FISCAL POLICY

1. Background and Contemporary Scenario

• Before the 2008 global financial crisis, the consensus was that monetary policy should take the lead in dealing with ordinary business cycles. 
• Fiscal policy should play a supporting role, except in the event of wars and natural catastrophes such as pandemics. 
• When systemic financial crises occurred, the thinking went, monetary policy could respond immediately but fiscal policy should quickly follow and take the lead over time. 
• Taxation and government expenditure are intensely political, but successful economies could navigate this problem in emergencies.

2. The dilemma of fiscal policy and monetary policy

• Expansionary fiscal policy can directly create jobs and economic activity by injecting demand into the economy. Keynes argued that expansionary fiscal policy is necessary for a recession because of the excess private sector saving which arises due to the paradox of thrift. 
• Expansionary fiscal policy enables unused savings to be used and idle resources to be put into work.
• In a deep recession and liquidity trap, fiscal policy may be more effective than monetary policy because the government can pay for new investment schemes, creating jobs directly – rather than relying on monetary policy to indirectly encourage businesses to invest.
• The drawback of expansionary fiscal policy is that it increases the budget deficit. Some argue this can lead to higher interest rates as markets require higher interest rates to fund borrowing.
• However, in many instances, government borrowing can increase recessions without increasing bond yields. But, it is a balancing act, if borrowing increases too much, markets may fear borrowing is out of control.

3. Objectives of Fiscal policy

• To promote economic growth: Government promotes economic growth by setting up basic and heavy industries like steel, chemical, fertilizers, machine tools, etc. It also builds infrastructure like roads, canals, railways, airports, education and health services, water and electricity supply, telecommunications, etc. that foster economic growth. Both basic and heavy industries and infrastructure require a huge amount of investment which normally the private sector does not take up. Since these industries and infrastructure facilities are essential for economic growth in the country, the burden to set up and develop them falls on the government.
• To reduce income and wealth inequalities: Government reduces inequalities in income and wealth by taxing the rich more and spending more on the poor. Further, it provides employment opportunities for the poor that help them to earn.
• To provide employment opportunities: Employment opportunities are increased by the government in various ways, One, jobs are created when it sets up public sector enterprises. Two, it provides subsidies and other incentives like tax holidays, low rates of taxes etc. to the private sector that encourage production and employment. It also encourages the setting up of small-scale, cottage and village industries by people who are employment oriented. This it does by providing them tax concessions, subsidies, grants, loans at low rates of interest, etc. Finally, it creates jobs for the poor when it undertakes public works programmes like the construction of roads, bridges, canals, buildings, etc.
• To ensure stability in prices: Government ensures the stability of prices of essential goods and services by regulating their supplies. Hence, it incurs expenditure on ration and fair price shops that keep sufficient stock of food grains. It also subsidizes cooking gas, electricity, water and essential services like transport and maintains its prices at a low level affordable to the common man.
• To correct balance of payments deficit: The balance of payments account of a country records its receipts and payment with foreign countries. When payments to foreigners are more than receipts from foreigners, the balance of the payments account is said to be in deficit. Quite often this deficit is caused when a country imports more than it exports. Consequently, the payments on imports to foreigners are more than the receipts from exports. In such a situation, to reduce the deficit in the balance of payment account, the government discourages imports by increasing taxes on them and encourages exports by increasing subsidies and other export incentives. However, it should be noted that import tax is not a popular measure now as it is treated as an obstacle to the free flow of goods and services between countries.
• To provide for effective administration: Government incurs expenditures on police, defence, legislatures, judiciary, etc. to provide effective administration

4. Political costs of monetary and fiscal policy

• In theory, the deflationary policy can reduce inflation. 
• Higher income tax would reduce inflation. 
• However, changing tax rates and government spending is highly political. 
• Neither politicians nor voters are likely to accept higher taxes on the basis that it is necessary to reduce inflation.
• Interest rates set by an independent Central Bank help to take the political calculations out of demand management. 
• In theory, a Central Bank would ignore political considerations and target low inflation. 
• A government may be tempted to encourage an economic boom – just before an election.

