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Fiscal Policy – Definition, Meaning, Objectives and Instruments

Fiscal Policy is the process of shaping taxation and public expenditure to help dampen the swings of the business cycle and contribute to the maintenance of a growing high-employment economy, free from high or volatile inflation.

Objectives of Fiscal Policy

The objective in developed countries

To achieve economic stability and maintain high aggregate demand

The objective in developing countries

To achieve economic growth and development

General objectives of fiscal policy are

  1. Optimum allocation of resources
  2. Full employment
  3. Economic stability
  4. Encouraging a socially optimum pattern of investment
  5. Increasing the rate of investment and capital formation
  6. Reducing income inequalities
  7. Reducing unemployment and underemployment
  8. Controlling inflation

Instruments of Fiscal Policy

  1. Taxation
  2. Public expenditure
  3. Public borrowings
  4. Deficit financing

1. Taxation

Tax refers to a compulsory payment levied by a public authority on persons or organizations to meet the expenditures incurred by the government.

Characteristics of tax

  1. Tax payments must be compulsorily made to the government.
  2. There is no quid-pro-quo between a taxpayer and public authorities, that is, the taxpayer cannot claim any specific benefit in return for the payment of tax.
  3. It involves some sacrifice on the part of the taxpayer. It is not levied as a fine or penalty for breaking the law.
  4. Taxes are classified as direct and indirect.

Direct Taxes

  • Direct Taxes are imposed on the income or wealth of individuals or corporations.
  • The impact and incidence of direct tax are on the same person.
  • This tax is progressive in nature and aims to reduce income inequalities.
  • Some important types of direct taxes have been listed below:

1. Personal Income Tax

  • It is levied on the total income of individuals after some permissible deductions.
  • Statistics: The personal income tax rate in India stands at 33.99% in 2016.

2. Corporate Income Tax

  • The tax base for calculating corporate income tax is the net accounting profit of companies.
  • To encourage the growth of the corporate sector, the government offers several incentives in the form of depreciation allowance, tax holidays, etc.
  • Statistics: The corporate tax rate in India stands at 34.61% in 2016.

3. Property Taxes

  • These taxes are designed to reduce inequalities of wealth distribution in an economy.
  • The imposition of property taxes considerably increases government revenue.
  • Property taxes include wealth tax, estate duty and inheritance tax.
  • New developments: Wealth tax is not applicable with effect from the assessment year 2016–17.

Indirect Taxes

These taxes are imposed on goods and services.

The person on whom the tax is imposed bears the impact, while the incidence is upon the person who ultimately pays it.

It is regressive in nature and is used to achieve different socio-economic objectives.

Indirect taxes can be levied on the following three broad aspects of commodities:

Production, for example, Excise Tax

Sales, for example, Sales Tax; – The sales tax rate in India stands at 14.50% in 2016.

Movement, for example, Customs Duty & Octroi Charges; – Octroi charges vary from 3% to 6% of the product value.

2. Public Expenditure

This refers to the expenses incurred by public authorities such as the central, state and local governments.

Public expenditure is incurred to maximize social welfare by bringing about desired changes in the economy.

It can be classified as follows

  1. Revenue and Capital Expenditure
  2. Productive and Unproductive Expenditure
  3. Transfer and Non-Transfer Expenditure

2.1 Revenue and Capital Expenditure

Revenue Expenditure

Revenue Expenditure includes current or consumption expenditures incurred on public administration, defence forces, public health and education, subsidies and interest payments.

It is recurrent in nature and does not create any capital assets.

Revenue expenditure is classified as follows

  • Development Expenditure
  • Non-Developmental Expenditure

Development Expenditure

Development Expenditure directly or indirectly contributes to the development of the country. It involves the maintenance and functioning of social and community services and physical infrastructure expenditure.

Non-Developmental Expenditure

Non-Developmental Expenditure may not directly contribute to economic development. It includes the maintenance of defence establishments, administrative expenses and interest payments.

Capital Expenditure

It is a non-recurring type of expenditure in the form of capital investments and it is aimed at improving the productive capacity of the economy. It includes expenditure incurred on building durable assets such as highways and multipurpose dams.

Non-developmental capital expenditures include expenses such as those on defence establishments, which do not have a direct impact on economic development but are necessary for the security of the nation.

2.2 Productive and Unproductive Expenditure

Productive (or Development) Expenditure

  • Productive (or Development) Expenditure includes expenditure on infrastructure development, public enterprises or development of agriculture which increase production capacity in the economy.
  • Productive expenditure helps generate government income through tax and non-tax revenues.

Unproductive (or Non-Development) Expenditure

  • Unproductive (or Non-Development) Expenditure includes expenditures of consumption nature such as defence, interest payments and public administration.
  • It neither creates any productive asset nor generates any income and returns for the government.

2.3 Transfer and Non-Transfer Expenditure

Transfer Expenditure

Transfer Expenditures are expenditures against which there is no corresponding transfer of real resources, that is, goods and services, are known as transfer expenditures.

They include expenditure incurred on old-age pension, unemployment allowance and welfare benefits. The result of this type of expenditure is the redistribution of money incomes within the community.

Non-Transfer Expenditure

Non-Transfer Expenditure refers to expenditures incurred for buying or using goods and services. It includes expenditure on defence, education, and public health as well as investment expenditures on capital assets because the government gets capital goods and assets in return for them.

3. Public Borrowings

  • It is an important source of income for the government and helps cover deficits in the budget.
  • Public debt may be raised internally or externally.
  • Loans taken by the government may be from individuals, banks or international financial institutions.
  • Instruments of public debt include securities or bonds.
  • Public debt cause repayment burdens on the economy which in turn, affect aggregate demand, production, private investment, employment and growth.

4. Deficit Financing

  • Deficit financing occurs whenever there is an excess of expenditure over current revenue receipts.
  • In developed countries, deficit financing is promoted to increase effective demand; in developing countries, deficit financing helps mobilize savings and utilize resources.
  • In developing countries, the total resources that the government can mobilize from taxation, public borrowings and assistance from abroad are generally insufficient to meet the demands for investment.
  • This gap is filled through deficit financing.