Role of Fiscal Policy in Controlling Cyclical Fluctuations | Economics

In this article we will discuss about the role of fiscal policy in controlling cyclical fluctua­tions in economic activity.

A positive fiscal policy refers to the process by which taxation and public expenditure programmes are so shaped as:

(1) To control or reduce the degree of business cycle fluctuations, and

(2) To contribute towards the maintenance of a growing, high employment economy free from high and volatile inflation and ensure and maintain full employment and price stability.

Suppose, there is a deflationary gap in the economy because private consumption and investment expenditures are too weak to ensure full employment. Now the central bank will have to adopt an expansionary monetary policy so as to stimulate private investment.

If it is not adequate and fully effective, the central government must introduce tax and public expenditure policies to help the economy to achieve economic stability, which implies full employment and price stability at the same time.

An exactly opposite type of fiscal action is called for when there is demand-pull inflation, i.e., inflation arising out of excess of aggregate expenditure over full employment output at current prices (i.e., there is an inflationary gap in the economy of the Keynesian type).

Prices and wages will continue to rise. The central bank will have to reduce money supply so as to raise the rate of interest. If the policy is effective, private investment expenditure will fall and inflationary gap will gradually be eliminated.

But, if this measure is not fully effective, the central government will have to initiate a restrictive fiscal programme. This will operate through higher tax rates and/or lower public expenditure programmes in an attempt to restore high-employment equilibrium without inflation.

In fact, fiscal or budgetary policies, dealing with taxes and public expenditure, in cooperation with stabilising monetary policies, have as their common goal a high employment and growing economy free from demand-pull inflation.

Objectives of Fiscal Policy:

So, the two objectives of fiscal policy are the maintenance of price level stability and full employment. The generally accepted goals of fiscal policy is that of attainment of greater economic stability, that is , the maintenance of a reasonably stable rate of economic unemployment, on the one hand, or of upward or downward movements in the general price level on the other.

This implies that real national product should go up continuously and steadily with the passage of time and reach the maximum level permitted by changes in technology and factor supplies, while at the same time the price level should remain stable.

Stability presupposes comparable rates of increase in aggregate demand and productive capacity. If aggregate de­mand grow faster than the rate of increase in output, inflation will occur. In the converse case, there will be unemployment (since employment depends upon aggregate demand and deficiency of demand often aggravates the problems of unemployment).

The actual growth rate will fall short of the expected level:

1. Price Stability:

Price-level stability is a major goal of fiscal policy. In the language of Lowes and Sparkes, “price inflation affects the level and competitiveness in international trade. People with fixed incomes or those whose money incomes are slow to adjust to rising prices experience a reduction in real income. Others benefit from buying and selling in a rising market. Appraisal of investment plans is made particularly diffi­cult with price instability.”

A sharp decline in the general price level makes difficult the mainte­nance of full employment, because of its adverse effect on expectations and the squeezing of profits. As a result, business investment may fall with consequent fall in employment.

Oppositely, while inflation helps maintain full employment and benefits some persons, it lessens the efficiency of operation of the economy by encouraging hoarding by both individuals and business firms. The growth rate falls and the problem of unemployment assumes a serious proportion.

2. Full Employment:

The objective of full employment is also desirable. Full employment may be defined as a situation “where all factor units whose owners wish to have them employed at existing prices actually find em­ployment, so that there is no involuntary idleness of resources including manpower.”

The dual objective of price-level stability and full employment is referred to usually as stabilisation. However, with a growing capital stock, labour force and technique of production, maintenance of full employment and price-level stability require maintenance of equilibrium rate of growth. Thus the problem of growth becomes an integral part of stabilisation policy.

Conflict of the Two Goals:

There is often a conflict between the two goals or two requirements of general price-level stability and full employment. Any attempt to achieve full employment, if effective, would eliminate the major checks upon continued increase in the price level.

Automatic vs. Discretionary Changes:

It is to be noted that fiscal policy will prove successful in stabilising the economy only when the government officials are “carefully watching trends, are successfully anticipating future developments and are meeting promptly to take decisive action.” Such deliberate policy changes are known as discretionary fiscal measures. They are, of course, important from the stability point of view. But this not the whole truth.

Automatic Stabilisers:

The modern fiscal system has certain inherent automatic (built-in) stabilis­ing properties.

These stabilisers help keep the economy stable and are of the following types:

1. Automatic Changes in Tax Receipts:

Under the present system of progressive taxation there occur automatic changes in tax receipts over the business cycle. When income begins to fall, the tax receipts fall automat­ically.

