Discuss the major instruments of fiscal policy? Elaborate on how tax rates can be utilized for encouraging/discouraging investment or demand in the economy?
Answers
Following are the important instruments of fiscal policy, and how they work :-
- Taxation policy :- Taxes determine the size of disposable income in the hands of general public. Lower taxes lead to high disposable, which means that people have more money in hand to spend or invest, which fuels higher demand. This demand leads firms to hire more, thereby decreasing unemployment. Less unemployment gives labourers a wage/income to spend on goods and services or invest. It’s a virtuous cycle. This expansionary fiscal policy can be used by the government when the economy is undergoing a recessionary phase. Government lowers the tax rates to increase aggregate demand and fuel economic growth.
- Public expenditure :- Government may also seek economic expansion through increases in spending/expenditure. By undertaking more public works; for example, building more highways, government can increase employment in the form of labour employed for such activities. More employment gives labourers a wage/income to spend on goods and services or invest, thus pushing up demand and growth.
- Public Debt :- Government also at times borrows to bring about economic stability and full employment in the economy. In case of a budget deficit, where government’s expenditure is more than its revenue, government has to borrow from domestic or foreign sources in order to meet the deficit. It can borrow from the public by issuing bonds or take a loan from any international finance institute. This borrowing can be used to pay interest payments on previous loans, finance new construction projects, or to undertake public welfare schemes etc. Government can also print money to finance the deficit, called deficit financing. This however has inflationary consequences.
Working mechanism of fiscal policy :-
A fiscal policy works through changes in (i) aggregate demand and economic activity (ii) saving and investment (iii) income distribution (iv) allocation of resources. As discussed above, a lower tax rate fuels higher demand in the economy. It does so by leaving a higher disposable income in hands of general public, allowing the consumer to spend or save the additional sum :-
- If consumer spends the additional income on purchase of more goods and services, it boosts aggregate demand directly. It indirectly boosts investment activity because now suppliers will have to undertake more production in order to meet the increased demand.
- A higher disposable income in hands of the consumer can also be saved instead. This saving goes to the bank and gets channelised into the larger process of capital formation in the economy. Banks lend this money to borrowers who undertake investment projects.
- Supply side tax cuts, like corporate tax cut, are aimed to stimulate capital formation. Lower taxes on business activities directly encourage investment activity.
Hence, we see that fiscal policy is a key strategy used by governments to advance their economic objectives. Generally, an optimum policy mix of fiscal and monetary policy is used to achieve macroeconomic goals. There are two powerful tools our government and central bank use to steer the economy in right direction.
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Taxation policy :- Taxes determine the size of disposable income in the hands of general public. Lower taxes lead to high disposable, which means that people have more money in hand to spend or invest, which fuels higher demand. ... Government lowers the tax rates to increase aggregate demand and fuel economic growth.
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