Fiscal Policy

What Is Fiscal Policy?

Fiscal policy is the means by which a government adjusts its spending levels and tax rates to monitor and influence a nation’s economy. It is the sister strategy to monetary policy through which a central bank influences a nation’s money supply. These two policies are used in various combinations to direct a country’s economic goals. Here’s a look at how fiscal policy works, how it must be monitored, and how its implementation may affect different people in an economy.

Before the Great Depression, which lasted from October 29, 1929, to the onset of America’s entry into World War II, the government’s approach to the economy was laissez-faire. Following World War II, it was determined that the government had to take a proactive role in the economy to regulate unemployment, business cycles, inflation, and the cost of money. By using a mix of monetary and fiscal policies (depending on the political orientations and the philosophies of those in power at a particular time, one policy may dominate over another), governments can control economic phenomena.

How Fiscal Policy Works

Fiscal policy is based on the theories of British economist John Maynard Keynes. Also known as Keynesian economics, this theory basically states that governments can influence macroeconomic productivity levels by increasing or decreasing tax levels and public spending. This influence, in turn, curbs inflation (generally considered to be healthy when between 2% and 3%), increases employment, and maintains a healthy value of money. Fiscal policy plays a very important role in managing a country’s economy.


Fiscal policy has been an important component of government’s economic policy during recent decades especially after the great depression of the thirties of the last century. According to Keynes, fiscal adjustments in any period are in the direction of stimulus or restraint and these adjustments take place through government purchase of goods and services, transfer payments and taxes.

In India, the fiscal policy has to perform a significant role. Among other things, the budgetary policies are expected to achieve the following objectives:

  • To promote and accelerate the growth of productive investment in the economy both in the public and the private sectors;
  • To mobilize the maximum volume of real and financial resources for the investment plan of the public sector, keeping in view the expanding demand for real and financial resources of the private sector, and in this way, to promote the growth of marginal and average rates of savings in the economy.
  • To promote the maintenance of a reasonable measure of economic stability in keeping with the maximum rate of growth of the Economy.
  • To redistribute the growing national output.

There are vast differences in economic conditions, in the cultural, legal and political environment within which economic policy must operate and in the state of development of the art of taxation and the science of government.


An evaluation of India’s fiscal policy should bring out as to how far this policy has succeeded in the achievement of the objectives set before it. The analysis here is confined to the following three objectives:

  • To promote saving and capital formation.

•To reduce economic inequalities.

  • To bring about domestic stability, specially to curb inflationary tendencies in the economy.

Fiscal Policy and Savings and Capital Formation

A major objective of fiscal policy has been to promote saving and capital formation and to mobilize these as instruments of economic development.

Relationship between taxation and savings is assumed to be direct and simple. Taxation is believed to reduce the disposable incomes of all sections of society and thereby reduce their conspicuous consumption, the resultant tax revenue will increase public sector savings. In pursuance to this assumption, taxation has been used to mobilize resources for increasing the domestic savings. In the process of mobilizing huge sums of additional taxes the tax structure of the country has also changed.

Empirical studies have shown that though additional taxation had some positive influence on government savings, such influence was not substantial. This would indicate that the fiscal strategy which was designed to mobilize additional taxation with a view to increasing government savings for development purposes had achieved Only partial success. This finding is further supported by the performance of the public sector in the field of capital formation.

Where as taxation was so designed as to divert increased income for public sector savings, a major objective laid down for public expenditure was to increase capital formation in the public sector.

Subsequent studies have shown that this unimpressive performance of the public sector in capital formation through assets creation has continued to persist. Three main reasons attributed to this unhealthy growth have been as follows:

  • The economic performance of the public sector as a whole has been disappointing not only in generating surplus but also inservice efficiency.
  • The attitude of some sections of public sector employees has not been helpful for achieving the envisaged objectives of the public sector.
  • All the funds invested in the public sector have not gone to increase capital formation. Consequently, the physical assets created in the public sector are not of the required standard and quality. This has been partly reflected in the upward trend in the

capital-output ratio.

The cumulative effect of all these has been that after fifty years of economic planning the country is starved of resources for public investment.

Fiscal Policy and Income Inequalities

The most important objective of direct taxes has been to achieve equity. The effectiveness of these taxes in reducing the inequality of income and wealth depends upon the progressive structure of the tax rates. The available evidence shows that only income tax has been progressive though not significantly, and all other direct taxes have been mostly proportional. Three reasons explain this situation.

