ROLE OF FISCAL POLICY IN UNDER

DEVELOPED COUNTRIES

NAME: ROHIT SHET

INTRODUCTION

Fiscal policy is the means by which a government adjusts its spending levels and tax rates

to monitor and influence a nation's economy. It is the sister strategy to monetary through which a

central bank influences a nation's money supply. These two policies are used in various

combinations to direct a country's economic goals. Here we look at how fiscal policy works, how

it must be monitored and how its implementation may affect different people in an economy.

Fiscal policy is an vital part of the economic framework of a country and so it is closely linked

with its overall economic policy strategy. Tax policy, expenditure policy, investment or

disinvestment strategies and debt or surplus management is the core basis of the Fiscal policy. It

is the policy of the government which particularly aims for nation's development. In this context

this article laid emphasis on the role of fiscal policy of India.

Tax policy, expenditure policy, investment or disinvestment strategies and debt or surplus

management is the core basis of the Fiscal policy. Fiscal policy is the policy of the government

which includes taxation, public expenditure and public borrowings. Fiscal policy is an vital part

of the economic framework of a country and so it is closely linked with its overall economic

policy strategy. In contemporary economic scenario the government is in trusted t deals with

fiscal policy while the central bank is held responsible for monetary policy. In underdeveloped

countries the importance of fiscal policy is very high. The state is loaded with responsibility in

order to play active role for allocating the revenue and expenditure properly. Hence, fiscal policy

is a powerful tool in the hands of government with the help of which it can attain the objectives

of development. Fiscal policy help government to create a balance between revenue generated

and revenue expend. Surplus occurs when the government receives more than what it spends.

Likely when the government expenditure turns to be more than what it receives it runs into a

deficit. So while formulation of fiscal policy government sees it neither run into deficit nor have

surplus. Planning is made to achieve best use of received revenue.

Before the Great Depression, which lasted from Sept. 4, 1929 to the late 1930s or early

1940s, the government's approach to the economy was laissez-faire. Following World War II, it

was determined that the government had to take a proactive role in the economy to regulate

unemployment, business cycles, inflation and the cost of money. By using a mix of monetary and

fiscal policies (depending on the political orientations and the philosophies of those in power at a

particular time, one policy may dominate over another), governments are able to control

economic phenomena.

Measures employed by governments to stabilize the economy, specifically by adjusting

the levels and allocations of taxes and government expenditures. When the economy is sluggish,

the government may cut taxes, leaving taxpayers with extra cash to spend and thereby increasing

levels of CONSUMPTION. An increase in public-works spending may likewise pump cash into the

economy, having an expansionary effect. Conversely, a decrease in government spending or an

increase in taxes tends to cause the economy to contract. Fiscal policy is often used in tandem

with MONETARY POLICY. Until the 1930s, fiscal policy aimed at maintaining a balanced budget;

since then it has been used “counter cyclically,” as recommended by JOHN MAYNARD KEYNES,

to offset the cycle of expansion and contraction in the economy. Fiscal policy is more effective at

stimulating a flagging economy than at cooling an inflationary one, partly because spending cuts

and tax increases are unpopular and partly because of the work of economic stabilizers.

How Fiscal Policy Works:

Fiscal policy is based on the theories of British economist John Maynard Keynes. Also

known as Keynesian economics, this theory basically states that governments can influence

macroeconomic productivity levels by increasing or decreasing tax levels and public spending.

This influence, in turn, curbs inflation (generally considered to be healthy when between 2-3%),

increases employment and maintains a healthy value of money. Fiscal policy is very important to

the economy. For example, in 2012 many worried that the fiscal cliff, a simultaneous increase in

tax rates and cuts in government spending set to occur in January 2013, would send the U.S.

economy back to recession. The U.SCongress avoided this problem by passing the American

Taxpayer Relief Act of2012 on Jan. 1, 2013.

India’s fiscal policy architecture

The Indian Constitution provides the overarching framework for the country’s fiscal

policy. India has a federal form of government with taxing powers and spending responsibilities

being divided between the central and the state governments according to the Constitution. There

is also a third tier of government at the local level. Since the taxing abilities of the states are not

necessarily commensurate with their spending responsibilities, some of the centre’s revenues

need to be assigned to the state governments. To provide the basis for this assignment and give

medium term guidance on fiscal matters, the Constitution provides for the formation of a Finance

Commission (FC) every five years. Based on the report of the FC the central taxes are devolved

to the state governments. The Constitution also provides that for every financial year, the

government shall place before the legislature a statement of its proposed taxing and spending

provisions for legislative debate and approval. This is referred to as the Budget. The central and

the state governments each have their own budgets. The central government is responsible for

issues that usually concern the country as whole like national defence, foreign policy, railways,

national highways, shipping, airways, post and telegraphs, foreign trade and banking. The state

governments are responsible for other items including, law and order, agriculture, fisheries,

water supply and irrigation, and public health. Some items for which responsibility vests in both

the Centre and the states include forests, economic and social planning, education, trade unions

and industrial disputes, price control and electricity. There is now increasing devolution of some

powers to local governments at the city, town and village levels. The taxing powers of the central

government encompass taxes on income (except agricultural income), excise on goods produced

(other than alcohol), customs duties, and inter-state sale of goods. The state governments are

vested with the power to tax agricultural income, land and buildings, sale of goods (other than

inter-state), and excise on alcohol. Besides the annual budgetary process, since 1950, India has

followed a system of five year plans for ensuring long-term economic objectives. This process is

steered by the Planning Commission for which there is no specific provision in the Constitution.

The main fiscal impact of the planning process is the division of expenditures into plan and non-

plan components. The plan components relate to items dealing with long-term socioeconomic

goals as determined by the ongoing plan process. They often relate to specific schemes and

projects. Furthermore, they are usually routed through central ministries to state governments for

achieving certain desired objectives. These funds are generally in addition to the assignment of

central taxes as determined by the Finance Commissions. In some cases, the state governments

also contribute their own funds to the schemes. Non-plan expenditures broadly relate to routine

expenditures of the government for administration, salaries, and the like.

While these institutional arrangements initially appeared adequate for driving the

development agenda, the sharp deterioration of the fiscal situation in the 1980s resulted in the

balance of payments crisis of 1991, which would be discussed later. Following economic

liberalization in 1991, when the fiscal deficit and debt situation again seemed to head towards

unsustainable levels around 2000, a new fiscal discipline framework was instituted. At the

central level this framework was initiated in 2003 when the Parliament passed the Fiscal

Responsibility and Budget Management Act (FRBMA).Taxes are the main sources of

government revenues. Direct taxes are so named since they are charged upon and collected

directly from the person or organisation that ultimately pays the tax (in a legal sense).2Taxes on

personal and corporate incomes, personal wealth and professions are direct taxes. In India the

main direct taxes at the central level are the personal and corporate income tax. Both are till date

levied through the same piece of legislation, the Income Tax Act of 1961. Income taxes are

levied on various head of income, namely, incomes from business and professions, salaries,

house property, capital gains and other sources (like interest and dividends).3 Other direct taxes

include the wealth tax and the securities transactions tax. Some other forms of direct taxation that

existed in India from time to time but were removed as part of various reforms include the estate

duty, gift tax, expenditure tax and fringe benefits tax. The estate duty was levied on the estate of

a deceased person. The fringe benefits tax was charged on employers on the value of in-kind

non-cash benefits or perquisites received by employees from their employers. Such perquisites

are now largely taxed directly in the hands of employees and added to their personal income tax.

