerations), yet the government can vary its expenditure to some extent to overcome inflationary pressures.

It is during depression that public spending assumes greater importance. It serves to lift the economy out of the morass of stagnation. Often a distinction is made between the two concepts of public spending during depression the pump priming and the ‘compensatory spending’.

Pump priming expenditure implies that a certain volume of public spending will help to start and revive the economic activity, which after some time will reach satisfactory levels of employment and output. What this volume of spending may be is not known; the idea is that, when private spending becomes deficient on account of business recession, then a small dose of public spending may prove stimulating.

Compensatory spending, on the other hand, means that public spending is undertaken with a clear view to compensating for the decline in private investment. The idea is that, when private investment declines, public expenditure expands and as long as private investment is below normal, public compensatory spending would go on. These expenditures will have multiplier and acceleration effects, which in turn, will raise the levels of income, output and employment. The compensatory public expenditure or spending may assume different forms like relief expenditure, subsidies, social insurance payments, public works, etc.

The essential conditions of the compensatory public spending are: that it must have the maximum possible leverage effects; it must not be mutually offsetting; it must create economically and socially desirable assets. But pump priming expenditures are of limited validity in advanced economies where the deficiency of investment is not merely cyclical but secular, falling to fill the gap between full employment income and expenditures in the long-run.

(e) Public Works:

Stabilizing expenditures of the pump priming and compensatory nature are incurred in two major areas:

(i) Expenditures on public works such as roads, schools, parks, buildings, airports, post-offices, hospitals, canals and other similar projects. Prof. Clark defines public works, “as durable goods, primarily fixed structures, produced by the government.”

(ii) Transfer payments, such as interest on the public debt, pensions subsidies, relief payments, unemployment insurance, social security benefits, etc. The expenditure on capital assets (public works) is called capital expenditure and the latter (transfer payments) is called current expenditure. It has been recommended that the governments should keep ready with them a list of public works, which may be taken up the moment the economy shows signs of decay or recession.

Such a programme of public investment will tone up the general morale of businessmen who will also start investing. The primary employment in public works programmes will, in turn, induce secondary and tertiary employment, thereby raising the level of business activity. As soon as the economy is put on the track, such programmes may be slackened and may be given up completely during inflation, so that at such a time, public investment may not compete with private investment.

Public works programmes during depression are supported on the grounds that they give employment to unemployed factors, remove wastage, do not come in competition with private investment, increase purchasing power, thereby stimulating demand for consumption goods, lead to the construction of useful projects at low cost, etc. But these programmes suffer from a few limitations and practical difficulties.

It is unrealistic to expect that public works will fill all the gaps of unemployment in the private sector of the economy. To be genuinely effective in promoting investment during depression, public works require proper timing, proper financing and general approval of business and investing communities. Public works programmes cannot be varied easily along with the movement of the cycle, because many projects like dams, etc., take a long time for completion and many others like schools and hospitals cannot be postponed, for if they are needed they have to be built, irrespective of inflation or deflation periods.

Again, certain heavy projects requiring a long time for completion and started during depression cannot be given up without serious loss to the government. Then, there are problems of forecasting of being able to know when a period of inflation or deflation may set in and to determine precisely the exact nature of programmes to be undertaken. Besides, there are delays in getting them started. Again, they lead to heavy debt burden and sometimes to misallocation of resources, for projects may be located in one region, while the unemployed resources are located in another region and their mobility may be difficult to achieve.

It is because of these limitations of public works that some economists favour a comprehensive programme of social security measures like pensions, subsidies, unemployment insurance, etc. These will not only raise consumption during depression but also stabilize it in the long run and if such a programme of social security is financed through progressive taxation, the purpose would be better served.

The correct position would be to coordinate the programmes of social security measures and public works. Public works programmes, despite their limitations, cannot be dispensed with, for they lead directly to the employment of more labour in public works and indirectly to monetary expansion, stimulating the economic activity.

(f) Built-in-Flexibility:

Another important consideration of fiscal policy is described by some as built-in-flexibility. One of the practical difficulties of government expenditure and taxation to compensate for deficiencies of excesses in private spending is making the fiscal tools flexible enough for prompt and effective use. For example, the tempo of business activity may change suddenly manifesting itself in booms and slumps but fiscal tools cannot be geared all at once to cope with such situations. To overcome such practical difficulties, built-in-flexibility, formula flexibility and executive discretions have been provided and resorted to.

A fiscal system with built-in-flexibility is one wherein a change in employment and output in the economy brings about, because of the very character of expenditures and taxes already in operations, a marked compensating change in the government’s fiscal position.

Unemployment, old-age insurance schemes, etc., are notable in this regard because they have built-in-flexibility on both the spending and taking sides. Price support programmes, some kinds of excise duties, specially those levied on luxuries, also have the quality of built-in-flexibility may prove inadequate to cope with strong deflationary pressures (though it may prove useful during mild pressures). Therefore, formula flexibility or flexibility by way of executive discretion will provide the necessary strength.

A system of formula flexibility provides for specific changes in the tax structure and in the volume of government spending as determined by certain clearly recognised developments in business activity. It differs from built-in-flexibility in that it calls for changes in the tax structure and spending programmes—it requires a decision on the part of the administration that the necessary changes must be given effect to without delay. Executive discretion implies the delegation to the President or Other chief executive authority to order whatever changes he thinks fit in government spending and tax structure to maintain full employment. These measures, therefore, make fiscal policy as such a very potent tool to meet extraordinary situations.

(g) Built-in-Stabilizers:

The fact that both taxes and transfer payment may vary with changes in income level is the basis for built-in-stabilizers—which have come to play a significant role in the working of an economy. The term stabilizer is used because they operate in a manner that counteracts fluctuations in economic activities. They are called built-in—because they come into play automatically as the income level changes. In other words, their operation does not depend upon the discretionary actions of the monetary and fiscal authorities.

Taxes may act as a stabilizing influence upon the economic system if the tax structure is such that the amount of taxes collected by the government rises with an increase in the income. In this case the effect will be to lessen the expansion in disposable income. From the stabilizing point of view, it means a less rapid rise in induced consumptions. If the tax system is such that not only the absolute amount of taxes but also the percentage of income going in taxes increases with an increase in income, the stabilizing impact will be even greater.

It will happen if the rate structure for tax system is progressive—the effective rate rising as the level of income increases. It is a system in which the net marginal propensity to tax (t) is not only positive but its value also increases. Stabilizing effects of opposite nature follow when income declines. In a regressive tax system total taxes (TX) are constant at all income levels—in a regressive tax system the rate of taxation (TX/Y_np) declines as the tax-base income increases.

Similarly, various forms of transfer expenditures affect the economy in a countercyclical fashion. If transfer payments are to have a stabilizing effect, they must decrease in absolute amount when income increases and increase when income declines. For example, when employment is falling, payments to the unemployed automatically increase, thereby increasing this disposable income and vice-versa. It would be too much to presume that these stabilizers by themselves can smoothen fluctuations in Y and O but most would agree that they are a vital and effective complement to discretionary actions.