Fiscal policy is an essential tool at the disposable of the government to influence a nation’s economic growth. The fiscal policy is used in coordination with the monetary policy, which a central bank uses to manage the money supply in a country. The meaning, types, objectives, and tools are discussed in detail below.
What is a Fiscal Policy?
A government uses fiscal policy to adjust its spending and tax rates to monitor and influence the performance of the country. The fiscal policy is based on Keynesian economics, a theory by economist John Maynard Keynes. As per the theory, a government can play a major role in influencing productivity levels in an economy by adjusting the tax rates and public spending.
So, this policy helps control inflation, address unemployment, and ensure the health of the currency in the international market. Now that we know what is fiscal policy let’s understand its objectives and types.
Objectives of Fiscal Policy
- Boosting employment levels
- Maintain or stabilize the economy’s growth rate
- Maintain or stabilize the price levels
- Encourage economic development
- Raising the standard of living
- Maintaining equilibrium in Balance of Payments.
Fiscal Policy Tools
A government has two tools at its disposal under the fiscal policy – taxation and public spending.
Taxation includes taxes on income, property, sales, and investments. On the one hand, more taxes means more income for the government, but it also results in less income in the hand of the people.
Public spending includes subsidies, and transfer payments, like salaries to government employees, welfare programs, and public works projects. Those who get the funds have more money to spend.
Types of Fiscal Policy
There are two types of fiscal policy – expansionary and contractionary fiscal policy.
Expansionary Fiscal Policy
A government uses this type of policy to stimulate economic growth by increasing spending or lowering taxes, or both. The objective of this policy is to ensure more money in the hands of the citizens so that they spend more. More spending, in turn, leads to more income and more job creation.
There have been debates over which is more effective – tax cuts or spending. Some say that spending in the form of public projects ensures that the money reaches the consumers. Those in favor of the tax argue that tax cuts allow businesses to hire more staff. Though there is no consensus on which of the two is better, the government uses a combination of both tools to boost economic growth.
Contractionary Fiscal Policy
A government rarely uses this policy as it aims to slow economic growth. You must be thinking about why any government will want to do that. The answer is to curtail inflation. Too much inflation has the potential to damage the economy in the long term. So, the government has to step in to control inflation.
Here also, the government has the same tools at its disposal – spending and tax cuts. But, they are used differently – taxes are raised while the spending is reduced. One can easily imagine how unpopular such measures will be among the voters.
A Balanced Approach
A government always faces a risk that more spending and lower tax rates could fuel inflation. This happens because more money in the economy pushes the consumer demand up, eventually leading to a fall in the value of money. This means it now takes more money to buy a product or service whose value is not changed.
So, it is very important for a government to monitor its fiscal policy constantly. And, if there are any signs of inflation going out of control, the government must address it accordingly.
Who All Are Affected with Fiscal Policy?
Fiscal policy may not benefit all the citizens in the same way. The scope of the policy depends on the goals that the policymakers aim to achieve. For example, if the government spends more on defense projects, it would benefit only a few. But, if the spending is on the construction of dams, the benefit would reach a larger group. Similarly, changes to a particular tax slab would affect only the people falling in that category.
Fiscal Surplus and Fiscal Deficit
Both of these terms are important concepts of fiscal policy. If a government spends more than what it earns, it leads to a deficit. The government then needs to borrow funds from external sources to maintain the balance.
If the government spends less than what it earns, it creates a fiscal surplus. Though the concept sounds great, it’s very rare you will hear a country getting a surplus.
Monetary Policy – How It’s Different?
The monetary policy helps in controlling the money supply. There are many tools under the monetary policy, but the authorities mainly rely on raising or lowering the fed funds rate. Monetary policy works faster than fiscal policy. To ensure that an economy remains efficient, policymakers should coordinate both fiscal and monetary policies.
The fiscal policy is a tool used by the government to influence the economic performance of the country. It can be of various types, and it can be in surplus and deficit depending upon the government expenditure and funds available.