Fiscal Policy in LDCs: Role, Objective and Limitations

In this article we will discuss about:- 1. Objectives of Fiscal Policy in LDCs 2. The Role of Fiscal Policy in LDCs 3. Limitations.

Objectives of Fiscal Policy in LDCs:

The major objectives of fiscal policy in the LDCs are as follows:

1. To raise revenues for the government.

2. To stabilise prices by changing aggregate demand.

3. To promote economic growth by mobilising ‘surplus’.

4. To promote foreign investment should it be considered desirable?

5. To change the pattern of income distribution according to some social objectives, e.g., more equal distribution of income.

6. To minimise the adverse effects on resource allocation.

Most governments in the LDCs try to achieve a combination of some of these major objectives. The main instruments to attain the targets are usually taxation, expenditure and deficit finance.

The Role of Fiscal Policy:

The role of fiscal and monetary policies and instruments in development can be discussed under two broad heading:

(1) Financing investment and

(2) Pattern of investment.

1. Financing Investment:

In fact, fiscal policy plays two major roles in raising finance for develop­ment. Firstly, it maintains an economy at full employment so that the aggregate capacity to save does not fall. Secondly, it helps to raise the marginal propensity to save (MPS) of the community above the average propensity to the maximum extent possible without discouraging work effort or violating the canon of equity.

Keynes pointed out that using fiscal policy to maintain full employment will involve deficit financing if there exist unemployed resources (especially manpower) and idle capacity. Defi­cit financing is likely to be inflationary.

However, if the economy is at less-than-full employment real output will increase. The additional saving generated by additional income will provide necessary fund for investment. But if the economy is at full employment output cannot increase further. So, inflation will occur due to an increase in money supply. In such a situation, more savings are likely to be generated by a reduction in total consumption of the community.

Fiscal policy may be used to raise the rate of saving. Since saving is the difference between disposable income and consumption, measures which succeed in restraining the growth of government expenditure and private consumption, without, at the same time, retarding the growth of produc­tion, will also raise the share of savings in national income. To ensure that the growth of production is not hampered, the government must see to it that there is an adequate increase in public investment.

Prof. E. Eshag has rightly suggested that in most developing countries, there is scope for reducing defence expenditure considerably and thus save foreign exchange which is normally used to import military equipment.

Taxation:

The most important instrument for increasing savings by restraining the growth of private consumption is taxation. Both direct and indirect taxes have the effect of reducing the disposable income and hence consumption spending.

Since private consumption spending is a more important component of GNP than investment, any reduction in its rate of growth is likely to raise the rate of savings and investment by a much higher percentage. This very fact explains how important the role of taxation is in economic development.

A growth-oriented tax system should have certain basic characteristics. First, it should ensure that the burden of taxation is primarily and largely borne by the higher income groups; the higher per capita income of a group, the larger its contribution to tax revenue as a proportion of its income should be.

This is possible through a proper implementation of a progressive system of direct taxation on income and wealth. It also implies that indirect taxes, levied for revenue purposes, should be imposed mainly on ‘luxuries’ or inessential items of consumption — namely, goods and services largely consumed by the few rich — rather than on those consumed by the vast majority of the poor (viz., necessities).

Secondly, taxation measures should, whenever possible, be so devised as to stimulate production and, in any case, should not significantly deter incentives. This is why in agriculture and small businesses, a system of progressive lump-sum taxation is better than taxation of production, in­come or profits.

Due to the lack of proper accounting or dependable book­keeping system, the tax system should be as simple as possible. Moreover, it should be so devised as to stimulate production. Similarly, ‘licence fees’ on small business should be fixed on the basis of location of a business and its size.

Thirdly, the tax system should be simple and readily understood by all concerned. Thus, simplicity may be achieved at the cost of some inequity in the distribution of the tax burden.

Fourthly, to permit a faster growth in investment than in consumption, tax revenue should be income-elastic. So, a progressive system of direct taxation has to be properly supported by lump-sum taxes, such as those on agriculture and small businesses. Such lump-sum taxes should be raised periodically in line with inflation and growth potential of land yield

Finally, to ensure stability of total tax revenue tax sources should be diversified. Stability can also be achieved through the taxation of agricul­tural incomes.

Fiscal policy to raise the MPS above the APS is concerned with shaping the tax structure in such a fashion that private consumption is reduced. Tax revenue as a proportion of GNP is very low in developing countries like India.

Moreover, income taxes are a minor source of tax revenue compared to indirect taxes.

