FISCAL POLICY

The fiscal policy is concerned with the raising of government revenue and incurring of government expenditure. To generate revenue and to incur expenditure, the government frames a policy called budgetary policy or fiscal policy. So, the fiscal policy is concerned with government expenditure and government revenue.

Fiscal policy has to decide on the size and pattern of flow of expenditure from the government to the economy and from the economy back to the government. So, in broad term fiscal policy refers to "that segment of national economic policy which is primarily concerned with the receipts and expenditure of central government." In other words, fiscal policy refers to the policy of the government with regard to taxation, public expenditure and public borrowings.

The importance of fiscal policy is high in underdeveloped countries. The state has to play active and important role. In a democratic society direct methods are not approved. So, the government has to depend on indirect methods of regulations. In this way, fiscal policy is a powerful weapon in the hands of government by means of which it can achieve the objectives of development.

Main Objectives of Fiscal Policy  ↓

The fiscal policy is designed to achive certain objectives as follows :-

1. Development by effective Mobilisation of Resources

The principal objective of fiscal policy is to ensure rapid economic growth and development. This objective of economic growth and development can be achieved by Mobilisation of Financial Resources.

The central and the state governments in India have used fiscal policy to mobilise resources.

The financial resources can be mobilised by :-

1.      Taxation : Through effective fiscal policies, the government aims to mobilise resources by way of direct taxes as well as indirect taxes because most important source of resource mobilisation in India is taxation.

2.      Public Savings : The resources can be mobilised through public savings by reducing government expenditure and increasing surpluses of public sector enterprises.

3.      Private Savings : Through effective fiscal measures such as tax benefits, the government can raise resources from private sector and households. Resources can be mobilised through government borrowings by ways of treasury bills, issue of government bonds, etc., loans from domestic and foreign parties and by deficit financing.

2. Efficient allocation of Financial Resources

The central and state governments have tried to make efficient allocation of financial resources. These resources are allocated for Development Activities which includes expenditure on railways, infrastructure, etc. While Non-development Activities includes expenditure on defence, interest payments, subsidies, etc.

But generally the fiscal policy should ensure that the resources are allocated for generation of goods and services which are socially desirable. Therefore, India's fiscal policy is designed in such a manner so as to encourage production of desirable goods and discourage those goods which are socially undesirable.

3. Reduction in inequalities of Income and Wealth

Fiscal policy aims at achieving equity or social justice by reducing income inequalities among different sections of the society. The direct taxes such as income tax are charged more on the rich people as compared to lower income groups. Indirect taxes are also more in the case of semi-luxury and luxury items, which are mostly consumed by the upper middle class and the upper class. The government invests a significant proportion of its tax revenue in the implementation of Poverty Alleviation Programmes to improve the conditions of poor people in society.

4. Price Stability and Control of Inflation

One of the main objective of fiscal policy is to control inflation and stabilize price. Therefore, the government always aims to control the inflation by Reducing fiscal deficits, introducing tax savings schemes, Productive use of financial resources, etc.

5. Employment Generation

The government is making every possible effort to increase employment in the country through effective fiscal measure. Investment in infrastructure has resulted in direct and indirect employment. Lower taxes and duties on small-scale industrial (SSI) units encourage more investment and consequently generates more employment. Various rural employment programmes have been undertaken by the Government of India to solve problems in rural areas. Similarly, self employment scheme is taken to provide employment to technically qualified persons in the urban areas.

6. Balanced Regional Development

Another main objective of the fiscal policy is to bring about a balanced regional development. There are various incentives from the government for setting up projects in backward areas such as Cash subsidy, Concession in taxes and duties in the form of tax holidays, Finance at concessional interest rates, etc.

7. Reducing the Deficit in the Balance of Payment

Fiscal policy attempts to encourage more exports by way of fiscal measures like Exemption of income tax on export earnings, Exemption of central excise duties and customs, Exemption of sales tax and octroi, etc.

The foreign exchange is also conserved by Providing fiscal benefits to import substitute industries, Imposing customs duties on imports, etc.

The foreign exchange earned by way of exports and saved by way of import substitutes helps to solve balance of payments problem. In this way adverse balance of payment can be corrected either by imposing duties on imports or by giving subsidies to export.

8. Capital Formation

The objective of fiscal policy in India is also to increase the rate of capital formation so as to accelerate the rate of economic growth. An underdeveloped country is trapped in vicious (danger) circle of poverty mainly on account of capital deficiency. In order to increase the rate of capital formation, the fiscal policy must be efficiently designed to encourage savings and discourage and reduce spending.