  • Though the nominal tax rates have been steeply progressive the effective tax rates have been made lower owing to exemptions, rebates and deductions. • Wherever tax rebates and deductions are available, the complexity of tax laws and procedures of assessment have been used for tax avoidance under legal protection.
  • Tax -evasion is evident particularly at the higher slabs of income and wealth as the average marginal effective tax rates become lower at higher levels of income and wealth. Similarly, in the case of incidence of indirect taxes, the estimates made by the Jha committee have shown that these are proportional with reference to the levels of consumer expenditure. As a rule increase in productivity has failed to absorb the rise in costs due to taxation and other related factors. Added to the burden of cost by high prices, scarcities, harsh living conditions and lack of employment opportunities, the tax system and changes effected in it from time to time have increased social discontent and the sense of grievance against public authority.

Administration of the tax system as a whole leaves much to be desired. Failure to properly administer a tax system threatens the canon of equity because full payment of taxes is then made only by those whose elasticity of conscience is such that they cannot do otherwise. It may further increase the evasion of tax because the large amount of evasion breaks the morale of the honest tax payers. Also, a poor quality tax management may collect large proportions from easy- to-tax sector, thereby further creating intersectoral inequity in the incidence of the tax.

Fiscal Policy and Inflation

A major failure of the fiscal policy has been on the price front-its inability to arrest inflation. Taxation both direct and indirect, and publicexpenditure have fuelled inflationary forces in the country. Public expenditure adds to the demand-pull inflation, where as taxation, specially indirect taxes, add to the price rise thought the process of shifting. It is generally believed that as soon as rates of union excise duties and sales tax are raised, the prices of these commodities will automatically rise. This belief is well founded because of the actual practice of the businessmen where manufacturers, wholesalers and retailers immediately shift the increased amount of tax in the form of higher prices of goods.

The other important source of inflation in the budget is deficit financing. During the earlier plans, deficit financing, as a means of financing government investment to create productive capacity, was vehemently defended. This argument was based on the assumption that all the funds obtained through the mechanism of deficit financing were invested to create productive capital assets. The development experience during

the last 50 years of planning, however, does not support this assumption. Several empirical studies have shown the close and direct association between deficit financing and price level in the country.

In short, the failures of fiscal policy have been too many, almost on all the major fronts that we have reviewed above. But its single foremost achievement has been that it has been used effectively as an instrument to raise huge additional resources required for both investment and consumption purposes in each of the successive five year plans.


At present, the focus around the world, as also in India, has shifted from managing the crisis to managing the recovery. The key challenge relates to the feasible fiscal exit strategy that needs to be designed and implemented. As a response to the current global crisis, the Indian government has adopted significant discretionary fiscal stimulus packages to promote investment and sustain aggregate demand.

It is time now to move away from the stimulus packages and concentrate on long-term policy scenarios to control the fiscal situation as well as improve GDP growth. The magnitude of fiscal adjustment needed in the next couple of decades is almost unprecedented, especially for countries like India with relative high debt.

The key challenge involves balancing between public interventions and maintaining market confidence in the sustainability of public finances. This will involve focusing policy attention on removing some of the structural bottlenecks on raising the potential GDP growth rate. Essentially, this will imply efforts to improve the investment climate for both domestic and foreign investors, remove entry barriers to corporate investment in education and vocational training, improve the delivery of public goods and services, and expand physical infrastructure capacities, including a major effort to improve connectivity in the rural regions.

Infrastructure is a key binding constraint on India’s growth and the government should take up long-term projects to improve infrastructure facilities. The government also needs to step-up investment in human capital development through increased spending in areas such as primary education, primary health, and research and development. Investment in human capital will help achieve inclusive growth, and furthermore such expenditures should be considered as part of capital expenditure rather than as revenue expenditure (which is how they are categorized now) since they yield a return in the long-term by way of inter-generational equity and economic growth. These measures will constitute the package of second-generation structural

reforms and will enable the Indian economy to climb out of the downward cyclical phase and then extend the upward phase for a longer period than was achieved in the last cycle. On the revenue side, one way to exit is to increase or restore excise duties, which were reduced during the economic slowdown, to previous levels. The consequent revenue gains can be used to generate employment in public infrastructure projects. However, given the uncertainty about the robustness of the recovery, completele reversing the tax cuts would affect the growth prospects. Partial reversing may help strengthen the revenues of the government without disrupting the growth prospects. Another possible option is to broaden the tax base. This will require changes to the tax structure, which is likely to become more important than before. An important step in this direction is the expected introduction of the GST in October 2010.

GST is going to replace CENVAT, state VAT, and service tax. Both the central governments and states have to levy GST concurrently on all goods and services other than a small list of exemptions. GST will have a two-rate structure: a standard rate for most goods and a lower rate for necessities. A combined rate of 12% (8% for states and 4% for the central government) is seen to be revenue neutral.

The proposed GST will be a comprehensive indirect tax levy on the manufacture, sale, and consumption of goods as well as services at a national level. The GST is likely to reduce indirect taxes paid on most of the goods and services as it would avoid the cascading effect. Product prices, therefore, can be expected to fall and ensure growth in demand.

