What is Fiscal Policy?

Fiscal policy is how the government manages the economy using spending (on things like
roads, schools, salaries) and taxes (on individuals and businesses).

Fiscal Policy in Government Expenditure

1. If Government Increases Spending

In times of economic slowdown or recession, private sector spending may decrease. The
government steps in to fill this gap through increased spending, which helps:

Create Jobs:

• Example: If the government starts a road construction project, it hires workers (direct
jobs) and purchases materials from suppliers (indirect jobs).
• This helps both skilled and unskilled labor get employment.

Boost Income and Consumption:

• Workers and suppliers earn income, which they spend on goods like food, clothing, and
transportation.
• This increases consumer demand in the economy.

Encourage Business Activity:

• With rising demand, businesses see an increase in sales.

• In response, they expand production, hire more people, and invest in new machinery or
technology.

Multiplier Effect:

• One rupee spent by the government circulates in the economy and leads to multiple
rounds of income and spending.
• For example, if a worker earns ₹500 from a government job and spends it at a shop, the
shopkeeper earns income and spends it elsewhere — this chain continues.

Result:

• Aggregate demand increases

• Employment rises
• Economic growth is stimulated

Example:
During the 2008 Global Financial Crisis and again during the COVID-19 pandemic, many
governments (including India) increased spending on:

• Public health (vaccines, hospitals)

• Welfare schemes (free ration, MGNREGA employment)
• Infrastructure projects to boost employment and demand

2. If Government Reduces Spending

Sometimes, to control inflation or reduce fiscal deficit (excessive government borrowing), the
government may decide to cut back on spending.

This can lead to:

Fewer Projects and Less Employment:

• Fewer infrastructure or welfare schemes mean fewer jobs.

• Contract workers and suppliers lose income sources.

Lower Disposable Income:

• When people earn less, they spend less.

• This affects demand for goods and services.

Reduced Business Revenues:

• With lower consumer spending, businesses face declining sales.

• They may reduce production, delay investment, or lay off workers.

Overall Economic Slowdown:

• Aggregate demand falls.

• GDP growth rate may decline.
• Unemployment may rise, especially in sectors dependent on government contracts
(construction, transport, education, etc.)

Example:

If the government delays payments in infrastructure or cuts funding to public schools:

• Construction companies halt projects.

• Teachers and staff face layoffs or delayed salaries.
• Households spend less, affecting local markets.

Conclusion:
Government spending is a powerful driver of economic activity, especially in developing
countries like India, where private investment and consumer spending may not be enough to
drive growth.

• More spending = boosts economy

• Less spending = can slow down economy

Fiscal policy in government taxes

Fiscal policy utilizes changes in government taxes as a key instrument to influence the
economy. Taxes directly impact the disposable income of households and the retained earnings
of businesses, thereby affecting consumption, investment, and overall economic activity.

Here's a detailed look at the impact of changes in government taxes:

I. Expansionary Fiscal Policy (Decreased Taxes / Tax Cuts)

When the government reduces tax rates or offers tax rebates, it aims to stimulate economic
growth.

A. Impact on Aggregate Demand (AD):

• Increased Disposable Income: For individuals, lower income taxes mean they have
more take-home pay. This directly boosts their disposable income.
• Increased Consumption (C): With more disposable income, households tend to increase
their spending on goods and services. This rise in consumption is a direct component of
aggregate demand (AD=C+I+G+NX).
• Increased Business Investment (I): For businesses, lower corporate taxes (on profits) or
tax incentives for investment (e.g., accelerated depreciation, investment tax credits)
increase their after-tax profits and reduce the cost of capital. This encourages businesses
to invest more in new plant, equipment, and technology.
• Overall AD Boost: The combined effect of increased consumption and investment leads
to an increase in overall aggregate demand in the economy.

B. Impact on Economic Growth (GDP):

• Short-term: The increase in aggregate demand stimulates production. Businesses

respond to higher demand by increasing output, leading to higher GDP. This effect is
amplified by the multiplier effect. Each dollar of tax cut leads to a larger increase in
GDP as the money circulates through the economy (e.g., people spend more, leading to
higher sales for businesses, which then hire more and pay higher wages, leading to even
more spending). However, the tax multiplier is generally smaller than the government
spending multiplier because a portion of the tax cut may be saved rather than spent.
• Long-term (Supply-Side Effects): Proponents of supply-side economics argue that
lower marginal tax rates can have significant long-term positive effects on economic
growth by altering incentives:
 o Work Incentive: Lower income tax rates might encourage people to work more
hours or for more people to enter the labor force, as they keep a larger share of
their earnings.
o Saving Incentive: Lower taxes on interest, dividends, or capital gains can
encourage individuals to save more, which provides more funds for investment.
o Investment and Innovation Incentive: Lower corporate taxes or specific tax
breaks can incentivize businesses to invest more in research and development,
new technologies, and expansion, boosting the economy's productive capacity
over time.
o However, these long-term supply-side effects are a subject of ongoing debate
among economists, and their magnitude is often uncertain.

C. Impact on Employment:

• As aggregate demand and economic activity increase, businesses need to produce more.
This often leads to increased hiring, reducing unemployment.

D. Impact on Inflation:

• If the economy is operating below its full capacity (e.g., during a recession with high
unemployment), tax cuts can boost demand without significant inflationary pressures.
• However, if the economy is already near full employment or overheated, an increase in
aggregate demand due to tax cuts can outstrip the economy's productive capacity, leading
to demand-pull inflation (a general rise in prices).

E. Impact on Government Debt/Deficit:

• Tax cuts, by reducing government revenue, generally lead to an increase in the budget
deficit (government spending exceeds tax revenue) and contribute to the growth of
national debt.
• This can lead to crowding out, where increased government borrowing to finance the
deficit drives up interest rates, making it more expensive for private businesses to borrow
and invest, potentially offsetting some of the positive effects of the tax cuts.

II. Contractionary Fiscal Policy (Increased Taxes)

When the government increases tax rates or eliminates tax exemptions, it aims to cool down an
overheated economy, combat inflation, or reduce budget deficits.

A. Impact on Aggregate Demand (AD):

• Decreased Disposable Income: Higher income taxes reduce the disposable income of
households.
• Decreased Consumption (C): With less disposable income, individuals tend to reduce
their spending on goods and services, leading to a fall in consumption.
 • Decreased Business Investment (I): Higher corporate taxes or fewer investment
incentives reduce after-tax profits and raise the cost of capital, discouraging business
investment.
• Overall AD Reduction: The combined effect of decreased consumption and investment
leads to a decrease in overall aggregate demand.

B. Impact on Economic Growth (GDP):

• Short-term: Reduced aggregate demand leads to a slowdown in economic activity and

potentially lower GDP. This is the intended effect when trying to curb inflation.
• Long-term: If higher taxes disproportionately fall on productive activities or
investments, they could, in the long run, disincentivize work, saving, and investment,
potentially hindering the economy's productive capacity.

C. Impact on Employment:

• A slowdown in economic activity generally leads to reduced demand for labor,

potentially increasing unemployment.

D. Impact on Inflation:

• Increased taxes effectively reduce purchasing power and aggregate demand, which helps
to mitigate demand-pull inflationary pressures. This is often the primary objective of
raising taxes in an inflationary environment.

E. Impact on Government Debt/Deficit:

• Increased tax revenue helps to reduce the budget deficit and slow the growth of national
debt. This can be a crucial goal for governments facing unsustainable debt levels.