Fiscal policy is the taxation and spending decisions of the government. It’s one of the three main economic policies that government use. There are two other policies which are called monetary policy and supply-side policies. Government can change tax rates. The aim of fiscal policy is to influence aggregate demand. Government can raise AD to increase either by increase it’s spending or by reducing taxes. To increase AD government may raise it’s spending and cut taxes this is called reflationary, expansionary or loose fiscal policy. To reduce AD government reduces spending and raises taxes this is called deflationary, contractionary or tight fiscal policy.
The nature of fiscal policy
Government may want to influence AD in order to make it match AS and so to avoid unemployment and inflation. If private sector demand (C+I+(x-m) is low government may try to increase AD, but if AD is high, government may try to reduce it. Government is seeking to create greater economic stability by offsetting changes in private sector spending.
To achieve this objective, a government can use something called discretionary fiscal policy, which is a change in government spending and taxation to influence AD. Or it can allow automatic stabilizers, which are forms of government spending and taxation that change automatically to offset fluctuations.
Types of taxes
The first most important source of tax revenue is income tax, and the second most important is value added tax(VAT). Income tax is a direct and progressive tax, a tax that takes a higher percentage from the rich peoples income. VAT is indirect and regressive tax, a tax that takes a greater percentage of the income of poor.
Government spending, which is also called public spending or public expenditure can be divided into:
- Capital expenditure(e.g, hospitals, schools roads etc.
- Current spending (e.g public services, teachers pay etc)
- Transfer payment ( e.g pensioners unemployed)
- Debt interest payment ( e.g, payments made to holders of government debt)
Budget provides information on the budget position in the past year and prediction for future years. Budget position shows relationship between government spending and tax revenue. A budget deficit may occur because of the cyclical or structural factors. If there is a recession( fall in real GDP or negative growth), taxes revenue will likely to fall and government spending on benefits is likely to increase.
Monetary policy is the government decisions on the rate of interest, the money supply and the exchange rates. Main monetary policy that is used almost in the whole world is the rate of interests. A higher interest rate may reduce consumption and lower firms investment. Rise in interest rates may decrease AD by reducing consumption, investment and exports minus imports.
It’s a policy that government use to increase aggregate supply by improving the efficiency of labour and product markets. There are some examples of supply-side policies. For example government invests in training, education, small firms, to encourage competitions. Training and education should raise the efficiency of labour and output per worker will be increased, potential output of the economy will rise, AS will shift to right. Government provides for unemployed people an educational and training courses, so they can raise their skills and experience.
Government assistance to new firms
New small firms provide employment, develop entrepreneurial skills, provide new ideas. But also they may find it difficult to break in established market. Government may help them buy subsidizing them charging low rate of corporation tax(a tax on firms, profit).
Privatasion is the transfer of assets from public sector to private sector. Some economists argue by saying that government shouldn’t intervene, they believe that private sector firms are in the best position to make decisions about what to produce, how to produce what to charge.
But other economist think opposite. They argue that government should intervene, because of the high risks of the market failure.
Policies to reduce umenployment
Because of the unemployment, economy could be operating below it’s productive capacity, but unemployment may be reduced by increase in AD. In that case , expansionary fiscal or monetary policy could be used to create jobs. Increase in the money supply or lower interest rates are also likely to raise AD. A fall in interest rates or increase in money supply should stimulate consumption and investment.
Unemployment may exist even if there is not shortage of AD, it’s because of the supply side problems. Those people who are out work when the level of AD is high. And inefficiency of labour, lack of skills can cause output to decrease.
Supply-side policies can be applied to increase incentives and the quality of labour services offered by the unemployed.
Policies to control inflation
If government thinks that inflation is caused by excessive increase in wage rates, it may try to stop an increase in wage rates. It can also restrict wage rises in both public and private sectors by introducing an income policy. Government may try to reduce firms cots by reducing corporation tax. This will have the advantage to stimulate investment. Government can even provide subsidies in order to help firms to cover their costs. But subsidies may be a failure if the firms will still be inefficient.
In order to reduce demand-pull inflation government may use deflationary fiscal or monetary police instruments. These help to reduce inflation by lowering AD. Government could raise income tax. This would reduce people’s disposable income, and they will spend less.
Effectiveness of fiscal policy
- Number of taxes, forms of government spending set automatically to offset Fluctuations in real GDP.
- Government spending and taxation, including cuts in corporation tax and training grants, have a chance to increase both AD and AS
It takes time for government spending and taxation to affect the economy.
There is a time lag between introducing fiscal policy instruments.
Number of government spending is inflexible( difficult to spending on health, education)
Based accurate information(a prediction saying that recession might lead to a change in expectations.)
Firms and households may react in unexpected ways( cut in income taxes etc)
Adverse effect on incentives and other macroeconomic objectives.
Can be offset by changes in the economic activities in other countries.
Possible conflicts between policy objectives
The objectives of economic growth and low unemployment may benefit from expansionary demand-side policy measures. Such a measures may make government to achieve low inflation and a satisfactory balance of payments position.
Methods of protection
International free trade occurs when there is no restrictions imposed on the movement of goods and services into and out of countries. Protectionism ( protection of domestic industries from foreign competitions) results in the careful restrictions of free movements of goods and services.
Voluntary export restraint(VER)
It’s a limit placed on imports from a country with the agreement of that country’s government. A country may agree to restrict it’s exports in return for a similar limit being put on the exports of the other country.