In addition, the integration of goods and services taxes will improve tax collections and thereby help increase economic growth. It will also end the long-standing differential treatment of the manufacturing and services sectors. Apart from eliminating cascading effects, double taxation, and other issues, the introduction of GST will facilitate credit on uniform terms across the entire supply chain and across all states.

The consensus GST rates may emerge to be 14%. Even this will sharply bring down the incidence of indirect taxes in the economy and release new growth impulses.


In the broad framework of the economic liberalisation approach of the recent years, the major themes of the fiscal policy have been concretised in India. There is broad agreement on these themes and as mentioned in (Dhingra, I.C., 2009), they can be summarised as follows:

  1. A systematic effort to simplify both the tax structure and the tax laws,
  • A deliberate shift a regime of reasonable direct tax rates, combined with better administration and enforcement, to improve compliance and raise revenues,
  • The fostering of a stable and predictable tax policy environment,
  • Greater recognition and weight given to the resource allocation and equity consequences of taxation,
  • More reliance on nondiscretionary fiscal and financial instruments in managing the economy, as compared to ad hoc, discretionary physical controls,
  • Concerted efforts to improve tax administration and reduce the scope for arbitrary harassment
  • Growing appreciations of the links between fiscal and monetary policy,
  • Fresh initiative to strengthen methods of expenditure control.


The biggest challenge facing the conduct of fiscal and monetary policy in India is to continue the accelerated growth process while maintaining price and financial stability. (Rakesh Mohan, 2008) The conduct of fiscal and monetary policy since the early 1990s has broadly succeeded in setting the economy on a higher growth path.

Far reaching fiscal reforms have been undertaken during this period, which are finally bearing fruit through increased revenue mobilisation, some compression in expenditure, and consequent reduction in the fiscal deficit, leading to the beginning of some reduction in the debt GDP ratio. The exercise of fiscal restraint and admirable fiscal and monetary policy cooperation has enabled the increasing effectiveness of monetary policy: the cessation of automatic monetisation of the fiscal deficit, increased importance of market borrowing in financing the deficit, introduction of the market stabilisation scheme, and the corresponding measures to deregulate interest rates to enable market discovery, have all contributed to the strengthening of monetary policy transmission. The self imposed rule based fiscal correction at both the national and sub-national levels has to be consolidated and carried forward. Achievement of the current objectives will still leave the combined fiscal deficit in India at around 4.8% of GDP and somewhat higher if theoff budget items are also taken into account. By international standards this is still very high and if this level continues it will be difficult to make much of a correction to the debt- GDP ratio to bring it down to

desirable levels within the foreseeable future. The government draft on private sector savings will therefore continue, and hence it will also be difficult to reduce substantially the various stipulations that mandate banks and other financial institutions to invest in government securities, thereby constraining further development in monetary policy and financial sector framework. The existence of such a high level of fiscal deficit also contributes to the persistence of an interest rate differential with the rest of the world which then also constrains progress towards full capital account convertibility. The sustained interest rate differential is also connected with the existence of a persistent inflation differential with the rest of the world.

A key challenge for fiscal and monetary policy in the coming years is to further reduce inflation expectations toward international levels. In view of higher inflation rates, higher interest rates, and exchange rate dynamics reflecting growth prospects and capital account movements, rather than inflation or interest rate differentials, there is a need to operate an intermediate regime with a managed floating exchange rate, and an active management of the capital account so as to have the necessary discretion and flexibility to operate monetary policy in order to maintain domestic macroeconomic and financial stability.

In the fiscal policy area, the success achieved in revenue buoyancy through tax rationalisation and compliance has to be strengthened further. Large proportions of the self employed remain outside the tax net, thus continued strengthening and modernisation of tax administration now needs to be emphasised, relative to further reforms in tax policy in terms of relative emphasis. This would enable further shifts in taxrevenue toward direct taxes from indirect taxes, thereby aiding greater economic efficiency. At the state- level also, the move to VAT has provide very significant tax rationalisation, and emphasis now needs to be put on its administration: In this sphere, the next step of reform would, of course, be the proposed move towards a unified “Goods and Service Tax” regime encompassing the centre and the states. The foundations of an efficient fiscal regime in India have, therefore, been achieved.

The second issue on the expenditure side relates to the funding of public investment, particularly related to infrastructure. As documented, public investment has been reduced over the past decade or so. Where as private investment has clearly substituted or complemented public investment successfully in areas such as telecom, ports and airports and partially in roads and power, total investment in infrastructure in clearly inadequate, and could constrain further acceleration in overall economic growth. Third, the government is already engaged in expanding programmes and spending for human development.

By Yash Sharma and Aastha Miglani, Content Board All India Legal Forum.

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