BQ Learning: What's Fiscal Policy And How Does It Work?
Governments tax, borrow and spend. How, when, at what level—that's the remit of fiscal policy.
This is a series of explainers to educate and inform watchers of the economy. In association with CRISIL as knowledge partner.
What is fiscal policy?
Governments tax, borrow and spend.
How, when, at what level—that's the remit of fiscal policy.
Essentially, the objective of fiscal policy is to support economic growth. By adjusting the level and type of spending, by borrowing, and by changing tax rates, governments influence individuals’ and businesses’ demand for consumption and investment.
Policy makers have two tools to influence this demand—fiscal and monetary. Monetary policy used by central banks alters money supply, and influences market interest rates.
How does fiscal policy work?
Fiscal policy can be expansionary or contractionary.
An expansionary policy encourages demand by stoking spending, reducing taxes, or both. A contractionary policy seeks to reduce demand by doing the opposite.
Theoretically, in the short term, the size or direction of spending depends on what the government is trying to stabilise. It may go expansionary when it perceives demand to be weak, or contractionary, when inflation is spiraling.
Recall the national income accounting equation from our first post in the series. We measured the country’s gross domestic product (GDP) from the demand side as:
GDP= C+I+G+(X-M)
Where C= private consumption expenditure, I= investment (both, by private sector and government), G= government consumption expenditure, X= exports of goods, M= imports.
This equation also helps us trace how fiscal policy works its way through the economy.
A change in G can directly change GDP. Or, it can indirectly influence C, I and (X-M). Here’s how:
Let’s say, the government allocates more funds to the rural employment guarantee works programme. The idea is to provide for more jobs in rural areas, more wages in the hands of workers, and more consumption by them (‘C’ goes up). Or, if the government slashes taxes on a particular category of goods, that has the same effect too. More government spend on infrastructure (say, roads, bridges) may lead to increase in demand for intermediate inputs (cement, steel) from the private sector (‘I’ goes up).
What factors influence fiscal policy?
Governments are understood to be constrained in how much they can expand spending, as these expenditures are financed by the revenue they collect (primarily through taxes). Governments generally need to spend much more than they earn in revenue—this gap is called the fiscal deficit. Sure, it can borrow in the financial markets to cover this gap, but this also pushes up its debt levels. High debt levels and the need to service it can reduce government’s ability to spend in the future.
Hence, most countries have instituted "fiscal rules" which stipulate the size of deficits or level of debts that are permissible. For instance, India’s Fiscal Responsibility and Budgetary Management Act, 2003, places a limit on the central government’s fiscal deficit at 3% of its GDP for a given year, subject to conditions of the economy. This target, however, has often been pushed back.
What was the Indian government’s fiscal response to the pandemic?
As the pandemic hit, the central government announced its Atmanirbhar package aimed at reducing financial stress among the most affected sections of society. Food rations, cash transfers to the poor, accelerated payments to farmers under PM-KISAN, collateral free credit for businesses (including micro, small and medium enterprises) and equity infusion were some of the immediate measures.
More measures followed in the second half of fiscal 2021 targeting consumption and public investment, in the form of interest-free advances to government employees, a production-linked incentive scheme, additional subsidies, capital expenditure and further support for rural employment.
In sum, the government’s above-the-line measures i.e. direct additional spending or foregone revenue, amounted to 3.5% of GDP in 2020 (IMF Fiscal Monitor database, July 2021). That was lower than the 4.1% of GDP average spend by emerging market economies (EMEs). The thrust of India’s response was on below-the-line measures (equity injections, provision of loans and guarantees), which totaled 5.2% of GDP (vs 2.6% EME average).
This is the second part in a BQ Learning series on core economic concepts.