Fiscal Policy and Economic Development

What is Fiscal Policy ?

• Fiscal policy is the general name for the federal government's taxation and expenditure decisions and activities, particularly as they affect the economy. (Monetary policy refers to policies that affect interest rates and the money supply.)

Government's Unique Situation• Government has the power to tax, which gives

it greater control over its revenue.• By increasing or decreasing taxes, the

government affects households' level of disposable income.

• The federal government can finance budget deficits by borrowing in the financial markets.

• The Federal government can print more money.

Fiscal Fundamentals:

• The previous figure ignores Taxes.• Taxes lower households' disposable income. • The amount collected in taxes doesn't find its way into

consumption (“C”). But if the government spends every dollar that it collects in taxes, then that amount does find its way into total demand through government expenditures.

• When that occurs, the GDP remains unaffected by taxes. • The size of the economy is the same whether people

choose to produce and consume private goods or public goods.

• The mix of goods doesn't affect the level of GDP, as long as the total amount spent on them doesn't change

What happens when the government collects more in taxes than it spends?

Total spending:• when the government brings in more in taxes than it

spends, it reduces disposable income and slows the growth of the economy. Fiscal policy prescription to stabilize an overheated economy is higher taxes.

In Times of inflation:• when too much demand is bidding up prices—a tax

increase, coupled with no increase in government spending, will dampen the upward pressure on prices. The tax increase lowers demand by lowering disposable income. As long as that reduction in consumer demand is not offset by an increase in government demand, total demand decreases.

Fiscal Policy Prescription

Spending Policy:• If the government were to keep taxes the same,

but decrease its spending, it would have the same effect as a tax increase, but through a slightly different channel.

• Instead of decreasing disposable income and decreasing consumption (“C”), a decrease in government spending decreases the “G” in C + I + G directly.

• The lower demand flows through to the larger economy, slows growth in income and employment, and dampens inflationary pressure.

Ricardian equivalence• The Ricardian equivalence theorem

essentially states that government deficits are anticipated by individuals who increase their saving because they realize that borrowing today has to be repaid later. More precisely, bond-financed deficits must be met by a future tax increase, which would be foreseen by individuals who would thus adjust their present consumption accordingly.

• If this theory is true, it would mean a tax cut financed by higher borrowing would have no impact on increasing aggregate demand because consumers would save the tax cut to pay the future tax increases.

• It is argued that if the government borrows money to fund a tax cut, rational consumers realize in the future taxes will have to rise to finance the borrowing. Therefore, they save the extra income so that they can pay future tax rises.

• Consumers wish to smooth their consumption over the course of their life. Thus if consumers anticipate a rise in taxes in the future they will save their current tax cuts to be able to pay future tax rises.

Fiscal Policy in Pakistan• In Pakistan, the fiscal deficit has a direct

impact on inflation as government expenditure constitutes a large part of aggregate expenditure that might lead to demand pull inflation, and an indirect impact as the fiscal deficit is financed partly through the central bank.

• During the period between 1965 and 1972, due to domestic and international political disturbances, the share of defense expenditure increased. In early 1970s, the initiation of nationalization strategy also contributed to the massive fiscal expenditure in terms of public investment.

• Consequently, during the 1980s and 1990s, policy has been preoccupied by the need to contain growing fiscal deficits and the accompanying increase in public indebtedness, and efforts to curb the cost of debt servicing.

• A rule based fiscal policy requires the government to commit to a fiscal policy strategy or to specific fiscal targets that can be monitored.

• To encourage fiscal sustainability and macroeconomic stability a fiscal policy rule can be used as an instrument.

• In Pakistan, macroeconomic imbalances have contributed to deceleration in economic growth and investment which in turns was translated into a rise in poverty levels.

Govt. Expenditure and Tax Revenues as the % of GDP

• There has been considerable improvement in the fiscal deficit and the overall fiscal deficit which averaged nearly 7.0 percent of the GDP in the 1990s has steadily declined to 2.3 percent in 2002-03 but increased to 3.3 percent in 2003-04 because of higher development spending.

• The fiscal deficit has remained above 4.0 percent of GDP for the years (2005- 06 and 2006-07, 2007-08) mainly because of earthquake related spending and higher development expenditure, particularly towards financing of physical and human infrastructure projects.

• Higher government spending on the war against the terrorism also contributes to the rise in the level of fiscal deficits.

Results of pure fiscal shocksThe effects of Government Expenditure Shock:• Government spending consists of the public

money spent to provide social goods such as public goods and merit goods. The size of government spending varies with government role but it is independent of profit expectations and way beyond minimum level of society needs.

• Government spending has prompt and significant effect on the aggregate demand and it is a key fiscal tool.

The Effects of Net Taxes:• Government expenditure falls in case of tight

fiscal policy in terms of high tax revenues.• This finding is theoretically inconsistent

because higher revenues encourage government spending and this relationship is statistically insignificant.

• The GDP response to a tax shock is positive.• These tax shocks are also inflationary as the

consumer price index is persistently increasing due to a positive shock in tax revenues.

Objectives and Role of Fiscal PolicyIncrease in Savings:-

This policy is also used to increase the rate of savings in the country. In the developing countries rich class spends a lot of money on luxuries. The government can impose taxes on them and can provide the basic necessities of life to the poor class on low rate. In this way by providing incentives, savings can be increased.

To Encourage Investment:-The government can encourage the investment by providing various incentives like the tax holiday in the various sectors of the economy. The capital can be shifted from less productive sectors to more productive sectors. So the resources of the country can be utilized maximum.

To Achieve Equal Distribution of Wealth:-Fiscal policy is very useful for the achievement of equal distribution of wealth. When the wealth is equally distributed among the various classes, then their purchasing power increases which ensures the high level of employment and production.

To Control Inflation:-Fiscal policy is very useful weapon for controlling the rate of inflation. When the expenditure on non productive projects is reduced or the rates of taxes are increased then the purchasing power of the people reduces.

Stabilization of Price Level:-Fiscal policy is also used to achieve desirable level of prices in the country. It means the cost and price should be at such level that production and employment may increase.

To Attain Maximum Welfare of the People:-Fiscal policy main objective is to achieve maximum welfare of the people. The quality of life must improve in the country.

To Check Rapid Increase in Consumption :-Fiscal policy is also used to check the rapid increase in the consumption will be high then the rate of saving will be low and consequently rate of investment will be low. A country cannot improve its economic condition without increasing their investment.

To Achieve Economic Stability:-The aim of fiscal policy is to increase the rate of production and employment without inflation. So in the entire countries fiscal policy major objective is to ensure the economic stability in the country.

Issues in Fiscal Policy

The Multiplier Effect:the multiplier will boost the effect of an increase or reduction in taxes or spending. For instance, an extra dollar of government spending will flow through the economy and, by being repeatedly respent, will magnify the stimulus provided by that incremental dollar. Likewise, a dollar of reduced spending will take a dollar out of the economy, and the multiplier applies to that as well.

The propensity to spend or save:• like the multiplier, the propensities to spend and to

save are at work. • If the government reduces taxes to stimulate

consumption, but households save the money rather than spend it, consumption will not rise, nor will investment. If people save the money, they are “sitting on their wallets” and consumption remains low.

• If consumption is low, businesses won't invest. This has been a problem in the application of fiscal stimulus in Japan, where people tend to save increases in income.