PACC9 Public Fiscal
Administration
Module 1
LESSON 3
ROLE OF FISCAL POLICY
What is Fiscal Policy
• Fiscal policy is the use of government revenue (taxes) and
expenditure (spending) to influence the economy and meet
macroeconomic goals.
• The government’s revenue and expenditure form its
budget. If the revenue collection in the form of taxes equals
its expenditure, it’s a balanced budget. If revenue exceeds
expenditure, the government has a budget surplus. On the
other hand, if expenditure exceeds revenue, it’s a budget
deficit.
What is Fiscal Policy
• A government follows a neutral fiscal policy when the economy
is in equilibrium. In such a case, the government’s expenditure
is fully funded by tax revenue. A government follows an
expansionary fiscal policy during times of recession. It may
reduce taxes or increase expenditure in order to stimulate the
economy – to increase demand, growth, and employment. The
government may follow contractionary fiscal policy to reduce
the fiscal deficit or pay down government debt. To do so, it
may increase taxes or decrease expenditure, which will
decrease demand, growth, and employment.
What is Fiscal Policy
• Fiscal policy is based on Keynesian economics, which
believes that the government can influence the
macroeconomic productivity levels by changing taxes and
spending. Such influence can curb inflation, increase the
employment rate, and stabilize the value of money.
Monetarists, however, believe that the effects of fiscal
policy are only temporary, and they advocate the use of
monetary policy to control inflation.
What is Fiscal Policy
• Fiscal policy can be discretionary or nondiscretionary (automatic stabilizers).
A discretionary fiscal policy refers to the deliberate changes in government
spending and taxes in order to stabilize the economy; for example, the
government decides to increase its capital expenditure on road
infrastructure. On the other hand, automatic stabilizers are the automatic
changes in the tax and spending levels because of the changes in economic
conditions. They help stabilize business cycles.
For example:
when the economy is expanding, the tax revenue increases, and vice versa.
There will also be lower government spending in the form of unemployment
benefits. Economists have observed that automatic stabilizers can reduce the
volatility of the economic cycle by up to 20%.
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-
3%), increases employment and maintains a healthy value of
money. Fiscal policy is very important to the economy.
Tools of Fiscal Policy
• The government has two primary fiscal tools to
influence the economy. They are revenue tools
and spending tools.
Revenue tools
•Revenue tools refer to the taxes collected by the
government in various forms. The taxes can be direct or
indirect. Direct taxes are taxes levied on the income or
wealth of individuals and firms. This includes income tax,
wealth tax, estate tax, corporate tax, capital gains tax,
social security tax, etc.
•Indirect taxes are taxes levied on goods and services.
This includes sales tax, value-added tax, excise duty, etc.
Spending Tools
Spending tools refer to increasing or decreasing government
spending/expenditure to influence the economy.
Government spending can be in the form of transfer
payments, current spending, and capital spending.
Current spending includes expenditure on essential goods and
services such as health, education, defense, etc.
Capital spending is the public investment in infrastructure
such as roads, hospitals, schools, etc.
• Fiscal policy tools have several advantages.
Spending tools enable services such as defense to benefit
everyone in the country and build infrastructure that
propels growth. Spending tools also ensure a minimum
standard of living for the residents. Subsidies in research
and development also help in future economic growth.
Taxes help the government in meeting its fiscal needs. By
levying high indirect taxes, the government can also
discourage use of items such as tobacco, and alcohol.
• Fiscal policy tools have several advantages.
• Spending tools enable services such as defense to benefit everyone
in the country and build infrastructure that propels growth. Spending tools
also ensure a minimum standard of living for the residents. Subsidies in
research and development also help in future economic growth.
•Taxes help the government in meeting its fiscal needs. By levying high
indirect taxes, the government can also discourage use of items such as
tobacco, and alcohol.
•
Challenges in Implementing Fiscal Policy
The government has two tools to implement its fiscal policy:
1. Taxes
2. Government spending
•If the economy is in recession, the government may decide to
increase aggregate demand, or decrease taxes to stimulate the
economy and increase aggregate demand. Similarly, if the economy is
facing an inflationary economic boom, it may decrease spending or
increase taxes.
• When the government takes specific actions to influence
aggregate demand, it’s called the discretionary fiscal policy.