Some states charge a tax on professions. Most local governments also charge property owners a

tax on land and buildings. Indirect taxes are charged and collected from persons other than those

who finally end up paying the tax (again in a legal sense). For instance, a tax on sale of goods is

collected by the seller from the buyer. The legal responsibility of paying the tax to government

lies with the seller, but the tax is paid by the buyer. The current central level indirect taxes are

the central excise (a tax on manufactured goods), the service tax, the customs duty (a tax on

imports) and the central sales tax on inter-state sale of goods. The main state level in direct tax is

the post-manufacturing (that is wholesale and retail levels) sales tax (now largely a value added

tax with intra-state tax credit). The complications and economic inefficiencies of this multiple

cascading taxation across the economic value chain (necessitated by the constitutional

assignment of taxing powers) are discussed later in the context of the proposed Goods and

Services Tax (GST).

Role of Fiscal Policy in under developing Countries

The fiscal policy in under developing countries should apparently be conducive to rapid

economic development. In a poor country, fiscal policy can no longer remain a compensatory

fiscal policy. It has a tough role to play in a developing economy and has to face the problem of

growth-cum-stability.

The main goal of fiscal policy in a newly developing economy is the promotion of the highest

possible rate of capital formation. Underdeveloped countries are encompassed by vicious circle

of poverty on account of capital deficiency; in order to break this vicious circle, a balanced

growth is needed. It needs accelerated rate of capital formation.

Since private capital is generally shy in these countries, the government has to fill up the lacuna.

A mounting public expenditure is also required in building social overhead capital. To accelerate

the rate of capital formation, the fiscal policy has to be designed to raise the level of aggregate

savings and to reduce the actual and potential consumption of the people.

Another objective of fiscal policy, in a poor country is to divert existing resources from

unproductive to productive and socially more desirable uses. Hence, fiscal policy must be

blended with planning for development.

An important aim of fiscal policy in a developing economy is to create an equitable distribution

of income and wealth in the society. Here, however, a difficulty arises. The aims of rapid growth

and attainment of equality in income are two paradoxical goals because growth needs more

savings and equitable distribution causes reduction of aggregate savings as the propensity to save

of the richer section is always high and that of the poor income group low.

As such, if high economic growth is the objective, the question arises as to what extent

inequalities should be reduced. Of course, many a time, under the goal of socialism, the

government unduly resorts to reduction of inequalities at the cost of growth which may lead to

the distribution of poverty rather than prosperity. A reconciliation of these two contradictory

goals of growth and reduction of inequalities can definitely bring forth better results.

Furthermore, fiscal policy in a poor country has an additional role of protecting the economy

from high inflation domestically and unhealthy developments abroad. Though inflation to some

extent is inevitable in the process of growth, fiscal measures must be designed to curb

inflationary forces. Relative price stability constitutes an important objective.

The approach to fiscal policy in an economy which is developing must be aggregative as well as

segmental. The former may lead to overall economic expansion and reduce the general pressure

of unemployment; but due to the existence of bottlenecks though general price stability may be

maintained, sectoral price rise may inevitably be found.

These sectoral imbalances are to be corrected by appropriate segmental fiscal measures which

would remove frictions and immobility’s turn demands into proper directions, seek to eliminate

bottlenecks and other obstacles to growth.

For less developed countries such as India the following main objectives of fiscal policy may

be restated as:

(i) To increase the rate of investment and capital formation, so as to accelerate the rate of

economic growth.

(ii) To increase the rate of savings and discourage actual and potential consumption.

(iii) To diversify the flow of investments and spendings from unproductive uses to socially most

desirable channels.

(iv) To check sectoral imbalances.

(v) To reduce widespread inequalities of income and wealth.

(vi) To improve the standard of living of the masses by providing social goods on a large scale.

For the purpose of development, not only an expansionary budget but a deficit is desirable too in

a developing country. The government expenditure on developmental planning projects must be

increased.

It may be financed even by means of deficit financing. Deficit financing, here, refers to the

creation of new money by printing additional notes by the government or by borrowing from the

central bank which ultimately means creation of additional money supply. However, the

government must use the technique of deficit financing cautiously. An excessive dose of deficit

financing may lead to inflation which may endanger economic growth.

Public borrowing also is an important means of getting resources for development of the public

sector. External loans are useful to some extent when the country has to import machines, capital

goods, etc., from a foreign country and the country has a scarcity of foreign exchange.

Anyway the effectiveness of fiscal measures in promoting development in a poor country

depends on the incentives administered to the strategic points in the productive set up by virtue

of the consequences of taxation and public spending.

It must be noted that fiscal policy in a developing economy has to operate within a framework

influenced by social, cultural and political conditions and institutions, which may inhibit the

formulation and implementation of good economic policies.

Further, fiscal policy in a poor country may be used to reduce inequalities in income and wealth

distribution by means of taxes and government expenditure. Taxation has to be progressive and

government spending must be welfare-oriented.

In short, for promoting economic growth, the fiscal policy must be first formulated in such a way

that it will increase the rate of volume of investment in the public and private sectors. The tax

policies must discourage unproductive and speculative investment. Second, fiscal policy must

mobilise more and more resources for capital formation. Hence, taxation must be used to curb

excessive consumption. Third, it must encourage an inflow of foreign capital.

Fiscal policy, however, cannot be effective when there are loopholes in the taxation laws and the

tax administration is corrupt so that there is large-scale tax evasion. Again, if the government is

extravagant in spending on non-developmental items, then a technique such as deficit financing

may prove to be inflationary. Again, market imperfections, bottlenecks, shortages of raw

materials, and lack of entrepreneurial skills, do not allow fiscal policy to be effective.

A high population growth, and an orthodox society also come in the way of development and

without a coordinated, sound, physical plan and its proper implementation, fiscal policy cannot

be very effective in reaching its goal of rapid economic development with stability.

Nonetheless, of all economic policies, fiscal policy today assumes unique importance in realising

general economic goals, depending on the size of the fiscal measures adopted and their timing.

The exact change effected in the national economy will depend on the form and the magnitude of

public revenue, especially, the rates and structure of taxation and the mode of public spending by

the government.

Further, when prices are rising, government has to adopt a surplus budget at an appropriate time

in order to avoid secular inflation. But, there is practical difficulty in knowing the changing

conditions or appearance of price stability; hence it is very difficult to forecast perfect timing.

Political and administrative delays tend to aggravate the problem and the desired effect of fiscal

programme may not be realised. Sometimes, even if the fiscal action is taken at a right time, in

quantitative or qualitative terms, it may not be adequate or appropriate.

Quite often, trade union activities come in the way of operating fiscal measures. The workers

may resent certain taxation measures or may demand high wages during inflation, and when the

government is forced to raise the wage level on account of demand- pull inflation, cost-push

inflation may also emerge to make the situation worse.

