Fiscal Policy in India: Objectives, Tools, Importance
Table of Contents
- jaro Education
- 14, July 2024
- 6:00 pm
Have you ever thought about how the government of India controls inflation while advancing economic growth and increasing the creation of jobs at the same time? The solution to this problem is in a strong economic tool called fiscal policy.
In its simplified form, the fiscal policy is defined as how the government utilizes taxes and government expenditure to dictate the course of the economy. When we discuss fiscal policy in India, we are examining a country where the government uses a balance between such instruments as a way of ensuring that financial stability is sustained, unemployment is minimized, and inflation is kept at bay, as well as bringing more people on board in terms of growth.
This blog discusses the aims of fiscal policy, the instruments of the fiscal policy that the government administers, and the significance of the fiscal policy overall in determining the financial health of India. Being a student, or a policymaker, or even someone who is simply interested in defining how the Indian economy can be run, this guide will enlighten you on how to regard the fiscal policy simply and understandably.
What is Fiscal Policy?
Fiscal policy refers to using government taxation and spending to influence the economy. It is essential for achieving macroeconomic goals such as job growth, controlling inflation, and reducing unemployment. By altering the economy’s total demand, it impacts economic activity. The government can adjust spending levels or modify tax rates to achieve its desired financial outcomes.
Objectives of Fiscal Policy
The objectives of Fiscal policy aim to achieve several key objectives that support economic stability and growth. These objectives include:
Full Employment
The primary goal of this policy in a developing economy is to achieve and maintain full employment. Even if full employment is not attainable, the focus is on minimizing unemployment and achieving near-full employment. The state should invest significantly in social and economic infrastructure to create more job opportunities and enhance the economy’s productive efficiency.
Price Stability
Price fluctuations affect various societal groups, including consumers, laborers, employees, agriculturists, producers, and traders. Rising prices can negatively impact the general public. The objective of fiscal policy is to stabilize prices by addressing price increases or decreases. This can be achieved through subsidies or tax reductions to mitigate the impact of rising prices.
Accelerating Economic Development
The policy should aim to accelerate economic growth in a developing economy. Proper use of fiscal measures such as taxation, public borrowing, and deficit financing is essential to ensure that production, consumption, and distribution are not negatively affected. These measures should promote overall economic growth, raising national and per capita income.
Optimum Allocation of Resources
Fiscal measures like taxation and public expenditure significantly influence resource allocation across various sectors. Public spending through subsidies and incentives can direct resources toward desired areas. For example, tax exemptions and concessions can attract resources to favored industries, while high taxation can deter resources from specific sectors.
Equitable Distribution of Income and Wealth
A welfare state should ensure social justice through equitable income and wealth distribution. The objective of Fiscal policy is an effective tool of fiscal policy for achieving this goal in developed and developing countries. A progressive tax system is particularly useful in realizing this objective. Additionally, public expenditure can help redistribute income from the wealthy to the poorer sections of society.
Economic Stability
Economic stability is another critical aim of sound fiscal policy, encompassing the maintenance of full employment with relative price stability. The policy should curb inflation and avoid deflation. This policy pursues the twin objectives of economic growth and stability. Measures should boost growth while controlling inflationary pressures. It also helps stabilize the economy against short-term international cyclical fluctuations, which often favor developed economies at the expense of developing ones.
Capital Formation
The objective of Fiscal policy is to increase investment rates in both the private and public sectors. Developing countries often have low capital formation rates due to unemployment and low per capita income, perpetuating the cycle of poverty. It should reduce undesirable consumption and encourage savings to increase capital formation.
Attraction of Foreign Investment
Fiscal incentives, such as customs duty exemptions and excise duty concessions, attract foreign investment, bolstering domestic production and foreign exchange earnings.
These two objectives of fiscal policy are complementary: achieving economic stability and growth.
Various Types of Fiscal Policies
Different types of fiscal policies are as follows:
- Contractionary Fiscal Policy
Contractionary fiscal policy involves cutting government spending or raising taxes, resulting in tax revenue exceeding government spending. This approach reduces aggregate demand in the economy, slowing economic growth and alleviating inflationary pressures.