Again, most people in such countries do not pay income tax because of:

(i) Low per capita income,

(ii) High exemption limit and

(iii) Absence of agricultural income tax.

So it apparently seems that there is a great scope for using tax policy to raise the total saving of the commu­nity. However, taxes which would make tax revenue highly elastic with respect to income are taxes which would be met out of saving or having the most discouraging effects on incentives. Thus, a basic paradox is encoun­tered.

For example, progressive income tax discourages work effort and saving and the latter may fall as much as tax revenue rises. A preferable alternative is to impose expenditure taxes on the rich people. But the disincentive effect of this type of tax cannot be avoided. This is so because if the expenditure tax encourages saving, the tax rate must be higher to yield the same revenue as income tax.

A.P. Thirlwall has argued that “in general the most effective tax policy to raise the level of saving relative to income would be to impose taxes on those with high marginal propensities to consume, namely the poor, but there are obvious considerations of equity to bear in mind, in pursuing such a policy.”

So far, very few developing countries have made adequate use of tax policy to curtail the growth of private consumption. Tax ratio, which is the ratio of tax revenue to GNP is a rough measure of government’s efforts to reduce private consumption and of their success in doing so.

This is very low in developing countries, largely due to lower per capita incomes. However, the large inequality of income distribution in such countries suggests that their tax potential is significantly higher than is indicated by their per capita incomes.

Since agriculture is the most important sector in developing countries there is enough scope for taxing the rural sector and making the rural sector a potentially significant source of tax revenue and a means of transferring resources for investment purposes. It is easier to collect marketing and export taxes than land revenue or agricultural income tax.

Indirect taxes also have some disincentive effects, but these are much less than those of direct taxes. Sales taxes and import duties can be levied on necessities without much social hardship. Indirect taxes on luxuries may raise revenue if demand for the taxed items is inelastic. But such taxes may be largely paid out of saving since luxuries are generally consumed by rich people having low propensity to consume.

In the absence of well-organised money markets, most developing coun­tries have to rely primarily on fiscal measures to mobilise domestic re­sources. The principal instruments of fiscal policy have been tax policies.

Taxation serves two purposes in developing countries like India. First, tax concessions and similar fiscal incentives have been thought of as a means of stimulating private enterprise. The second major purpose of taxation is the mobilisation of resources to finance public expenditures.

Needless to say, the economic progress of a developing country like India largely depends on its government’s ability to generate sufficient revenues to finance an expanding programme of essential, non-revenue-yielding public services such as health, education, transport, communication and other components of the economic and social infrastructure.

In addition, most LDCs are directly involved in the economic activities of their nations through their ownership and control of public corporations and state trad­ing agencies. Various taxes — direct and indirect — levied enable the government to finance the capital and revenue expenditures of these public enterprises, many of which often run at a loss.

2. The Pattern of Investment:

Market forces would inevitably tend to direct a large proportion of investible resources to ‘inessential industries’ producing luxury goods. Such industries are those that cater to the relatively strong demand of higher income groups.

This would stimulate the production of luxuries at the expense of necessities or mass consumption goods and generate a ‘lopsided’ development. Fiscal and monetary measures can be used in a selective way to influence the pattern allocation of resources in such a fashion as to discourage this type of development.

Such measures should be directed at:

(a) Promoting industries, which produce necessities or essential items of consumption. The basic objective is to prevent a rise in the price of mass consumption goods which generally results in the redistribution of income in favour of the rich people. Such policies should also be directed at

(b) Ensuring balanced growth (both sectoral and regional) as to reduce produc­tion bottlenecks and regional inequalities of income.

In most developing countries the public sector accounts for a major proportion (varying between 30 to 50 percent) of total investment. The pattern of this investment is determined by government policy. The volume or value of public investment is equal to the government’s savings plus its net borrowing.

This means that a rise in tax ratio would increase public investment at the expense of the private. Thus, taxation, apart from raising the share of investment in GNP by restraining con­sumption, enables the government to regulate the pattern of investment.

Limitations of Fiscal Policy:

However, instead of stimulating growth fiscal policy in most developing countries have caused inflation. In fact, tax systems in such countries are often inelastic with respect to income. This inelasticity, combined with political pressures for public spending, causes budget deficits which are covered by inflationary (deficit) financing (spending).

Inflation, in its turn, reduces the real value of savings. The fiscal systems of most developing countries contain a variety of subsidies to industrialists and other interest groups. Most of these subsidies are of questionable merit in terms of benefits to society at large in comparison with revenue sacrificed.