Importance of Fiscal Policy in the Economic Development of India

The attitude of economists and government regarding the role of fiscal policy has

radically changed owing to the Keynesian impact. The old conception of “neutrality” of public

finance has yielded place to a new one namely functional finance,” public finance with its fiscal

measures has been assigned a positive and dynamic role for the promotion and acceleration of

the rate of economic development. The Keynesian analysis of fiscal policy is however,

applicable to the advanced and well-to-do countries of Europe and it has little relevance to

underdeveloped economies. The problem of developed countries is to stabilize the rate of

economic growth by maintaining effective demand at a high pitch and for that fiscal policy aims

at reducing the savings of the people and increasing their propensity to consume, The problem of

under-developed countries is however different.

They need more savings so as to increase the rate of capital formation and thereby

achieve higher rate of economic development. But in these countries the general level of incomes

of the people is low and their propensity to consume is high and hence the rate of savings is

small. The fiscal measures in these countries, therefore, should aim at raising the rate of capital

formation by reducing consumption and encouraging propensity to save. Our analysis of the

problems connected with voluntary savings indicated that the per capita incomes and savings are

extremely low and as such capital formation in underdeveloped economies cannot be left to

voluntary savings. According to an expert UN study, the annual per capita incomes in the Middle

East, in Asia and in Latin America are less than 200 US dollars or less than one-seventh of the

US level and one-fourth of the Canadian level. It was revealed in the I.M.F. “staff papers” that in

India savings contributed only 2½ percent of the national income for development purpose.

The crucial determinant of economic growth is the rate of savings and, therefore savings

cannot be left to themselves to grow automatically. On the contrary, fiscal measures have to be

adopted to increase the savings of the people and to mobilize them for productive purpose. In the

words of Nurkse, “fiscal policy, assumes a new significance in the face of the problem of capital

formation in under-developed countries.The backward countries are caught in the vicious circle

of low income, high consumption, low savings, and low rate of capital formation and therefore,

low incomes. To get out of this vicious circle of poverty, the fiscal policy can play a constructive

and dynamic role for the economic development of the underdeveloped countries.“To break out

of this circle, apart from foreign aid,” observes an expert UN study “calls for vigorous taxation

and government development programmes.” Thus in poor countries, the importance of fiscal

policy lies in raising the rate and volume of savings and to divert them into the desired channels.

In this connection, the UN report on Taxes and Fiscal Policy says, “Fiscal policy is assigned the

central task of wresting from the pitifully low output of under-developed countries sufficient

savings to finance economic development programmes and to set the stage for more vigorous

private and public investment activity.”

The limitations and ineffectiveness of monetary policy in securing an accelerated rate of

economic growth has further added to the importance of fiscal policy. Fiscal policy was designed

to supplement monetary policy but now it seems to have supplanted monetary policy altogether.

The role of fiscal policy in economic development cannot be overemphasized. The importance of

fiscal policy as an instrument of economic development was first envisaged by Keynes in his

General Theory wherein he showed that the total national income was an index of economic

activity and brought out the relation of economic activity of total spending.

The direct and indirect effects of fiscal policy on aggregate spending in the community

were clearly established and as a result the budgetary policy of the government as a weapon of

economic control and development came into prominence. The fiscal policy can affect the rate of

economic development in a variety of ways such as by increasing the rate of saving and

investment, affecting the allocation of resources, controlling inflation, promoting economic

stability. We now discuss them in detail.

To Increase the rate of saving and Investment:

Shortage of financial resources is the main obstacle in the way of economic development

of under- developed countries. There are certain forces operating in these countries which

increase consumption and reduce savings. The first among them is the population pressure.

Besides, the high income groups spend much of their income on conspicuous

consumption and their propensity to consume is further reinforced by the ‘demonstration effect’.

According to “Still-worse,” a large part of the meager savings is dissipated in unproductive

channels—real estate, hoarding, gold, jewellery, speculation etc.

The fiscal policy can be employed effectively to divert savings of the people into

productive channels. It should aim at raising the incremental saving ratio through taxation and

forced loans and make funds available for investment purposes in the public and private sectors

of the economy.

This can be done by checking conspicuous consumption and preventing the flow of funds

for unproductive purposes. For this, high taxes on personal and corporate incomes and

commodity taxation on articles of widest use and conspicuous consumption should be imposed

to check the actual and potential consumption of the people.

In this connection, report of the Taxation Enquiry Commissions, Government of India,

observes, “A tax system, which on the whole, promotes capital formation in is two aspects of

saving and investment fulfills an essential desideration”.

It should be borne in mind that the purpose of taxation should not be merely to transfer

funds from private to public use but to enlarge the total volume of savings available for

investments. This requires that the general emphasis should be on curtailing and restraining

consumption and thereby increasing the volume of saving in the community.

In Japan, for example, agricultural productivity was doubled between 1885 and 1915 and

the instruments of taxation was used effectively and much of the increase was taken away from

the farmers by imposing on them higher rents and taxes and the resources thus collected were

channelled into productive investments.

Forced loans were also imposed on the business community to mop up surplus funds for

economic development. In USSR also, collective farms were heavily-taxed and agricultural

surplus were siphoned off by raising the prices of manufactures relating to farm products. The

Economic Bulletin for Asia and the Far East States observes, “Taxation, therefore, remains as the

only effective financial instruments for reducing private consumption and investment and

transferring resources to the government for economic development.”

It will be essential for the purpose to relay on both direct and indirect taxes. Their form and

magnitude should be determined in the light of the requirements of development.

We may discuss the role of Fiscal policy, in this connection, after Prof. Kurihara regards

Fiscal policy as a “desiderate for underdeveloped countries, lacking in private initiative, private

voluntary saving and private innovation.” He discusses the fiscal roles of government as an

additional saver, an investor, an innovator and an income-redistributors.

As an additional saver, the government should, “maintain a persistent budgetary surplus

through (a) a decrease in the government average propensity to spend, (b) an increase in the

average propensity to tax, or (c) a decrease in the government average propensity to make

transfer payments”. Prof. Kurihara observes, “As for as under-developed economy is concerned,

budgetary surplus is the relevant position to be achieved and maintained. For it is as

supplementing deficient private saving that the fiscal role of government as a saver is to be

contemplated.”

As an additional investor, the government can increases the productive capacity of the

economy and secure an accelerated rate of economic growth by changing the pattern of

investments and laying emphasis on capacity creating rather than on income-generating aspects;

by decreasing government consumption and thereby increasing government investment and by

raising the tax-rate which “has the effects of decreasing private consumption expenditure and

hence of increasing that part of real income which is available for government investment.”

As an innovator, the Government should spend on research and experimentation and

stimulate innovations and new techniques of production. This will reduce the costs of production

and encourage investment. Besides, the Government can encourage innovations by giving

subsidies and tax-relief to those firms and industries which may introduce them of their own.

