June 16, 2024

Fiscal Policy

The fiscal policy

The fiscal policy is concerned with the raising of government revenue and incurring of government expenditure. To generate revenue and to incur expenditure, the government frames a policy called budgetary policy or fiscal policy. So, the fiscal policy is concerned with decision of government expenditure and government revenue.

According to Culbarston, “By fiscal policy we refer to government actions affecting its receipts and expenditures which ordinarily as measured by the government’s receipts, its surplus or deficit.” The government may change undesirable variations in private consumption and investment by compensatory variations of public expenditures and taxes.

Fiscal policy also feeds into economic trends and influences monetary policy

Fiscal policy is the use of government revenue collection (mainly taxes)  and  expenditure(spending) to influence the economy.

Surplus and deficit

Fiscal policy help government to create a balance between revenue generated and revenue expend.

When the government receives more than it spends, it has a surplus. If the government spends more than it receives it runs a deficit.

To meet the additional expenditures, it needs to borrow from domestic or foreign sources, draw upon its foreign exchange reserves or print an equivalent amount of money.


This tends to influence other economic variables. On a broad generalisation, excessive printing of money leads to inflation. If the government borrows too much from abroad it leads to a debt crisis. If it draws down on its foreign exchange reserves, a balance of payments crisis may arise.

Excessive domestic borrowing by the government may lead to higher real interest rates and the domestic private sector being unable to access funds resulting in the „crowding out‟ of private investment. Sometimes a combination of these can occur.

So while formulation of fiscal policy government sees it neither run into deficit nor have surplus. Planning is made to achieve best use of received revenue.

According to Keynesian economics, when the government changes the levels of taxation and government spending, it influences aggregate demand and the level of economic activity. Fiscal policy can be used to stabilize the economy over the course of the business cycle.[2]

 Aggregate Demand = Consumption + Investment + Govt Spending + Net Exports

Fiscal policy has an effect on each of these categories

The two main instruments of fiscal policy are changes in the level and composition of taxation and government spending in various sectors. These changes can affect the following macroeconomic variables, amongst others, in an economy:

  • Aggregate demandand the level of economic activity;
  • Savings  and Investment in the economy
  • The distribution of income


Fiscal policy vs monetary policy

Fiscal policy can be distinguished from monetary policy, in that fiscal policy deals with taxation and government spending and is often administered by an executive under laws of a legislature, whereas monetary policy deals with the money supply, lending rates and interest rates and is often administered by a central bank.

Sources of revenue

This expenditure can be funded in a number of different ways:

  • Taxation
  • Seigniorage, the benefit from printing money
  • Borrowing money from the population or from abroad
  • Consumption of fiscal reserves
  • Sale of fixed assets (e.g., land)

Revenue  receipts represent regular „earnings‟, for  instance  tax receipts through direct tax and indirect tax and non-tax revenues including from sale of telecom spectrums.

capital receipt arises from the liquidation of an asset including the sale of government shares in public sector companies (disinvestments), the return of funds given on loan or the receipt of a loan. This again usually arises from a comparatively irregular event and is not routine.

Sources of expenditure

 Expenditure is the total amount of money that a government or person spends:

Revenue expenditures:  are fairly regular and generally intended to meet certain routine requirements like salaries, pensions, subsidies, interest payments, and  the  like.

capital expenditure :  A spending item is a capital expenditure if it relates to the creation of an asset that is likely to last for a considerable period of time and includes loan disbursements. such as land, building, equipments which are continually used for the purpose of earning revenue. These are not meant for sale.

Interpretation of deficits

There are various ways to represent and interpret a government‟s deficit.

The simplest is the revenue deficit which is just the difference between revenue receipts and revenue expenditures.

Revenue Deficit = Revenue Expenditure  –  Revenue Receipts  (that is Tax + Non-tax Revenue)

A more comprehensive indicator of  the government‟s deficit  is  the fiscal deficit.

This is the sum of revenue and capital expenditure less all revenue and capital receipts other than loans taken. This gives a more holistic view of the government‟s funding situation since  it gives the difference between all receipts and expenditures other than loans taken to  meet such expenditures.

Fiscal Deficit = Total Expenditure (that is Revenue Expenditure + Capital Expenditure) –  (Revenue Receipts + Recoveries of Loans + Other Capital Receipts  (that is all Revenue  and Capital Receipts other than loans taken))

Components of fiscal policy

  • Fiscal policy is composed of several parts. These include,
  • tax policy,
  • expenditure policy,
  • investment or disinvestment strategies
  • debt or surplus management.

 Types of Fiscal Policy

The three main stances of fiscal policy are:

Neutral fiscal policy 

neutral fiscal policy is usually undertaken when an economy is in equilibrium. Government spending is fully funded by tax revenue and overall the budget outcome has a neutral effect on the level of economic activity.

Expansionary Fiscal Policy:

Expansionary fiscal policy involves government spending exceeding tax revenue, and is usually undertaken during recessions.