- Expansionary Fiscal Policy
Expansionary policy stimulates the economy, especially during recession periods when national income growth is insufficient to maintain the current living standards of the population. This approach involves tax cuts and increased government spending to boost economic growth and reduce unemployment rates. However, this method could be more sustainable in the long term, as it can lead to a budget deficit. Therefore, it should be used with caution.
- Neutral Fiscal Policy
A neutral fiscal policy balances government spending with tax revenue, meaning that all tax revenue is fully utilized for government spending. This approach ensures that the overall budget has a neutral effect on the level of economic activities.
How Does Fiscal Policy Operate?
The fiscal policy is conducted by utilization of two significant tools: taxation and government spending. These are tools applied to affect the entire economic activity and maintain a stable condition.
When the economy experiences a deceleration or recession, it means that consumers are less interested in spending and businesses are less eager to invest. In response, the government can adopt an expansionary fiscal policy that involves reducing taxes and increasing government spending. A decrease in taxes provides people and companies more disposable income, promoting increased consumption and investment. As a result, demand will rise, businesses will grow, and employment opportunities will increase, which in turn stimulates economic growth.
Conversely, when the economy is producing too much, other than what is needed by the people at the prevailing rates, then the government pursues a contractionary fiscal policy. This involves increased taxes and reduced expenditure. Increased taxes decrease the disposable income, which slows consumer demand, leading to a curb on inflation.
The key mission that fiscal policy seems to have is to balance economic growth and price stability. The government balances tax rates and government spending so that the economic climate allows long-run development.
Tools of Fiscal Policy
Just imagine a big household as a country. Just as a family arranges its revenues and expenditures so that it may be in good economic health, a government operates fiscal policy to help it control the economy of the country. It determines the expenditure level and tax revenues. These policies assist in checking inflation, high unemployment rates, and economic growth.
The government has at its disposal two tools that are effective in doing this- Government Spending and Taxation.
- Government Spending
This implies that the government uses money on infrastructure (such as roads and bridges), education, health, defense, and welfare of the people.
Use:
- Increases economic activity through the creation of jobs and demand.
- Assists in the case of recession or slowdowns.
- Gives welfare to the disadvantaged.
Importance:
The more the government spends, the more money is available in the hands of people. This raises the buying capacity and is a boost to business and industry.
An example is when the government has been experiencing a recession, it can contribute funds to constructing highways to generate employment and improve the construction industry.
- Taxation
It is the money collected by the government in the shape of taxes that people and companies pay, such as the income tax, GST, excise duty, etc.
Use:
- Regulates the amount of money that people can spend (helps to control inflation).
- Finance government projects and government services.
- It can be controlled to facilitate savings or investments.
Importance:
Tax policy may increase spending by lowering taxes or decrease spending by increasing taxes, depending on the requirements of the economy.
Example: The Government can also raise taxes in periods of inflation to decrease the amount of money in the system.
How These Tools Work Together
| Situation | Government Spending | Taxation | Result |
|---|---|---|---|
| Recession | Increase | Decrease | Boosts economy & jobs |
| Inflation | Decrease | Increase | Controls prices and demand |
The Cyclicality of Fiscal Policy
The cyclicality of fiscal policy refers to adjusting government expenditures and taxes in response to economic conditions and fluctuations in economic growth. There are two main types of cyclical budgetary policies:
- Counter-Cyclical Fiscal Policy
Counter-cyclical policy involves taking actions that oppose the direction of the economic or business cycle. For instance, the government typically adopts expansionary budgetary policies during a recession or economic slowdown. These entail increasing expenditures and reducing taxes to stimulate demand, thereby aiding economic recovery. By boosting consumption potential, these measures help mitigate the effects of the recession.
- Pro-Cyclical Fiscal Policy
The pro-cyclical policy involves actions that reinforce the business cycle by being expansionary during economic prosperity and contractionary during recessions. However, pursuing pro-cyclical objectives of fiscal policy is often considered risky, as it can exacerbate macroeconomic volatility, dampen investment, impede growth, and disproportionately affect the less affluent segments of society. For example, implementing contractionary fiscal policies during a recession, such as reducing government expenditure and increasing taxes, can further dampen consumption potential, exacerbating the economic downturn.
Evolution of Fiscal Policy and Institutions in India (2014-2025)
Between 2014 and 2025, India witnessed significant shifts in the objectives of fiscal policy and institutions under the government. Significant changes included:
- The introduction of the Goods and Services Tax (GST).