The government has an important role to play as an income redistributors and for that

fiscal measures can go a long way in reducing economic inequalities. A broad-based and sleepy

progressive tax structure can serve as a potent weapon in the hands of the state to secure

equitable distribution of income and wealth. However, there is a limit to which taxation can be

carried for resource mobilisation. If the taxes are excessive they will adversely affect people’s

desire and ability to work, save and invest. This will obviously retard the pace of economic

development. To avoid such a situation, the gap in resources required for economic development

may be covered by mobilising savings through voluntary loans.

Financing of economic development through borrowings is not harmful it loans are used

for productive projects. Further, unlike taxes, borrowing is not harmful if loans are the public,

does not adversely affect people’s desire to work, save and invest as lending is voluntary and the

lenders not only get back the amount lent but also earn interest on it. Instead Public borrowing

may add to the incentive of the people to save and invest more as the lure of interest is there.

However, public borrowing is beset with certain limitations in under-developed countries

and as such much reliance cannot be placed on it. The general masses are poor and their

propensity to consume is very high and hence they have no lending capacity. The rich generally

do not like to lend to the government but instead divert their invisible resources into speculative

channels as they can earn more from there.

Besides, the absence of organised money and capital markets inadequate banking

facilities and lack of confidence in the financial and political stability in the governments of most

of the underdeveloped countries are some of the other obstacles in the way of public borrowing

programme.

Therefore, steps may be taken to remove these and other obstacles and all out efforts

must be made to educate people and persuade them to save more in the wider interest of the

community.

But if inspite of all this, adequate resources are not forthcoming, the government may

resort to compulsory borrowing. For financing economic development. In this connection,

Nurkse says, since individuals are interested not only in their consumption but also in the size of

their asset holdings, there is a case for forced loans as an alternative to taxation.

They may be little more than tax receipts and yet make a difference to the incentive to

work and to produce as was found during the war period when the un-spendable cash reserves

accumulated as a result of rationing made consumers feel much better off. Forced loans in place

of taxation would be a method of forced saving in form as well in substance.

Those people who spend the major portion of their income on conspicuous consumption

and divert their resources into unproductive channels or those who stand to be benefitted from

particular development projects may be forced to invest in government bonds.

But it may be noted that no democratic government can rely on forced loans except for a

short period and for certain specified projects. Ultimately, it is the voluntary lending by the

people that matters and the Government must be prepared to increase its domestic borrowing

when the income and saving of the people increase as a result of economic development and

make public borrowing an important tool of resource mobilisation.

Under the policy of Laissez. Faire when state was regarded as police state, the role of

public expenditure in the economic life of the people and community remained neglected. Its

effects on production and distribution were not take notice of and it was held that public

expenditure should be kept at the minimum level. But today, the pendulum has moved to the

other side.

Public expenditure is one the most potent weapons in the hands of the state to secure

economic development of the underdeveloped. In underdeveloped countries, there is lack of

basic facilities such as transport, power, irrigation, education etc. and also of basic and key

industries.

The availability of such facilities and provides by the private sector for want of resources

and entrepreneurial ability. Thus, public expenditure should aim at creating basic facilities and

establishing basic and key industries and encourage the development of agriculture and industry

by giving loans, grants, subsidies etc.

Thus a carefully and wisely planned public expenditure by creating social and economic

overheads can go a long way in creating necessary environment for the growth of the economy.

But public expenditure can achieve its wider objective of development only it conforms to

certain well-defined principles of public expenditure.

The expenditure on the armed forces must not be overdone and other wasteful and

excessive expenditure on administration must be avoided. Public enterprises must conform to the

principle of economic efficiency so that costs fall and profits increase.

Care should be taken that public expenditure does not adversely affect people’s desire to

work, save and invest and for that people should not be provided with direct money help but with

goods and services in the form of free education, free medical facilities etc. This will go a long

way in increasing the efficiency and productive capacity of the people. Thus public expenditure

can play an important role in economic development.

Dr. R.N. Tirpathy, in his book, Public Finance in Under-developed Countries has

suggested the following methods which the government may adopt to increase the volume of

domestic savings to meet the financial requirements of economic development:

(i) Direct physical controls.

(ii) Increase in the rate of existing taxes.

(iii) Imposition of new taxes.

(iv) Surplus from public enterprises.

(v) Public borrowing of a non-inflationary nature.

(vi) Deficit financing.

The process of economic development inevitably leads to inflationary pressures in the

economy because it generates additional effective demand without an immediate and

corresponding increase in the production of consumption goods.

Direct physical controls can be used most effectively to curtail consumption and check

socially undesirable investment and thereby releasing resources for economic development.

Though direct physical controls are not compatible with maintenance of democratic freedom and

may be difficult to administer in an underdeveloped economy yet they are a necessary adjunct to

a developmental fiscal policy.

To meet the financial requirements of economic development, the imposition of a new

variety of taxes both direct and indirect becomes indispensable in absence of sufficient voluntary

savings. In some countries profits made in public enterprises bring the government closer to

economic realities and enable it to measure the efficiency and taxpaying capacity of their

counterparts and in the private sector.

It is desirable that the government herself starts highly profitable enterprises and utilises

the surplus from them for economic development. But the scope for any large surplus from

public enterprises in under developed countries is limited due to high cost of production, in the

initial stages of economic development and also because of limited number of such enterprises.

A mild dose of deficit financing is very useful for the employment of unemployed

economic resources but its scope is limited in underdeveloped countries because of its

inflationary impact resulting from the lags in the supply of consumer goods.

Similarly, public borrowing cannot be expected to bring in adequate resource in the

absence of properly developed capital markets in most of the underdeveloped countries. Besides

a vigorous programme of public borrowing may push up interest rates and affect investments

adversely.

Of all methods, therefore, main reliance has to be placed on taxation for the mobilisation

of resources for economic development. Besides, “fiscal policy in the shape at fiscal concessions

such as investment and depreciation allowances, provisions of finance and foreign exchange, tax-

holiday, development rebates subsides etc., can contribute materially to the growth of investment

in the private sector of the economy”. Thus the first role of fiscal policy is to make available for

economic development maximum resources consistent with minimum current consumption.

Optimum Pattern of Investment:

An underdeveloped country can ill-afford the diversion of her limited resources into

socially undesirable channels. The fiscal measure can be used to secure the pattern of investment

which is in conformity with the criteria of social marginal productivity.

High taxes on land value increments on capital gains and other windfalls should be

imposed to prevent the flow of funds into unproductive channels such as land, buildings,

inventories and other investments of speculative nature.

The tax system can provide positive inducement to productive and socially desirable

investment in the private sector. This can be done by differential rates of taxation and the grant

of tax exemption in selected cases.

Investment in economic and social overheads, viz. transport, power, soil conservation,

education public health, technical training facilities etc., is of vital importance for attaining

optimum pattern of investment because the provision of these basic facilities is essential for

speeding up development.

Such an investment widens the extent of the market; helps reduce cost of production and

raise productivity by creating external economies. Private enterprise cannot be expected to

provide such basic facilities as the investment involved in them is very huge and they are low

yielding and slow yielding projects.

Therefore, Governments of under-developed countries should take upon themselves the

responsibilities to the execution of these basic facilities. However, such projects should be

financed through taxation and not with borrowed funds because they do not yield direct returns

necessary for the repayment of these debts.