5. Which is the best monetary or fiscal policy?

Monetary policy is most widely used for ‘fine-tuning’ the economy. Making minor changes to interest rates is the easiest way to influence the economic cycle. Deflationary fiscal policy is highly politically unpopular. However, in some circumstances, monetary policy has its limitations. In serious recessions, a combination of two policies may be needed.

However, in some circumstances, monetary policy has its limitations. In serious recessions, a combination of the two policies may be needed.

• Monetary policy involves changing the interest rate and influencing the money supply.
• Fiscal policy involves the government changing tax rates and levels of government spending to influence aggregate demand in the economy.

They are both used to pursue policies of higher economic growth or control inflation.

6. Monetary policy

Monetary policy is usually carried out by the Central Bank/Monetary authorities and involves:

• Setting base interest rates (e.g. Bank of England in the UK and Federal Reserve in the US)
• Influencing the supply of money. E.g. Policy of quantitative easing to increase the supply of money.

6.1.How monetary policy works

• The Central Bank may have an inflation target of 2%. If they feel inflation is going to go above the inflation target, due to economic growth being too quick, then they will increase interest rates.
• Higher interest rates increase borrowing costs and reduce consumer spending and investment, leading to lower aggregate demand and lower inflation.
• If the economy went into recession, the Central Bank would cut interest rates.

7. Fiscal policy

Fiscal policy is carried out by the government and involves changing:

• Level of government spending
• Levels of taxation

1. To increase demand and economic growth, the government will cut taxes and increase spending (leading to a higher budget deficit)
2. To reduce demand and reduce inflation, the government can increase tax rates and cut spending (leading to a smaller budget deficit)

7.1.Example of expansionary fiscal policy

• In a recession, the government may decide to increase borrowing and spend more on infrastructure spending. The idea is that this increase in government spending creates an injection of money into the economy and helps to create jobs. There may also be a multiplier effect, where the initial injection into the economy causes a further round of higher spending. This increase in aggregate demand can help the economy to get out of recession.
• This shows that in 2009/10 the UK ran a budget deficit of 10% of GDP. This was caused by the recession and also the government’s attempt to provide a fiscal stimulus (VAT tax cut) to try and get the economy out of recession.
• See more at Expansionary fiscal policy
• If the government felt inflation was a problem, they could pursue deflationary fiscal policy (higher tax and lower spending) to reduce the rate of economic growth.

8. Which is more effective monetary or fiscal policy?

In recent decades, monetary policy has become more popular because:

• Monetary policy is set by the Central Bank, and therefore reduces political influence (e.g. politicians may cut interest rates in the desire to have a booming economy before a general election)
• Fiscal policy can have more supply-side effects on the wider economy. E.g. to reduce inflation – higher tax and lower spending would not be popular, and the government may be reluctant to pursue this. Also, lower spending could lead to reduced public services, and the higher income tax could create disincentives to work.
• Monetarists argue expansionary fiscal policy (a larger budget deficit) is likely to cause crowding out – higher government spending reduces private sector expenditure, and higher government borrowing pushes up interest rates. (However, this analysis is disputed)
• Expansionary fiscal policy (e.g. more government spending) may lead to special interest groups pushing for spending which isn’t really helpful and then proves difficult to reduce when the recession is over.
• Monetary policy is quicker to implement. Interest rates can be set every month. A decision to increase government spending may take time to decide where to spend the money.

However, the recent recession shows that monetary policy too can have many limitations.

• Targeting inflation is too narrow. During the period 2000-2007, inflation was low but central banks ignored an unsustainable boom in the housing market and bank lending.
• Liquidity trap. In a recession, cutting interest rates may prove insufficient to boost demand because banks don’t want to lend and consumers are too nervous to spend. Interest rates were cut from 5% to 0.5% in March 2009, but this didn’t solve the recession in the UK.
• Even quantitative easing – creating money may be ineffective if banks just want to keep the extra money on their balance sheets.
• Government spending directly creates demand in the economy and can provide a kick-start to get the economy out of recession. Thus in a deep recession, relying on monetary policy alone, may be insufficient to restore equilibrium in the economy.
• In a liquidity trap, expansionary fiscal policy will not cause crowding out because the government is making use of surplus saving to inject demand into the economy.
• In a deep recession, expansionary fiscal policy may be important for confidence – if monetary policy has proved to be a failure.