What is implication of progressive taxation from the stability point of view? The implication is simple enough: as soon as national income starts falling even in the absence of a change in government’s tax policy, tax revenues fall automatically. When income output falls the consequent fall in tax revenues of the government might be desirable.

Hence, the present tax system is undoubtedly a strong and rapid built-in stabiliser. It may be noted that taxes stabilise against both upward and downward movements. In times of sharp increases in GNP, higher taxes might be desirable to control inflation. The progressive tax system would automatically ensure this.

Happily, the present tax system of every modem mixed economy has come to possess a higher degree of automatic flexibility, with its receipts tending to rise in times of prosperity and falling in times of depression. This acts as a stabiliser.

2. Unemployment Insurance and Transfer Incomes:

During depression workers are laid off. They receive insurance benefit from the unemployment compensation funds. With recovery and economic expansion they are put to work and the payments are stopped. This unemployment insurance pumps funds into or out of the economy in a counter-cyclical stabilising way.

3. Household Savings and Business Saving:

Similarly, the convention of corporations’ maintaining their dividends, even in the face of income changes in the short run, often causes their retained earnings to act as a built-in stabiliser. In a like manner, to the extent to which households attempt to maintain previous living standards and are slow to adjust their living standards upward they too act as a shock absorber.

Limitation:

However, the built-in stabilisers are not by themselves ade­quate to achieve and maintain full stability. The automatic tendency for taxes to take away a portion of each extra rupee of GNP implies that the size of the multiplier is correspondingly reduced.

Each rupee swing in invest­ment or defence spending — whether caused by innovation, or threat of a war, or anything else — will now have its destabilising effect on the system reduced but not wiped out completely. In other words, such stabilisers cannot wipe out 100% of the disturbance. Hence, there is need for discre­tionary fiscal measures.

Discretionary Fiscal Policy:

The government often makes deliberate adjustments in revenues and ex­penditures for the purpose of obtaining greater economic stability. Such adjustments go by the name of fiscal policy. The most important fiscal policy variables are the overall level of tax rate and the level of planned government outlays. For stabilisation purposes, changes in specific tax, transfer, or expenditure programmes are normally important only to the extent that they affect the overall tax and outlay levels.

To quote J. F. Due, “Government expenditure and revenue programmes inevitably have some influence upon the level of national income. The expenditures themselves are almost certain to be expansionary, the exact extent depending upon the purposes for which money is spent. The revenue collections tend to be contractionary, to a degree dependent upon the exact sources employed. On the whole, taxation is more contractionary than bor­rowing and borrowing is more contractionary than the issuance of paper money (deficit financing). The net effect of the combined revenue-expenditure programme is likely to be expansionary.”

Weapons of Discretionary Fiscal Policy:

The principal weapons of discretionary fiscal policy — programmes which imply explicit public decision making — are:

(a) Varying public works and other expenditure programmes.

(b) Public-employment projects.

(c) Varying transfer expenditure programmes.

(d) Varying tax rates over the business cycle.

(a) Public Works:

During depressions most governments undertake public investment projects like construction of roads, bridges, dams, etc. for the unemployed. However, modern economists and planners now realise that it takes a long time to put into effect a road-building or a slum-clearance programme or to get a post office started.

Thus, fiscal policy operates with a time lag. Plans must be made; blueprints drawn; land acquired by purchase or through court cases; buildings constructed; new streets and roads built. There is thus need to improve fiscal timing. In fact, most such programmes are directed towards achieving long-run rather than short-run stabilisation.

(b) Public Employment Projects:

Public road-construction and similar projects are highly capital-intensive and their duration is long. On the other hand, some public employment projects (known as public-service employ­ment jobs in the U.S.A.), generally sponsored by state and local governments (like municipalities and panchayats in rural areas) are more flexible in nature. They are undertaken to hire unemployed workers, for a few months or at best one year. The Food for Work Programme started in India in 1976 may be cited as an example.

Such programmes avoid one of the major drawbacks of public works programmes. They can be started quickly and terminated quickly.

(c) Welfare Expenditure:

The government may also initiate various discretionary programmes of transfer expenditures for achieving stability. For example, it could refrain from giving some pending pensions to free­dom fighters in depression (when effective demand is too weak to ensure full employment).

(d) Variation of Tax Rates:

If a recession is supposed to be short-lived, a temporary cut in income-tax is desirable. It may be one way of keeping disposable incomes from falling and of preventing a decline from becoming cumulative. Similarly, the tax rate may be varied to control an inflationary gap and long-run sluggishness (prolonged depression). However, if people expect the tax rise to be temporary, they are unlikely to reduce their consumption expenditure very much. So, the anti-inflationary effect of tax rate changes may be partly lost.