The raising of collective compulsory saving through taxation for such development

programmes is now widely recognised. Thus fiscal measures should be directed to secure the

optimum pattern of investment so as to accelerate the pace of economic development of the

underdeveloped countries.

To Counteract Inflation:

The process of economic development in underdeveloped countries inevitably leads to

inflationary pressures as a result of the imbalances between the demand for and supply of real

resources.

The pressure of wages on prices, structural rigidities of their economic systems, market

imperfections and bottle- necks impede the supply of goods and services and prices start rising.

Inflation feeds on itself and if it goes out of control, it ruins the entire economy and all progress

comes to standstill.

That is why economic growth and stability are regarded as joint objectives for

underdeveloped countries to pursue. Today the choice is not between economic growth and

stability “but only over the inter-relations ups between them and over the policies necessary to

achieve them.”

The fiscal measures should be used to counter act the inflationary pressures by reducing

over a effective demand for the attainment of this objective. The tax structure should be so

devised that it mops up a major portion of the rise in money income.

For that, greater reliance should be placed on progressive direct taxes and commodity

taxes, the yield of which changes more than in proportion to changes in tax base. Special anti-

inflationary taxes on excess profits, capital gains and other windfalls including taxes on articles

of conspicuous consumption may be imposed.

Besides, the fiscal policy of the Government should extend to the removal of structural

rigidities, market imperfections and imposition of physical controls including subsidies and

protection to essential consumer goods industries. However, if inflationary pressures go on

mounting, capital levy on cash balances and liquid assets may be imposed.

Alternative Fiscal Policies for Curbing Inflation:

The inflationary situation may basically be caused by the condition of excess demand,

when the spending on consumption and investment goods and the foreign spending on the goods

of home country, aggregate together, exceed the full employment output. This implies that true

inflation starts only after full employment. But actually, inflationary pressure are felt even before

full employment on account of the bottle necks and rigidities of factor supply and the pushes of

wages, profits and costs.

The fiscal remedies of inflation are discussed below:

(i) Reduction in Government Spending and no Change in Tax Rates:

Such a fiscal policy will give rise to budget surplus and drain out the purchasing power of

the people. Tins will set a reverse process of government expenditure multiplier in motion and

bring about a contraction in national income and employment and a consequent mitigation of

inflationary phenomenon.

(ii) Reduction in Government Spending and Increase in Tax Rates:

This set of fiscal measures is likely to be made effective than the previous one since an

increase in tax rates coupled with a reduction in government spending will create a larger budget

surplus and consequently a larger reduction will be affected in national income and employment.

(iii) Rigid Government Spending and Increasing Tax Rates:

Sometimes the Government spending is rigid as for instance during the period of war the

reduction in aggregate spending can be affected. In this case, only through an increase in tax

rates. This results, in a reduction in private disposable incomes and hence private consumption

and investment expenditures fall which can check inflation. It was through such a policy that the

United States during the period of Second World War could siphon of purchasing power by a

measure sufficient to finance more than 48 percent of the cost of war out of tax proceeds.

(iv) Reduction in Government Spending and an Equivalent Reduction in Taxes:

Just as an increase in government expenditure and an equivalent increase in tax revenues

raises the national income through the operation of the balanced budget multiplier, similarly a

decrease in government spending and equivalent decrease in tax revenue brings about a

reduction in national income and expenditure on account of its reverse operation.

If these fiscal changes result in a redistribution of income between the beneficiaries of

government expenditure and tax payers in such a way that it results in reduction in government

expenditure. A balanced budget multiplier greater than unity will in this situation have an anti-

inflationary impact upon the economy.

This discussion clearly brings out the fact that variation in taxes is the most crucial

instrument of an anti-inflationary fiscal policy. There is a controversy about the relative anti-

inflationary impact of income-tax and consumption tax of an equal yield.

The latter is sometimes conceived as more effective, since it results entirely in reducing

consumption. The income tax, on the contrary, falls partly upon consumption and partly upon

savings, to the extent income-tax reduces savings, if will not help in curtailing inflationary

pressure.

To Promote Economic Stability:

The underdeveloped countries are susceptible to economic instability resulting from

deficiency of effective demand in the short-run and fluctuations in demand for their products in

the world market. Underdeveloped countries mainly export agricultural and mineral products the

demand for which is generally less elastic.

On the other hand these countries import capital goods and finished manufactured

articles, the demand for which is elastic. When the prices of export goods fall in the international

markets the terms of trade becomes unfavourable, foreign exchange earnings decline and

national income falls which produces depression effects on the economy.

The under-developed countries cannot push their, exports to take advantage of the fall in

prices because their capacity to produce more is limited. Similarly, when the prices of the

exports rise due to the boom conditions in the world-markets, the increase in export earnings

does not lead to increased output and employment but instead it is dissipated in conspicuous

consumption and speculative investment which further generate inflationary pressure in the

economy.

Fiscal measures can be used to offset the effects of international cyclical fluctuations in

the prices of exports. For example, in booms heavy export and imports duties may be imposed

export duties to neutralise the windfall gains arising from the rise in world market prices and

import duties to discourage conspicuous consumption.

The earnings from such export and import duties should be used for capital formation. In

periods of depression on the other hand, subsidies may be given to encourage exports and

government should directly intervene to maintain the level of effective demand through public

work programmes etc.

Thus, contra-cyclical fiscal policy should be followed to mitigate the effects of

international cyclical movements and all out efforts should be made to develop all sectors of the

economy so as to reduce an excessive dependence on the primary sector alone. Hence a well-

devised fiscal policy can go a long way in promoting economic stability.

Main Objectives of Fiscal Policy in India

The Indian Constitution gives the balanced fiscal policy framework for the country. India

constitutes federal form of government which is having divided responsibility of imposing taxes

and spending between the central and the state governments. The Indian constitution provides

for the formation of a Finance Commission (FC) every five years which provides medium term

guidance on all the fiscal matters. It is with help of report of the FC that the central taxes are

delegated to the state governments. The Constitution also says that for every financial year, the

government shall prepare its proposal of taxation and spending execution and place them before

the legislature for legislative debate and approval. This is known as the Budget. Both the central

and the state governments have their own budgets. The various objectives of Indian fiscal policy.

Development by effective allocation of Resources

The primary objective of fiscal policy is to produce rapid and sustainable economic

growth and development. By Mobilization of Financial Resources this objective of economic

growth and development can be attained. Both the central and the state governments in India

have been empowered to mobilize financial resources in order to bring effective financial

planning and its uses. In India financial resources are mobilized by following three means :-

Taxation : Through fiscal policies, the government generated revenue. It aims to allocate

resources by means of direct taxes as well as indirect taxes. Direct taxes involves income tax

which each working citizen of India pays form his salary.Public Savings : By reducing

government expenditure and increasing surpluses of public sector enterprises is one of the

emerging tool of fiscal policy. Hence financial resources can be mobilized well through public

savings. Private Savings : With the help of effective fiscal policy such as tax benefits, the

government can bring resources from households and private sector. Resources can be allocated

and managed through government borrowings by means of loans from domestic and foreign

parties, treasury bills, issue of government bonds, deficit financing etc.

