A country’s fiscal policy along with the monetary policy plays a crucial role in managing the growth in the economy. The main purpose of both fiscal and monetary policy is to achieve full employment, maintain or achieve high economic growth and to stabilise the price and wages.
Fiscal policy refers to the use of the Government spending and tax policies to influence the country’s economic conditions. The government decides how much money it should spend to support economic activity, how much money it should earn from the system and how they are going to manage to keep the wheels of the economy running.
In other words, in fiscal policy, the government deals with the revenue and expenditure policy of the country. Its main motto is to increase GDP and aggregate demand in a sustainable manner.
In fiscal policy they manage two things to have a better growth rate: taxation and government spending.
Tax policy: Major source of revenue for a country
In tax policy they decide how much tax that businesses will be paying to the government. They also decide individual tax rates for the financial year based on the economic conditions of the country.
A decrease in personal tax rates will lead to an increase in consumption, which will in turn have a stimulatory effect on the overall economy. A decrease in corporate tax rates will stimulate investment.
Conversely an increase in personal tax will lead to lower consumption and slow growth in the economy. Increase in corporate tax rate will lead to lower investment and lesser profitability, resulting in slow growth in the economy.
In a declining economy, personal and corporate tax rates are increased to make sure that government revenues are not reduced. The main motto is to reduce consumption until an increase in surplus industrial activity. Instead of an increase in tax rates, they may reduce government spending to create downward pressure on the economy.
Government spending: Stimulate economic growth
Government decides how the revenue collected during the year or money received will be spent throughout the year. Aggregate demand of the country is raised based on how the government spends money.
Spending of the government is determined based on sectors needing an economic boost.
Increase in government spending will have an expansionary effect on the economy. Conversely, lower spending by the government has the effect of contracting the economy.
In simple words, fiscal policy deals with the taxation and expenditure decisions of the government. Monetary policy deals with the supply of money in the economy and the rate of interest.
How tax and government spending are managed in fiscal policy
During inflation, the Government in its fiscal policy will raise tax rates, cut spending to cool down the economy.
Conversely, during a recession, they will lower tax rates and increase spending to encourage demand and economic activity.
Increase in spending and lowering taxes is known as expansionary fiscal policy. The main purpose is to put more money in the hands of consumers who can spend more to stimulate the economy.
The opposite of expansionary fiscal policy is contractionary fiscal policy. It’s used to slow the economic growth when inflation is growing too rapidly. In it the government will increase the tax rates and cut spending. When less money is spent, economic growth will slow down to balance inflation.
How fiscal policy is used by the government.
Government’s fiscal policies are tied to each year’s budget.
A country’s budget spells out the government’s spending plan for the financial year and how they are going to fund that spending.
Each year our finance minister will present a budget to the parliament that sets the tone for the coming year’s fiscal policy.
A country’s fiscal policy outline followings;
- How will money be spent on public needs, such as defence, education and healthcare?
- How much will the government collect in tax revenues?
- How much will be the deficit or surplus for the financial year?
Basically fiscal policy controls the flow of tax revenue and public expenditure to navigate the economy. It tries to maintain the desired economic growth and to achieve full employment or near full employment for the country.
If the government spends more than its tax and non-tax receipts,it runs a deficit. Conversely, if the government receives more money than it spends, it runs a surplus.
Revenue deficit = revenue expenditure – revenue receipts
Revenue surplus = revenue receipts – revenue expenditure
Revenue receipts include both tax and non-tax revenue.
Fiscal deficit = revenue expenditure + capital expenditure – all revenue and capital receipts other than loans taken
Taxes are the main source of government revenues. Taxes on personal and corporate incomes are direct taxes.
Indirect taxes are charged and collected from persons other than those who finally end up paying the tax. For instance, a tax on sale of goods and services is collected by the seller, but the tax is paid by the buyer while buying the goods and/or services. This means the responsibility of collecting indirect tax is with the seller who collects it from the buyer and pays it to the government.
In India the main direct taxes at the central level are the personal and corporate income tax.
Deficit means there are additional expenditures which will not be funded by the receipts. Therefore to fund this deficit, the government will either borrow from domestic or foreign sources.
Businesses closely watch a country’s fiscal policy as it defines the direction of the economy.
Based on how the government spends money, businesses will see investment opportunities to make money. Rising taxes and slow government spending will impact the profitability of businesses.