- The abolition of the Planning Commission.
- Revisions to the Fiscal Responsibility and Budget Management Act.
- Fiscal prudence initially emphasized deficit reduction but later saw increased off-budget borrowing.
- Key fiscal trends
- Fiscal deficits were initially reduced but later increased, with significant off-budget borrowing.
- Factors contributing to this included disappointing revenue collection and economic slowdown.
- Welfare expenditure was used strategically for electoral gains, emphasizing direct benefit transfers and schemes like PM-KISAN.
- Intergovernmental transfers saw changes, including increased devolution to states but reduced central contributions to centrally sponsored schemes.
- On fiscal policy and growth strategy
The government shifted towards using the objective of fiscal policy to promote growth, employing fiscal policy instruments like production-linked incentives (PLIs), increased capital expenditure, and corporate tax cuts.
Capital expenditure saw a notable rise, particularly in infrastructure sectors, aiming to stimulate economic activity.
Looking ahead
- The government aims for fiscal consolidation, targeting a primary surplus in the medium term.
- Fiscal consolidation is expected mainly through cuts in revenue expenditure.
- Efforts to increase revenue, including tax and non-tax sources, are crucial, along with potential privatization initiatives.
- Off-budget borrowing practices are discouraged for fiscal transparency, despite most government debt being held domestically.
Key Differences Between Monetary and Fiscal Policy
Monetary and fiscal policy represent distinct tools of fiscal policy wielded by policymakers to influence economic activity. While both are fiscal policy instruments in shaping the economic landscape of a country, they operate in different spheres and address varied aspects of economic management.
Differences Between Monetary and Fiscal Policy
| Factors | Monetary Policy | Fiscal Policy |
|---|---|---|
| Definition | Monetary policy is a set of measures enacted by the central bank to regulate the money supply and manipulate interest rates within an economy. | Fiscal policy pertains to the government's management of tax revenues and spending decisions to steer the economy in a desired direction |
| Managed By | Central banks are entrusted with the responsibility of formulating and executing monetary policy | It is formulated and executed by the Ministry of Finance or equivalent government entities. |
| Measures | The focus of monetary policy lies in determining the prevailing interest rates and influencing the availability of credit within the economy. | Unlike monetary policy, it revolves around decisions related to government spending, taxation, and borrowing |
| Focus Area | Monetary policy aims to ensure stability within the economy, particularly by controlling inflationary pressures. | The primary objective of fiscal policy is to foster economic growth and stability through the strategic allocation of government resources |
| Impact on Exchange Rates | Changes in interest rates, as influenced by monetary policy, can impact exchange rates, with higher interest rates generally leading to an appreciation of the domestic currency. | It typically has no direct impact on exchange rates, as it primarily deals with fiscal measures rather than monetary ones. |
| Targets | Inflation is often the primary target of monetary policy, with central banks aiming to achieve a predetermined inflation rate conducive to economic stability. | While fiscal policy does not have a specific target akin to inflation in monetary policy, it aims to address various economic challenges, including unemployment and income inequality, through fiscal interventions |
| Impact | The effectiveness of monetary policy is evident in its influence on borrowing and lending activities, affecting investment, consumption, and overall economic activity | Its impact is felt primarily through its influence on the budget deficit, as well as its role in shaping public investment, taxation levels, and overall economic demand. |
Conclusion
Fiscal policy in India serves as a vital tool of fiscal policy for economic management, encompassing a range of measures aimed at achieving macroeconomic stability, promoting inclusive growth, and addressing societal challenges. Through strategic decisions on taxation, government spending, and borrowing, policymakers endeavor to steer the economy towards desired objectives such as full employment, price stability, and equitable distribution of income and wealth. While fiscal policy operates in conjunction with monetary policy, its focus on government interventions distinguishes it as a crucial driver of economic development and welfare. Moving forward, maintaining fiscal prudence and transparency will be essential for sustaining growth and addressing emerging economic imperatives.
If you want to gain knowledge on various integral matters of the world economy, enroll in the Online Master of Science (Economics) from Symbiosis School for Online and Digital Learning. It offers a globally recognized curriculum designed by top experts. It equips students to critically analyze economic issues, business, public policy, and society, enhancing their careers with a credible, valuable degree.
Frequently Asked Questions
Trending Blogs