Expenditure of Financial Resources

The central and state governments have worked to make efficient allocation of financial

resources. These resources are utilized mainly to increase production of necessary and desirable

goods and discourage socially undesirable goods. The central theme of fiscal policy includes

development Activities which are expenditure on railways, infrastructure, etc. While other part

of non-development activities includes expenditure on interest payments defense, subsidies, etc.

Planning is made systematically at end of every financial year and action is taken accordingly.

Reduction of Income and Wealth inequalities

Fiscal policy by reducing income inequalities among different sections of the society

leads to strive equity or social justice. The direct taxes play crucial role in this, income tax are

charged on all salaried person which is directly proportion to the income of the person. More the

person earns more he is entitled to pay tax. Hence direct tax applied more on the higher income

groups as compared to lower income groups. Likely indirect taxes are also more in the case of

semi-luxury and luxury items than that of necessary consumable items. In this way government

generates good amount of revenue which is on significant proportion is implemented on Poverty

Alleviation Programmes which improves the conditions of poor people in society and

consequently leads to reduction of income and wealth inequalities.

Price Stability and Control of Inflation

One of the major objective of fiscal policy is to have stabilize price and control inflation.

Inflation and price instability have hazardous impact on over all economy. If inflation increses at

high rate in any country then it can finally lead to overall collaspe of country. Hence, the

government being particular about this and always tries to control the inflation by various means

such as bringing reduction in fiscal deficits, introduction of tax savings schemes, induce correct

use of financial resources, etc.

Employment Generation

The government is inducing every possible effort for increasing employment throughout

the country with help of effective fiscal measure. Direct and indirect employment are one of the

outcome of various investments in infrastructure of the country. Small-scale industrial (SSI)

units are encouraged to bring in more investment by providing lower taxes and duties which

consequently creates more employment. Government of India in order to solve problems in rural

areas initiated various rural employment programmes to generate employment and cope up with

increasing poverty. Likely, self employment schemes have been taken up in order to generate

employment for persons in the urban areas who are technically qualified. 

Balanced Regional Development

Balanced regional development is very important for any nation. Government key

responsibility is to see that all states and its sub units whether urban or rural develop equally and

no part of country be away from development. So fiscal policy planning occupies larger portion

for regional development. Government in order to accomplish its aim provides various incentives

such as Finance at concessional interest rates, Cash subsidy, Concession in taxes and duties in

the form of tax holidays etc for setting up projects in backward areas.

Reducing the Deficit in the Balance of Payment

Fiscal policy aims to encourage more exports by means of various fiscal measures such

as exemption of central excise duties and customs, exemption of income tax on export earnings,

exemption of sales tax etc. The foreign exchange is also protected by giving import substitute

industries fiscal benefits, applying customs duties on imports etc. The problem of balance of

payment is solved since foreign exchange received by means of exports and saved by way of

import substitutes. With the help of this method the adverse balance of payment is rectified either

by applying duties on imports or by providing subsidies to export.

Capital Formation

The aim of fiscal policy in India is also to improve and increase the rate of capital

formation so as to increase the overall economic growth. An underdeveloped country is badly

trapped with the problem of increasing poverty which is mainly an outcome of capital

deficiency. In order to defeat poverty and increase the capital formation generation, the fiscal

policy must be systematically prepared to encourage savings and decrease spending.

Increasing National Income

National income growth of any country shows its efficiency and overall development.

Any activities of development closely have impact on national income. If production and

services within a country increases the overall national income also increases. National income is

calculated by addition of contribution from all the sectors in a country. So government with the

help of fiscal policy tries to increase capital formation which in turn increases GDP, per capita

income and national income of the country.

Development of Infrastructure

Development of infrastructure is the core element that is seen in fiscal policy.

Infrastructure development benefits is enormous, it help to provide boost in all the sector of the

economy. So government always see which area needs new or further infrastructural

development and accordingly investment is put in from the revenue to bring desired result.

Wrap up

The fiscal policy is the first step towards efficient and profound nation. It is a jest and

planning of all the sect oral development along with it carter the need of common people and

inducing the social justice. It’s a great tool in the hands of government and if effective fiscal

policy is applied then the growth of any nation is inevitable. The proper investment in different

program and policy can bring great results in the long terms. In context of developing nation the

importance of fiscal policy is just too much because a developing nation have limited resources

and many responsibility and needs that require urgent attention. So mobilization of recourses

towards most urgent requirement is the prerequisite of any developmental action. India has

achieved to utilize benefit with help of fiscal policy but certain gaps in the implementation is still

exists which need a corrective measure to bring over all sustainable economic growth.

Improved Growth Effects of Fiscal Policy

In general, the increases in government revenue that occur as a result of economic growth

allow the government to employ policies that promote more jobs and swell benefits in kinds. In

this regard, fiscal consolidation can be rather regressive and less distributive although mixed

outcomes have been presented in some cases. In a comprehensive study, Carre’re and De Melo

(2012) provided a cross country analysis of the correlation between fiscal policy and growth for

118 developing and 22 high income OECD countries during the period of 1972–2005. The study

found that a growth event is more likely to occur when there is a fiscal event. In the case of a

typical developing country, the probability of an occurrence of a fiscal event is high for the

bottom half of the incomedistribution, but the probability that this fiscal event is followed by a

growth event is higher for the third quartiles. This findings are consistent with the view that the

success of a growthoriented fiscal expenditure plan for developing countries depends on their

institutional environment. Mertens and Ravn (2013) estimate the dynamic effects of changes in

taxes in the U.S. by distinguishing between the effects of changes in personal and corporate

income taxes. The result suggests different types of taxes should be distinguished when

estimating their growth impacts. European Commission (2013) reported that fiscal devaluation

has only a limited and short-lived expansionary effect on employment and GDP. The fiscal

devaluation has a regressive effect to workers regardless of types of changes in the VAT rate.

Tax swap cannot be the substitute for structural reforms needed for addressing causes of external

imbalances and poor growth. The repeated use of consumption tax will eventually grind down

the credibility of the government and minimize the effectiveness of the reform. Kuttner and

Posen (2002) investigated the effectiveness of Japanese fiscal policy over the 1976-1999 period

by analyzing real GDP, tax revenues and public expenditures. The expansionary fiscal policy, in

form of tax cuts or increased public expenditure, does stimulate the economy substantially. The

results implied that a tax cut multiplier is 25% higher for a four-year horizon than that of public

spending. Historical data showed that Japanese fiscal policy was contractionary in the 1990s

leading to a significant variation in growth. Most increases in public debt were associated with

declining tax revenues from the recession. The effects of fiscal policy responses in 118 episodes

of banking crisis in advanced and emerging market countries is examined by Baldacci et al.

(2009). Timely countercyclical fiscal measures shorten the length of crisis episodes by

stimulating aggregate demand. Fiscal expansions that support government consumption are more

effective in decreasing crisis duration than those based on public investment or income tax cuts.