9. Increasing National Income

The fiscal policy aims to increase the national income of a country. This is because fiscal policy facilitates the capital formation. This results in economic growth, which in turn increases the GDP, per capita income and national income of the country.

10. Development of Infrastructure

Government has placed emphasis on the infrastructure development for the purpose of achieving economic growth. The fiscal policy measure such as taxation generates revenue to the government. A part of the government's revenue is invested in the infrastructure development. Due to this, all sectors of the economy get a boost.

11. Foreign Exchange Earnings

Fiscal policy attempts to encourage more exports by way of Fiscal Measures like, exemption of income tax on export earnings, exemption of sales tax and octroi, etc. Foreign exchange provides fiscal benefits to import substitute industries. The foreign exchange earned by way of exports and saved by way of import substitutes helps to solve balance of payments problem.

Conclusion On Fiscal Policy ↓

The objectives of fiscal policy such as economic development, price stability, social justice, etc. can be achieved only if the tools of policy like Public Expenditure, Taxation, Borrowing and deficit financing are effectively used.

Though there are gaps in India's fiscal policy, there is also an urgent need for making India's fiscal policy a rationalised and growth oriented one.

The success of fiscal policy depends upon taking timely measures and their effective administration during implementation

Fiscal policy plays an important role in influencing the economic direction of the country. When speaking of fiscal policy, the government generally is referring to two major governmental economic activities, taxation and spending. The national budget is the major fiscal instrument by which the federal government determines how much of its energy and resources to devote to these two major activities. The development of a fiscal policy generally has four primary purposes or functions.

Allocation

The first major function of fiscal policy is to determine exactly how funds will be allocated. This is closely related to the issues of taxation and spending, because the allocation of funds depends upon the collection of taxes and the government using that revenue for specific purposes. The national budget determines how funds are allocated. This means that a specific amount of funds is set aside for purposes specifically laid out by the government. This has a direct economic impact on the country.

Distribution

Whereas allocation determines how much will be set aside and for what purpose, the distribution function of fiscal policy is to determine more specifically how those funds will be distributed throughout each segment of the economy. For instance, the government might allocate $1 billion toward social welfare programs, but $100 million could be distributed to food stamp programs, while another $250 million is distributed among low-cost housing authority agencies. Distribution provides the specific explanation of what allocation was intended for in the first place.

Stabilization

Stabilization is another important function of fiscal policy in that the purpose of budgeting is to provide stable economic growth. Without some restraints on spending, the economic growth of the nation could become unstable, resulting in periods of unrestrained growth and contraction. While many might frown upon governmental restraint of growth, the stock market crash of 1929 made it clear that unfettered growth could have serious consequences. The cyclical nature of the market means that unrestrained growth cannot continue for an indefinite period. When growth periods end, they are followed by contraction in the form of recessions or prolonged recessions known as depressions. Fiscal policy is designed to anticipate and mitigate the effects of such economic lulls.

Development

The fourth major function of fiscal policy is that of development. Development seems to indicate economic growth, and that is, in fact, its overall purpose. However, fiscal policy is far more complicated than determining how much the government will tax citizens one year and then determining how that money will be spent. True economic growth occurs when various projects are financed and carried out using borrowed funds. This stems from the the belief that the private sector cannot grow the economy by itself. Instead, some government input and influence are needed. Borrowing funds for this economic growth is one way in which the government brings about development. This economic model developed by John Maynard Keynes has been adopted in various forms since the World War II era.

Cost benefit analysis

A cost benefit analysis is done to determine how well, or how poorly, a planned action will turn out. Although a cost benefit analysis can be used for almost anything, it is most commonly done on financial questions. Since the cost benefit analysis relies on the addition of positive factors and the subtraction of negative ones to determine a net result, it is also known as running the numbers.

A cost benefit analysis finds, quantifies, and adds all the positive factors. These are the benefits. Then it identifies, quantifies, and subtracts all the negatives, the costs. The difference between the two indicates whether the planned action is advisable. The real trick to doing a cost benefit analysis well is making sure you include all the costs and all the benefits and properly quantify them.

Should we hire an additional sales person or assign overtime? Is it a good idea to purchase the new stamping machine? Will we be better off putting our free cash flow into securities rather than investing in additional capital equipment? Each of these questions can be answered by doing a proper cost benefit analysis.

