Crucial Role of Fiscal Policy in an Under-Developed Economy

Read this article to learn about the crucial role of fiscal policy in an under-developed economy.

The efficiency of fiscal measures in promoting economic development of an under-developed economy is more difficult to assess than the influence of the same in counteracting cyclical fluctuations in advanced economies.

In an advanced economy, it is possible to assume that the economic mechanism would respond to the fiscal manipulations.

But in an under-developed economy, such a presumption may not be valid, at least over a wide range of non-monetized sector of the economy which provides employment to a majority of the people.

The problem in such an economy is not one of excess or deficient effective demand. The level of employment and income is low, not because of the lack of effective demand but on account of a good deal of underemployment, unemployment, disguised unemployment, lack of capital and complementary resources.

Farmers who are engaged in subsistence agriculture and other primary occupations are, perhaps, not affected by tax reduction. Most of them do not pay indirect taxes because of low levels of their income. The general structure of the economy is such that marginal variations in fiscal measures are not of very great importance.

When we talk of economic development of under-developed areas and of raising income, output and employment of these regions, we have to think of improving the productivity of primary sector and fast capital formation and the provision of complementary resources to labour becomes a positive tool for promoting economic development as it is consciously used to influence the flow of resources in the interest of planned economic development to divert resources from unproductive consumption into productive investment channels.

It should be able to cope with the twin problems of inflation and unemployment. “In this context, the main goal of fiscal policy in an under-developed country may be the promotion of the highest possible rate of capital formation without inflation. Stability is necessary for progress, but the maintenance of stability does not require a fall in the rate of saving……… but a rise in it, as raising the proportion of savings to income will enable the economy at the same time to reduce unemployment and maintain stability.”

Attempts have to be made to divert funds by suitable fiscal measures to productive channels from unproductive channels, like speculators, stock-holders or hoarders. Again, government has to play a more active role to meet the deficiencies of private investment.

The government shall have to raise funds from taxation, public debt and from other minor sources like profits from state enterprises and may have to indulge in deficit financing. Capital accumulation through deficit financing, however, is likely to generate inflation.

Since the propensity to consume is high and there are many imperfections and the elasticity’s of food supply are low, a poor country becomes so prone to inflation that a given amount of deficit financed investment is likely to result in much smaller increase in output.

Therefore, to control inflation, the government should attempt to finance expenditures through taxation and borrowing from the public. In short, fiscal policy will have to be anti-inflationary, investment-encouraging and consumptions-restraining.