Devereux et al. (2013) studied how Pigouvian levies on bank liabilities associated with systemic

risk have affected European banks capital structures. In a related study, Göndör and Nistor

(2012) empirically studied the relationship between FDI and fiscal policy and found that fiscal

policy affects the competition environment and is a crucial factor affecting FDI. Brzozowski and

Gorzelak (2010) provided evidence on the impact of balanced budget and debt rules on the

degree of fiscal policy volatility. Motivated by previous studies, which showed a negative and

robust correlation of fiscal policy volatility and long run growth, they tried to identify the

possible determinants of such a correlation. They concluded that fiscal rules have a significant

impact on fiscal policy volatility, but depending on the target, public debt or fiscal balance, the

rules will increase or decrease policy volatility. A sound fiscal policy stimulates both FDI and

economic growth, which in turn indirectly improves income inequality. The increases in

government revenues that occur as a result of economic growth allows the government to

implement policies that are conductive to business environments, promote more jobs and

increase the benefit in kinds.

Financial Consolidation Effects of Fiscal Policies

When introducing fiscal policy options, a key challenge is how to fiscal policy generates

economy growth which in turn indirectly improves income inequality. A central concern lies on

how to leverage fiscal policy for more inclusive growth while minimizing fiscal constraint.

Fiscal consolidation is creation of contraction strategies for minimizing deficits and preventing

the accumulation of more public debt. Larch (2012) finds that to run deficits across the cycle, so

called deficit bias, is predominantly attributed to the ‘common pool’problem especially for

developed and middle-income countries, which externalizes the costs for society as a whole

thereby overspending. According to the study, the relationship between income distribution and

fiscal performance is indirect. He concludes that failing to address issues of income distribution

may lead to unfavorable sustainability outcomes. The Rada and Kiefle (2013) study of dynamics

in income distribution and economic activity for a panel of 13 OECD countries, show that

contractionary monetary policy, R&D spending and more financialization, shift from production

to finance, have a negative effect on the labor’s welfare. OECD (2013) reported that fiscal

consolidation would make governments’ policy goals elsewhere more complicated. Fiscal

consolidation would slow the process of global rebalancing, undermine long-term growth and

aggravate income inequality. The report recommended an implementing of consolidation

strategies that minimize these adverse sideeffects. Cottarelli and Jaramillo (2013) discussed the

ongoing debate as to trade-off between fiscal policy and economic growth. Stabilizing public

debt-to-GDP shows a penalizing effect to potential growth, which in turn would make it harder

to sustain high public debt over the longer run. Thus, lowering public debt over time is

inevitable. In the short-run, however, front-loaded fiscal adjustment is likely to hurt growth

prospects, which would delay improvements in fiscal indicators, including deficits, debt, and

financing costs. Bouvet (2010) used data from 197 European regions between 1977 and 2003

and found that, while income inequality has been decreased within richer countries, convergence

criteria of the single market exacerbated regional inequality in poorer EU countries. Bertola

(2010) argues that Europe’s EMU had a relatively petite impact on income inequality due to its

less munificent social policies. Conducting independent fiscal policies and enforcing income

redistribution schemes became more difficult for National governments. In a recent study,

Agnello and Sousa (2012) assess the impact of fiscal consolidation on income inequality. A

panel analysis of 18 industrialized countries from 1978 to 2009 shows significant rises income

inequality during periods of fiscal consolidation. In addition, while fiscal policy driven by

spending cuts seems to be detrimental for income distribution while, tax hikes have an equalizing

effect. The fiscal consolidation program shows quantitative impacts on income inequality. When

consolidation plans represent a small share of GDP, the income gap widens, affecting households

at the bottom of the income distribution. Considering the linkages between banking crises and

fiscal consolidation, they found that the income gap effect is amplified when fiscal adjustments

take place after the resolution of such financial turmoil. In the short-run, front-loaded fiscal

adjustments are likely to hurt growth prospects, which would delay improvements in fiscal

indicators, including deficits, debt, and financing costs. A number of studies addressed that the

relationship between income distribution and fiscal performance is indirect. Income inequality

rises during periods of fiscal consolidation. The income gap widens, strongly affecting

households at the bottom of the income distribution.

Other Views on Effects of Fiscal Policies

There are other effects than inequality and growth from fiscal policy and its

consolidation. The Ardagna (2007) study looked at an economy that contained unionized labor

markets and heterogeneous agents. Changes in macroeconomics and distributional consequences

in response to the various fiscal policy implementations are examined. The author suggested that

when employment in the private sector and capital stock fall, the economy contracts. Simulations

implied that debt financed policy initiatives increases public employment, and 14 wages and

unemployment benefits increases workers’ utility in the short-run. The negative effect of

expansions in public employment are mitigated if public spending enters the production function.

In another study, Benetrix (2012) studied the impact of fiscal shocks in a panel of 11 EMU

countries and provided empirical evidence on the effects of different types of spending on real

wages. The result shows that an increase in government spending raises the real wage with

variable impact depending on the spending type. Atkinson and Leigh (2010) used taxation data

to create the distribution of top incomes covering five Anglo-Saxon countries of relatively

similar backgrounds and tax systems. They find that a reduction in the marginal tax rate on wage

and investment incomes increase the share of the top percentile group. Peñalosa and Turnovsky

(2011) examined how changes in tax policies affect the dynamics of distributions of wealth and

income. They investigated the impact of recent tax changes in the U.S. and Europe. Tax changes

that affect working hours will affect wealth and income distributions, which in turn will either

reinforce or offset the redistributive impact of taxes. Considering financing government

expenditure, they found that with policies that reduce the labor supply and output, they also lead

to a more equal distribution of after-tax income. Beetsma et al. (2013) studied budgetary

planning and implementation in the Netherlands over the period 1958-2009. The key findings are

related to: planned surplus variability across terms, trend-based budgeting planning process,

positive association between expected growth and public debt and how strict the budget plans

will be. Kenworthy and Smeeding (2013) by analyzing U.S. data found that actual changes in tax

or transfer policy did not raise inequality, government transfers and economic growth but merely

kept up with inflation. Policies that redistribute income in favor of only one particular type of

worker are found to be detrimental to the workers as a group. While tax changes that affect

working hours will affect wealth and income distribution, which in turn will either reinforce or

offset the direct redistributive impact of taxes. Some studies showed that tax changes or transfer

based policies had little effect on stemming the rise in inequality. Government transfers only

keep up with the level of inflation, rather than making any contribution to economic growth.

Fiscal Policy in Asia

“Historically in Asia, the role of fiscal policy has been to facilitate economic growth by

providing basic infrastructure while safeguarding macroeconomic stability. A tradition of fiscal

prudence was instrumental in Asia’s past success, along with public investments in growth

conducive physical and human”. (ADB, 2014) Jomo (2006) argues that both rapid growth and

structural change have reduced poverty in a number of East Asian economies. Income inequality

has been low in Korea and Taiwan, but has risen in recent years. Contrary to Kuznets’

hypothesis, the cases of Korea and Taiwan suggest that lower inequality can be complementary

to rapid growth in early stages. In Thailand, Malaysia and Indonesia, despite different policies,

poverty has declined, while income inequality trends have varied. With openness and sustained

rapid growth, China has experienced increased inequality despite considerable poverty reduction.