Example Cost Benefit Analysis

As the Production Manager, you are proposing the purchase of a $1 Million stamping machine to increase output. Before you can present the proposal to the Vice President, you know you need some facts to support your suggestion, so you decide to run the numbers and do a cost benefit analysis.

You itemize the benefits. With the new machine, you can produce 100 more units per hour. The three workers currently doing the stamping by hand can be replaced. The units will be higher quality because they will be more uniform. You are convinced these outweigh the costs.

There is a cost to purchase the machine and it will consume some electricity. Any other costs would be insignificant.

You calculate the selling price of the 100 additional units per hour multiplied by the number of production hours per month. Add to that two percent for the units that aren't rejected because of the quality of the machine output. You also add the monthly salaries of the three workers. That's a pretty good total benefit.

Then you calculate the monthly cost of the machine, by dividing the purchase price by 12 months per year and divide that by the 10 years the machine should last. The manufacturer's specs tell you what the power consumption of the machine is and you can get power cost numbers from accounting so you figure the cost of electricity to run the machine and add the purchase cost to get a total cost figure.

You subtract your total cost figure from your total benefit value and your analysis shows a healthy profit. All you have to do now is present it to the VP, right? Wrong. You've got the right idea, but you left out a lot of detail.

Running The Numbers Means All The Numbers

Lets look at the benefits first. Don't use the selling price of the units to calculate the value. Sales price includes many additional factors that will unnecessarily complicate your analysis if you include them, not the least of which is profit margin. Instead, get the activity based value of the units from accounting and use that. You remembered to add the value of the increased quality by factoring in the average reject rate, but you may want to reduce that a little because even the machine won't always be perfect. Finally, when calculating the value of replacing three employees, in addition to their salaries, be sure to add their overhead costs, the costs of their benefits, etc., which can run 75-100% of their salary. Accounting can give you the exact number for the workers' "fully burdened" labor rates.

In addition to properly quantifying the benefits, make sure you included all of them. For instance, you may be able to buy feed stock for the machine in large rolls instead of the individual sheets needed when the work is done by hand. This should lower the cost of material, another benefit.

As for the cost of the machine, in addition to it's purchase price and any taxes you will have to pay on it, you must add the cost of interest on the money spent to purchase it. The company may purchase it on credit and incur interest charges, or it may buy it outright. However, even if it buys the machine outright, you will have to include interest charges equivalent to what the company could have collected in interest if it had not spent the money.

Check with finance on the amortization period. Just because the machine may last 10 years, doesn't mean the company will keep it on the books that long. It may amortize the purchase over as little as 4 years if it is considered capital equipment. If the cost of the machine is not enough to qualify as capital, the full cost will be expensed in one year. Adjust your monthly purchase cost of the machine to reflect these issues. You have the electricity cost figured out but there are some cost you missed too.

Optimal fiscal policy under commitment

Ramsey approach to the optimal taxation

“Ramsey approach to optimal taxation” is a solution to the problem of choosing optimal taxes and transfers given that only distortionary tax instruments are available.

A starting point of a Ramsey problem is postulating tax instruments. Usually, it is assumed that only linear taxes are allowed. Importantly, lump sum taxation is prohibited. Another assumption crucial to this approach is that all activities of agents are observable.

Given the set of taxes, a social planner (government) maximizes its objective function given that agents (firms and consumers) are in a competitive equilibrium. Usually, it is assumed that government’s objective is to finance an exogenously given level of expenditures. It is important to note that, if lump sum taxes were allowed, then the first welfare theorem would hold, and the unconstrained optimum would be achieved.

There are two common approaches to solving Ramsey problems. The first is the primal approach, which characterizes a set of allocations that can be implemented as a competitive equilibrium with taxes. By implementation we mean: for a set of taxes find a set of (consumption and labor) allocations and equilibrium prices such that these allocations are a competitive equilibrium given taxes. Conversely, a set of (consumption and labor) allocations is implementable if it is possible to find taxes and equilibrium prices such that these allocations are a competitive equilibrium given these prices and taxes. Implementation often makes it possible to simplify a Ramsey problem by reformulating a problem of finding optimal taxes as the problem of finding implementable allocations. This reformulation of the problem is referred to as a primal approach to Ramsey taxation.

Main lessons of Ramsey taxation: uniform commodity taxation, zero capital tax in the long run, and tax smoothing.