When an economy is in a recession, expansionary fiscal policy is in order. Typically this type of fiscal policy results in increased government spending and/or lower taxes. A recession results in a recessionary gap – meaning that aggregate demand (ie, GDP) is at a level lower than it would be in a full employment situation. In order to close this gap, a government will typically increase their spending which will directly increase the aggregate demand curve (since government spending creates demand for goods and services). At the same time, the government may choose to cut taxes, which will indirectly affect the aggregate demand curve by allowing for consumers to have more money at their disposal to consume and invest. The actions of this expansionary fiscal policy would result in a shift of the aggregate demand curve to the right, which would result closing the recessionary gap and helping an economy grow.

 Contractionary Fiscal Policy

Contractionary fiscal policy occurs when government spending is lower than tax revenue, and is usually undertaken to pay down government debt.

 Contractionary fiscal policy is essentially the opposite of expansionary fiscal policy. When an economy is in a state where growth is at a rate that is getting out of control (causing inflation and asset bubbles), contractionary fiscal policy can be used to rein it in to a more sustainable level. If an economy is growing too fast or for example, if unemployment is too low, an inflationary gap will form. In order to eliminate this inflationary gap a government may reduce government spending and increase taxes. A decrease in spending by the government will directly decrease aggregate demand curve by reducing government demand for goods and services. Increases in tax levels will also slow growth, as consumers will have less money to consume and invest, thereby indirectly reducing the aggregate demand curve.

Main Objectives of Fiscal Policy in India

Before moving on the discussion on objectives of India’s Fiscal Policies, firstly know that the general objective of Fiscal Policy.

General objectives of Fiscal Policy are given below:

  1. To maintain and achieve full employment.
  2. To stabilize the price level.
  3. 3. To stabilize the growth rate of the economy.
  4. To maintain equilibrium in the BOP.
  5. To promote the economic development of underdeveloped countries.Fiscal policy of India always has two objectives, namely improving the growth performance of the economy and ensuring social justice to the people.

The fiscal policy is designed to achieve certain objectives as follows:-

  1. Development by effective Mobilization of Resources: The principal objective of fiscal policy is to ensure rapid economic growth and development. This objective of economic growth and development can be achieved by Mobilisation of Financial Resources. The central and state governments in India have used fiscal policy to mobilise resources.

The financial resources can be mobilised by:

  1. Taxation: Through effective fiscal policies, the government aims to mobilise resources by way of direct taxes as well as indirect taxes because most important source of resource mobilisation in India is taxation.
  2. Public Savings: The resources can be mobilised through public savings by reducing government expenditure and increasing surpluses of public sector enterprises.
  3. Private Savings:Through effective fiscal measures such as tax benefits, the government can raise resources from private sector and households. Resources can be mobilised through government borrowings by ways of treasury bills, issuance of government bonds, etc., loans from domestic and foreign parties and by deficit financing.
  4. Reduction in inequalities of Income and Wealth:Fiscal policy aims at achieving equity or social justice by reducing income inequalities among different sections of the society. The direct taxes such as income tax are charged more on the rich people as compared to lower income groups. Indirect taxes are also more in the case of semi-luxury and luxury items which are mostly consumed by the upper middle class and the upper class. The government invests a significant proportion of its tax revenue in the implementation of Poverty Alleviation Programmes to improve the conditions of poor people in society.
  5. Price Stability and Control of Inflation: One of the main objectives of fiscal policy is to control inflation and stabilize price. Therefore, the government always aims to control the inflation by reducing fiscal deficits, introducing tax savings schemes, productive use of financial resources, etc. 
  1. Employment Generation:The government is making every possible effort to increase employment in the country through effective fiscal measures. Investment in infrastructure has resulted in direct and indirect employment. Lower taxes and duties on small-scale industrial (SSI) units encourage more investment and consequently generate more employment. Various rural employment programmes have been undertaken by the Government of India to solve problems in rural areas. Similarly, self employment scheme is taken to provide employment to technically qualified persons in the urban areas. 
  1. Balanced Regional Development:there are various projects like building up dams on rivers, electricity, schools, roads, industrial projects etc run by the government to mitigate the regional imbalances in the country. This is done with the help of public expenditure.  
  1. Reducing the Deficit in the Balance of Payment:some time government gives export incentives to the exporters to boost up the export from the country. In the same way import curbing measures are also adopted to check import. Hence the combine impact of these measures is improvement in the balance of payment of the country.7. Increases National Income: it’s the strength of the fiscal policy that is brings out the desired results in the economy. When the government want to increase the income of the country then it increases the direct and indirect taxes rates in the country. There are some other measures like: reduction in tax rate so that more peoples get motivated to deposit actual tax.

    8. Development of Infrastructure: when the government of the concerned country spends money on the projects  like railways, schools, dams, electricity, roads etc to increase the welfare of the citizens, it improves the infrastructure of the country. A improved infrastructure is the key to further speed up the economic growth of the country.

    9. Foreign Exchange Earnings: when the central government of the country gives incentives like, exemption in custom duty, concession in excise duty while producing things in the domestic markets, it motivates the foreign investors to increase the investment in the domestic country.


100 thoughts on “Fiscal Policy

Comments are closed.

Download Study Material Here Download Study Material