These suggest that inequality tends to worsen with economic liberalization in the absence of

redistribution. Using the Atkinson inequality measure of income distribution, Sato and

Fukushige (2010) analyze the impact of China’s income inequality on total income inequality

among ASEAN countries. They found that China's domestic income inequality worsened income

inequality among East Asian countries from the 1980s, and this effect became even more

prominent 15 from 1990. The growth of China's per capita GDP had an equalizing effect on

income distribution initially, but was reversed around 1997. Although economic growth of China

has improved income inequality it has had a more equalizing effect overall. The ADB’s (2012)

research on financing Asian higher education for inclusive growth, have traditionally dominated

debates on measures of financing higher education. Privatization of education is a pivotal

component of the analysis. The study deliberately links the financing of higher education to

questions of equity. Any higher education system that fails to cultivate the breadth of talent in

society is sacrificing both quality and efficiency. The failure to make progress on inclusive

growth is resulting in lower growth and higher inequalities. This issue is further emphasized in

the ADB Outlook (2012) report suggesting that Asia’s rapid growth in recent decades has led to

a significant reduction in extreme poverty, but it has also been accompanied by rising inequality

in many countries. Since the income inequality coexists with non-income inequality, it contrasts

with the “growth with equity” characteristics. Since technological progress has favored capital

over labor, the declining labor income share has resulted in rising inequality. In many Asian

countries income inequality is due to uneven growth and unequal access to opportunity. Claus et

al. (2012) assesses the impact of fiscal policies on income inequality in Asia. In order to discuss

the role and effectiveness of taxation and government expenditure on income distribution, it

conducts analysis over the 1970-2009 periods. Even though tax systems tend to be progressive,

government expenditures are a more effective tool for redistributing income. Both social

protection spending and government expenditure on housing appear to increase income

inequality. Rodgers and Zveglich (2012) examine gender inequality in labor markets in Asia and

the Pacific, with a focus on the structural drivers of women’s labor force participation. In Asia’s

lower-income countries, economic necessity is an important push factor behind women’s

employment. China and Taiwan have been successful in conducting policies to support women

in market-based activities. Kar and Saha (2012) conducted analysis on recent Latin America

studies and argued that as the size of the informal economy grows, corruption is less harmful to

inequality. They investigated if the Latin American environment applies to cases for developing

countries in Asia where corruption, inequality and shadow economies are large. Both the

corruption and risk guide indices are sensitive to a number of important macroeconomic

variables. Although corruption increases inequality in the absence of the shadow economy, the

income inequality tends to fall as there are larger shadow economies in South Asia. Balakrishnan

et al. (2013) assesses how pro-poor and inclusive Asia’s recent growth has been, and what

factors have been driving these outcomes. It finds that while poverty has fallen across the region

over the last two decades, inequality has increased. Compared to other regions and to Asia’s own

past, the recent period of growth has been both less inclusive and less pro-poor. A number of

fiscal policies are suggested to broaden the benefits of growth. These include increase in

spending on health, education, and social safety nets; labor market reforms to boost the labor

share of total income; and to make financial systems more inclusive. Yoshida et al. (2014)

reviews different projection methods and estimates the global poverty rate of 3 percent by 2030.

The study argues that accelerating growth is not enough and that sharing prosperity is essential in

order to end extreme poverty in one generation. Cornia and Martorano (2013) focus on the

income inequality changes that have taken place in a few representative developing regions

during the last 30 years. While inequality rose in the majority of the countries in the 1980s and

1990s, the last decade was characterized by divided inequality trends. With contrasting the

experience of virtuous regions and non-virtuous regions, the difference in inequality trends was

likely due to institutional factors and public policies. Tests conducted confirmed that a reduction

in inequality levels is possible if appropriate macroeconomic, labor, fiscal and social policies are

adopted by governments. In many Southeast Asian economies, market liberalization policies and

sustained economic growth platforms have led to both declines in poverty levels and variations

in inequality trends. For some countries increased inequality levels have been experienced

despite considerable poverty reduction. Several studies showed that income inequality tends to

worsen with economic liberalization, especially in the absence of effective provisions for

redistribution systems. Some suggested that a reduction in inequality levels is possible even

during an economic liberalization process, given appropriate policies are adopted by

governments.

Balancing Act

The idea, however, is to find a balance between changing tax rates and public spending.

For example, stimulating a stagnant economy by increasing spending or lowering taxes runs the

risk of causing inflation to rise. This is because an increase in the amount of money in the

economy, followed by an increase in consumer demand, can result in a decrease in the value of

money - meaning that it would take more money to buy something that has not changed in value.

Let's say that an economy has slowed down. Unemployment levels are up, consumer

spending is down and businesses are not making substantial profits. A government thus decides

to fuel the economy's engine by decreasing taxation, which gives consumers more spending

money, while increasing government spending in the form of buying services from the market

(such as building roads or schools). By paying for such services, the government creates jobs and

wages that are in turn pumped into the economy. Pumping money into the economy by

decreasing taxation and increasing government spending is also known as "pump priming." In

the meantime, overall unemployment levels will fall.

With more money in the economy and fewer taxes to pay, consumer demand for goods

and services increases. This, in turn, rekindles businesses and turns the cycle around from

stagnant to active. If, however, there are no reins on this process, the increase in economic

productivity can cross over a very fine line and lead to too much money in the market. This

excess in supply decreases the value of money while pushing up prices (because of the increase

in demand for consumer products). Hence, inflation exceeds the reasonable level.For this reason,

fine tuning the economy through fiscal policy alone can be a difficult, if not improbable, means

to reach economic goals. If not closely monitored, the line between a productive economy and

one that is infected by inflation can be easily blurred.

And When the Economy Needs to Be Curbed …

When inflation is too strong, the economy may need a slowdown. In such a situation, a

government can use fiscal policy to increase taxes to suck money out of the economy. Fiscal

policy could also dictate a decrease in government spending and thereby decrease the money in

circulation. Of course, the possible negative effects of such a policy in the long run could be a

sluggish economy and high unemployment levels. Nonetheless, the process continues as the

government uses its fiscal policy to fine-tune spending and taxation levels, with the goal of

evening out the business cycles.

Who Does Fiscal Policy Affect?

Unfortunately, the effects of any fiscal policy are not the same for everyone. Depending

on the political orientations and goals of the policymakers, a tax cut could affect only the middle

class, which is typically the largest economic group. In times of economic decline and rising

taxation, it is this same group that may have to pay more taxes than the wealthier upper class.

Similarly, when a government decides to adjust its spending, its policy may affect only a

specific group of people. A decision to build a new bridge, for example, will give work and more

income to hundreds of construction workers. A decision to spend money on building a new space

shuttle, on the other hand, benefits only a small, specialized pool of experts, which would not do

much to increase aggregate employment levels.

The Bottom Line

One of the biggest obstacles facing policymakers is deciding how much involvement the

government should have in the economy. Indeed, there have been various degrees of interference

by the government over the years. But for the most part, it is accepted that a degree of

government involvement is necessary to sustain a vibrant economy, on which the economic well-

being of the population depends.

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