One of the central results of the literature on Ramsey taxation is uniform commodity taxation (Atkinson and Stiglitz 1972). Consider a model with a finite set of consumption goods that can be allocated between government and private consumption. All of these goods are produced with labor. Assume that each consumption good can be taxed at a linear rate. Then, under certain separability and homotheticity assumptions, commodity taxation is uniform, i.e. the optimal taxes are equated across consumption goods.

Ramsey taxation provides a compelling argument against taxing capital income in the long run in a model of infinitely lived households. The Chamley-Judd result (Chamley 1986, Judd 1985) states that in a steady state there should be no wedge between the intertemporal rate of substitution and the marginal rate of transformation, or, alternatively, that the optimal tax on capital is zero. The intuition for the result is that even a small intertemporal distortion implies increasing taxation of goods in future periods in contrast to the prescription of the uniform commodity taxation. Therefore, distorting the intertemporal margin is very costly for the planner. Jones, Manuelli, and Rossi (1997) extend the applicability of the Chamley-Judd result by showing that the return to human capital should not be taxed in the long run. Chari, Christiano, and Kehoe (1994) provide the state-of-the art numerical treatment of optimal Ramsey taxation over the business cycle and conclude that the ex ante capital tax rate is approximately zero.

There has been a long debate on the optimal composition of taxation and borrowing to finance government expenditures. Barro (1979) considered a partial equilibrium economy and argued that it is optimal to smooth distortions from taxation over time, a policy referred as tax smoothing. The implication of this analysis is that optimal taxes should follow a random walk. Lucas and Stokey (1983) considered an optimal policy in a general equilibrium economy without capital, and showed that if government has access to state contingent bonds optimal taxes inherit the stochastic process of the shocks to government purchases. Chari, Christiano and Kehoe (1994) extended this analysis to an economy with capital and showed the Lucas and Stokey results remain valid in that set up with or without state contingent debt, as long as the government can use taxes on capital to effectively vary the ex-post after tax rate of return on bonds. Finally, Aiyagari et al. (2002) analysis showed that if ex-post taxation of returns is impossible, the optimal taxes follow a process similar to a random walk. They also showed the conditions under which the tax smoothing hypothesis is valid.

Mirrlees Approach to optimal taxation

The Mirrlees approach to optimal taxation is built on a different foundation than Ramsey taxation. Rather than stating an ad hoc restricted set of tax instruments as in Ramsey

the set of taxes that implement the optimal allocation. This setup allows arbitrary nonlinear taxes, including lump-sum taxes.

The informational friction posed in those models is unobservability of agent’s skills: only labor income of agents can be observed. Therefore, from a given level of labor income it cannot be determined whether a high skill agent provides a low amount of labor or effort, or whether a low skill agent works a prescribed amount. The objective of the social planner (government) is to maximize ex-ante, before the realization of the shocks, utility of an agent. This objective can be interpreted as either insurance against adverse shocks or as ex-post redistribution across agents of various skills. An informational friction imposes incentive compatibility constraints on the planner’s problem: allocations of consumption and effective labor must be selected such that an agent chooses not to misrepresent its type.

In summary, the objective of the Mirrlees approach is to find the optimal incentive-insurance tradeoff: how to provide the best insurance against adverse events (low realizations of skills) while providing incentives for the agents to reveal their types (provide high amount of labor).

Main lessons of Mirrlees approach in a static framework.

Theoretical results providing general characterization of the optimal taxes in the static Mirrlees environment are limited. The central result is that the consumption-leisure margin of an agent with the highest skill is undistorted, implying that the marginal income tax at the top of the distribution should be optimally set equal to zero. Saez (2001) is a state-of-the art treatment of the static Mirrlees model in which he derives a link between the optimal tax formulas and elasticities of income. Mirrlees (1971) was also able to establish broad conditions that would ensure that the optimal marginal tax rate on labor income was between 0 and 100 percent.

