Top 13 Limitations of Fiscal Policy

Some of the major limitations of fiscal policy are as follows:

Although fiscal policy gained prominence during world depression of 1930’s, yet its practical application has a number of problems or limitations.

In view of such a situation, let us understand fully problems and limitations which are associated with a fiscal policy.

They are:

1. Policy Lags:

During the recent times, there is not much argument about the desirability or otherwise of a discretionary fiscal policy. The burning question in this context is related with the timing of the fiscal measures. Unless the variations in taxes and public expenditure are neatly timed, the desired counter-cyclical effects can not be realized.

There is generally some interval between the time when a particular action is needed and the time when a fiscal measure has its impact felt. The duration of this interval determines the extent to which a specific fiscal measure can be effective. This time interval comprises of three types of lags-recognition lag, administrative lag and operational lag.

(а) Recognition Lag:

This is the interval between the time when action is needed and when it is recognized that action is needed. This lag may exist when a change in the economy and a report concerning the change do not coincide. Such a lag has a duration of 3 months. It can be reduced if the forecasting is satisfactory.

(b) Administrative Lag:

This is the interval between the time when need of an action is recognized and the time when the action is actually taken. This is perhaps the most difficult lag to deal with. Even when the need of action has been recognized, the sanction from legislature and executive must take some time and that may involve about 1 to 15 months of time.

In order to reduce such a lag and to minimize the legislative and executive red-taps, it is important to keep a shelf of public works in readiness. The recognition and administrative lags together determine the inside lag of the fiscal policy and its length, according to Willes, is 4 to 18 months.

(c) Operational Lag:

The time interval between when action is taken and when it has its impact on income and employment is known as the operational or the outside lag. Albert Ando and E.C. Brown have pointed out that the change in personal income taxes produce significant changes in disposable money income and consumption within a month or two; changes in the corporate tax structure produce changes in corporate spending in about 3 or 4 months. Willes was of the view that the outside lag of fiscal policy has a short duration of 1 to 3 months only. J.G. Ranlett, however, considers that these estimates need modification.

On the basis of U.S. income tax data of 1960’s, he emphasized that the valuation in income tax rates affected changes on consumption spending with a lag of about 3 to 9 months. Even this estimate of outside lag of fiscal policy is much lower than that of the monetary policy.

2. Forecasting:

Another most serious limitation of fiscal policy is the practical difficulty of observing the coming events of economic instability. Unless they are correctly observed the amount of revenue to be raised, the amount of expenditure to be incurred or the nature and extent of budget balance to be framed cannot be suitably planned. In fact, success of fiscal measures depends on the accurate predictions of various economic activities. In its absence, it proves to be a little bit erratic.

3. Correct Size and Nature of Fiscal Policy:

The most important necessity on which the success of fiscal policy will depend is the ability of public authority to frame the correct size and nature of fiscal policy on the one hand and to foresee the correct timing of its application on the other. It is, however, too much to expect that the government would be able to correctly determine the size, nature of composition and appropriate execution-time of fiscal policy.

4. Fiscal Selectivity:

When monetary policy is general in nature and impersonal in impact, the fiscal policy, in contrast, is selective. The former permits the market mechanism to operate smoothly. The latter, on the contrary, encroaches directly upon the market mechanism and gives rise to an allocation of resources which may be construed as good or bad depending upon one’s value judgements. A particular set of fiscal measures may have an excessively harsh impact upon certain sectors, while leaving others almost unaffected.

5. Inadequacy of Fiscal Measures:

In anti-depression fiscal policy, the expansion of public spending and reduction on taxes are always important elements. The question arises naturally, whether a specific variation in public spending or taxes will bear the desired results or not. In case the injections or withdrawals from the circular flow are more or less than what are required, the system will fail to move in the desired direction. This results in exaggeration of instability in the economy.

6. Adverse Effect on Redistribution of Income:

It is felt that fiscal policy measures redistribute income, the actual effect will be uncertain. If income is redistributed in favour of the low-income classes whose marginal propensity to consume is high, the effect will be increase in total demand. But the fiscal action will be contractionary if larger part of the additional income goes to people having higher marginal propensity to save.

7. Self-offsetting Effect:

The compensatory fiscal policies of the government may discourage private investment, since the private entrepreneurs have to face a competition from public enterprises in securing labour, raw materials and finances. Moreover, increased involvement of the government in economic activity at the onset of recession strengthens the pessimistic expectations of the private entrepreneurs. The expansion of public spending may be associated with a curtailment of private spending. Consequently, the fiscal measures may be self-offsetting.

8. Reduction in National Income:

Balanced budget multiplier as a fiscal weapon can be gainfully applied during depression is conditioned by the fact of marginal propensity to spend of the recipients of public expenditure being larger than or, at least, equal to that of the taxpayers. In case it becomes smaller than the taxpayers, the fiscal programmes under balanced budget will bring about reduction in the national income.

9. Solution for Unemployment:

The purpose of fiscal policy will be defeated if the policy can not maintain a rising supply level of work effort. The money national income will rise with increase in productive efficiency and increased supply of work effort. But if the tax measures are stringent and too high, they will certainly affect the incentive to work. This is an important limitation of fiscal policy.

10. Adverse Effect on debt Management:

The use of fiscal instruments during unemployment and depression is often associated with the subsequent problem of debt management. Because deficit budgeting is the normal fiscal cure, public debt is made for financing it. And if the process of recovery from depression is long, the creation of budget deficit year after year will create a huge problem of debt repayment and debt management.

11. Adverse Psychological Reaction:

Large deficit programmes financed by borrowings bring about adverse psychological reactions. Rumours of government bankruptcy discourage investors and often flight of capital takes place.

12. Hardships in U.D.Cs:

The creation of additional income through compensatory fiscal measures is not easily possible in underdeveloped countries as in advanced economies. This is mainly because a stagnating agricultural sector dominates the largest part of their economy where marginal propensity to consume is so high that most of the additional income is consumed and the marketable surplus is the least.

13. Administrative Problems in Democratic Countries:

In a democracy fiscal policy measures must be a time-consuming process. Legislative actions, administrative tasks and the executive process are often delayed and the original estimates of revenue earnings and government expenditures often become irrelevant. The operational lag relating to fiscal measures results in a considerable erosion of effect and the gap between expected achievement and the real attainment often becomes vast.