OBJECTIVES: The major objectives of fiscal policy are as follows:
A. Full employment
It is a very important objective of fiscal policy. Unemployment reduces the
level of production, and hence the level of economic growth. It also creates
many problems for unemployed people in their day-to-day life. So, countries
try to remove unemployment and attain full employment. Full employment
refers to a situation, where there is no involuntary unemployment in the
economy. To attain this objective, the government should:
increase its spending
lower the personal income taxes
lower the business taxes, or
employ a combination of increasing government spending and decreasing
taxes
B. Price stability
• Both sharp rise and sharp fall in the
general price level are not desirable. It is
because the sharp rise in prices makes many
goods and services unaffordable to the users
whereas a sharp fall in prices discourages the
producers to produce goods and services. So,
price stability is desirable.
C. Economic growth
• It is also an important objective of
fiscal policy. By means of a higher rate of
economic growth, the problem of
unemployment can also be solved.
However, it may create some problems in
the maintenance of price stability.
• D. Resource allocation
• Resource allocation refers to assigning the available resources of the
economy to the specific uses chosen among many possible and competing
alternatives.
It gives answers to what to produce and how to produce questions of the
economy (Tragakes, 2009:17). Fiscal policy should ensure the optimum
allocation of resources.
It should divert the resources from unproductive sectors to productive
sectors of the economy.
It is the long-run objective of the government.
The emphasis of the government on full employment, price stability, and
economic growth should not overshadow the resource allocation goal.
What Is an Expansionary Policy?
• Expansionary, or loose policy is a form of macroeconomic policy
that seeks to encourage economic growth. Expansionary policy
can consist of either monetary policy or fiscal policy (or a
combination of the two). It is part of the general policy
prescription of Keynesian economics, to be used during
economic slowdowns and recessions in order to moderate the
downside of economic cycles.
KEY TAKEAWAYS
Expansionary policy seeks to stimulate an economy by boosting demand through
monetary and fiscal stimulus.
Expansionary fiscal policy includes issuing stimulus checks or creating tax breaks,
while expansionary policy includes lowering the fed funds rate.
Expansionary policy is intended to prevent or moderate economic downturns and
recessions.
Though popular, expansionary policy can involve significant costs and risks
including macroeconomic, microeconomic, and political economy issues.
Expansionary policy is directly related to the cause of inflation; though expansionary
policies fight unemployment, it may unintentionally cause higher prices.
What Is a Contractionary Policy?
A contractionary policy is a monetary measure to reduce
government spending or the rate of monetary expansion by a
central bank. It is a macroeconomic tool used to combat rising
inflation.
The main contractionary policies employed by the United
States government include raising interest rates, increasing
bank reserve requirements, and selling government securities.
KEY TAKEAWAYS
Contractionary policies are macroeconomic tools designed to combat
economic distortions caused by an overheating economy.
Contractionary policies aim to reduce the rates of monetary expansion by
putting some limits on the flow of money in the economy.
Contractionary policies are typically issued during times of extreme inflation or
when there has been a period of increased speculation and capital investment
fueled by prior expansionary policies.
Tools Used for Contractionary Policies
Both monetary and fiscal policies implement strategies to combat rising inflation and
help to contract economic growth.
Monetary Policy
Increasing interest rates reduces inflation by limiting the amount of active money
circulating in the economy. This also quells unsustainable speculation and capital
investment that previous expansionary policies may have triggered.
Increasing bank reserve requirements, the level of required reserves held by banks
effectively decreases the funds available for lending to businesses and consumers.
Selling assets like U.S. Treasury notes, the Federal Reserve uses open-market
operations as a tool. These sales lower the market price of such assets and
increase their yields.
Fiscal Policy
Increasing taxes reduces the money supply and decreases the
purchasing power of consumers. It may also slow down
unsustainable production or lower the value of assets.
Reducing government spending in areas such as subsidies,
welfare programs, contracts for public works, or the number of
government employees.
Contractionary Policy vs. Expansionary Policy
• A contractionary policy attempts to
slow the economy by reducing the money supply and fending off
inflation.
• An expansionary policy is an effort that central banks use to stimulate
an economy by boosting demand through monetary and fiscal stimulus.
Expansionary policy is intended to prevent or moderate economic
downturns and recessions.
ALTERNATIVE FISCAL POLICIES
A.Fiscal policy during the contraction
increase in government spending
reduction in personal income taxes
reduction in business taxes
increase in transfer payments
practicing deficit budget
ALTERNATIVE FISCAL POLICIES
B. Fiscal policy during the expansion
decrease in government spending
increase in personal income taxes
increase in business taxes
reduction in transfer payments
practicing surplus budget
Thank You!