Main lessons of dynamic Mirrlees literature: distorted intertemporal margin

Recent literature starting with Golosov, Kocherlakota, and Tsyvinski (2003) and Werning (2001) extends the static Mirrlees (1971) framework to dynamic settings. Golosov, Kocherlakota, and Tsyvinski (2003) consider an environment with general dynamic stochastically evolving skills. An example of a large unobservable skill shock is disability that is often difficult to observe (classical example is back pain or mental illness). Golosov, Kocherlakota, and Tsyvinski (2003) show for arbitrary evolution of skills that, as long as the probability of agent’s skill changing is positive, any optimal allocation includes a positive intertemporal wedge: a marginal rate of substitution across periods is lower than marginal rate of transformation. The reason for this is that this wedge improves the intertemporal provison of incentives by implicitly discouraging savings. This result holds even away from the steady state and sharply contrasts with the

Optimal monetary policy

The theory of the optimal monetary policy is closely related to the theory of optimal taxation. Phelps (1973) argued that the inflation tax is similar to any other tax, and therefore should be used to finance government expenditures. Although intuitively appealing, this argument is misleading. Chari, Christiano and Kehoe (1996) extended the Ramsey approach to analyze optimal fiscal and monetary policy jointly in several monetary models, and found that typically it is optimal to set the nominal interest rate to be equal to zero. Such policy, called a Friedman rule, after Milton Friedman, who was one of the first proponents of zero nominal interest rates (Friedman (1969)). To understand intuition for the optimality of Friedman rule, it is useful to think about a distinctive feature of money from other goods and assets. In most models, money play a special role of providing liquidity services to households that cannot be obtained by using other assets such as bonds. Inefficiency arises if the rates of return on bonds and money are different, since households, by holding money balances lose the interest rate. When a nominal interest rate is equal to zero, which in deterministic economy implies that inflation is negative, with nominal prices declining with the rate of households time preferences, the real rates of return on money and bonds are equalized, and this inefficiency is eliminated.

Good taxation

Although Adam Smith is often quoted, the so-called "Father of Economics" has rarely been read, either by his detractors or his admirers. Consequently he is often misunderstood.

Smith, who made such a strong stand against the protectionist mercantile system of trade of his day, devoted over ONE THIRD of his masterpiece An Inquiry into the Nature and Causes of the Wealth of Nations, to discussing the subject of government revenue and the methods by which it may be best collected, including new taxes. This is not generally known.

When examining the different forms of taxation, Smith adheres to four maxims which a good tax should conform to:

1. "The subject of every State ought to contribute towards the support of the government, as nearly as possible, in proportion to their respective abilities; that is, in proportion to the revenue which they respectively enjoy under the protection of the State."

2. "The tax each individual is bound to pay ought to be certain, and not arbitrary. The time of payment, the manner of payment, and the quantity to be paid, ought all to be clear and plain to the contributor, and to ever other person."

3. "Every tax ought to be levied at the time, or in the manner in which it is most likely to be convenient for the contributor to pay it."

4. "Every tax ought to be so contrived as both to take out and to keep out of the pockets of the people as little as possible, over and above what it brings into the public treasury of the State."

Bearing all these things in mind, there are two types of taxation which obtain Smith's recommendations: a tax on luxury consumables and a tax on ground-rents (the annual value of holding a piece of land).

On the subject of luxury consumables, he is adamant about the definiton of 'luxury' and of 'necessary.' By his definition, a 'necessary' may vary from place to place and from time to time. At the time of his writing, linen shirts, leather shoes and a minimum of food and shelter were definitely to be regarded as essential to a minumum decent standard of living. Taxes on salt, soap, etc., he harshly criticized as inequitably taking from the poorest elements of society. Taxes on luxuries, which were to include tobacco, he considered excellent in that no one is obliged to contribute to the tax: "Taxes upon luxuries have no tendency to raise the price of any other commodities except that of the commodities taxed ... Taxes upon luxuries are finally paid by the consumers of the commodities taxed, without any retribution."

More deserving of priase is the tax on ground-rents: "Both ground- rents and the ordinary rent of land are a species of revenue which the owner, in many cases, enjoys without any care or attention of his own. The annual produce of the land and labour of the society, the real wealth and revenue of the great body of the people, might be the same after such a tax as before. Ground-rents, and the ordinary rent of land are, therefore, perhaps the species of revenue which can best bear to have a peculiar tax imposed upon them."

Excise, customs, taxes on profits, were, according to Smith, either expensive to collect, as in the case of excise, or disincentives to produce, as in the tax on profits. He reserves harsh words for taxes which occasion the invasion of privacy, and on the subject of excise he says: "To subject every private family to the odious visits and examination of the tax-gatherers ... would be altogether inconsistent with liberty."

The harshest condemnation of all, however, was for taxes upon labour: "In all cases, a direct tax upon the wages of labour must, in the long run, occasion both a greater reduction in the rent of land, and a greater rise in the price of manufactured goods, than would have followed from a proper assessment of a sum equal to the produce of the tax, [levied] partly upon the rent of land, and partly upon consumable commodities."

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