Fiscal Policy | Definition & Objectives

Fiscal policy is the manipulation of government revenue through tax system, government expenditure and debt management to achieve pre-determined macro-economic objectives. It can be used for allocation, stabilization and distribution.

It refers to the part of government policy concerning the raising of revenue through taxation and other means and deciding on the level and pattern of expenditure for the purpose of influencing economic activities or attaining some desirable macroeconomic goals.

It also refers to the use of the spending levels and tax rates to influence the economy. It is the sister energy to monetary policy which deals with the central banks influence over a nation’s money supply.

The governing bodies use combinations of both these policies to achieve the desired economic goals. Thus, the essential tools of fiscal policy are taxing and spending. The primary objectives is to balance the use of resources of the public and private sector and by so doing avoid inflation, unemployment, balance of payment pressure and income inequality.

Fiscal policy is controlled by those people in the government who have control over the tax rates and government spending. It varies from country to country. The individuals who have control over the budget are referred to as the fiscal authority. In Nigeria, it is held by the executive and legislative branches.

So we must understand that fiscal policy is traditionally administered by the executive arm through the Ministry of Finance, and this depends more on the state of the economy. This is to say that fiscal policy, affects aggregate demand by changing the income available to spending units in the economy and its impact will depends on the nature of government spending, that is, what goods government decides to buy, what taxes it decides to charge and what amount it decides to transfer.

Any of these policies could affect the level of demand and cause an increase in consumption spending or in the case of investment subsidy which could increase investment spending.

In order to learn and understand fiscal policy or monetary policy, it is important to know whether an economy, no matter where it may be in the world, can self regulate, or whether it needs an outside influence in order to adjust.

This is where Classical and Keynesian economics will come into play. If you are of the Keynesian school of thought, you believe that the economy needs your influence in order to correct itself. This correction can be in form of fiscal policy. Fiscal policy can be used to either a sluggish economy or to slow down an economy that is growing at a rate that is getting out of control (which can lead to inflation or asset bubbles).

OBJECTIVES OF FISCAL POLICY

  • Relative stability in prices
  • High rate of or full employment
  • Promoting economic growth and development
  • Balance of payments equilibrium
  • Stable exchange rate
  • Equitable income redistribution
  • Increase rate of investment

Relative stability in price: Fiscal policy aims at price stabilization by counteracting inflation and deflation. Expansionary fiscal policy (reduced taxation and increased expenditure) counter deflation while contractionary fiscal policy (increased taxation and reduced expenditure) is used to counter inflation.

High rate of or full employment: Full or high rate of employment can be achieved by expansion fiscal policy, but it an eagle eye on its inflationary effect.

Promoting economic growth and development: Another objective is the attainment and sustenance of a high rate of growth of national product with its accompanying attitudinal and structural change i.e. economic development.

Balance of payment equilibrium: Both taxation and government expenditure can be used to pursue and achieve a favorable or equilibrium balance of payments. Different type of taxes can be used to discourage imports (import duties etc), and promote export (tax holidays, low or zero export duties).

Stable exchange rate: This may be achieved by avoiding fundamental disequilibrium in the country’s balance of payments situation through effective fiscal policy measures, as suggested in balance of payments equilibrium above.

Equitable income redistribution: Progressive taxation and government expenditure on welfare services can be applied to attain equity in income distribution as well as social justice.

Increased rate of investment: It can be directed at raising revenues for investment in certain key sector of the economy, which the multiplier effect will increase economic growth.

It can easily be seen from these objectives that fiscal policy does not only concern itself with aggregate effects of government expenditure and taxation on income, production and employment but also with the manner in which all the different elements of public finance, while still primarily concerned with carrying out their duties (as the first duty of a tax is to raise revenue), may collectively, be geared to promote the aims of the economic policy.

Therefore the crux of a good and effective fiscal policy lies in keeping its ingredients like expenditure, debt management, and the likes in a proper balance so as to achieve the best possible result in terms of the desired economic objectives.

How does Fiscal Policy Affect Macro Economy?

It affects aggregate demand, the distribution of wealth and the economy capacity to produce goods and services. In the short run, changes in spending can alter both the magnitude and the pattern of demand for goods and services.

With time, this aggregate demand affects the allocation of resources and the productive capacity of an economy through its influence on the returns to factors of production, the development of human capital, the allocation of capital spending and investment in technological innovations.

Tax rates, through their effects on the net returns to labour, savings and investment, influence both the magnitude and the allocation of productive capacity.

Macroeconomics has long featured two general views of the economy and the ability of fiscal policy to stabilize or even affect economic activity. The equilibrium view sees the economy quickly returning to full capacity whenever disturbances displace it from full employment.

Accordingly, changes in fiscal policy or even in monetary policy for that matter have little potential for stabilizing the economy, instead inevitable delays in recognizing economic disturbance, in enacting fiscal response and in the economy reacting to the changes in policy can worsen, rather than diminish business cycle fluctuation.

An alternative view sees critical market failure causing the economy to adjust with more difficulty to these disturbances. Changes in fiscal and monetary policy have greater potential for stabilizing aggregate demand and economic activity. How the economy reacts to fiscal policy depends on whether it is at full employment or operating below its full capacity.

Limitations of Fiscal Policy

Fiscal policy is a powerful tool that can maintain the economy in perfect balance. However, putting them into practice is quite a difficult task because of various reasons.

A major chunk of government funds is devoted to healthcare, social service and veteran’s benefits.  Thus, changes in expenditure generally must come from the small part of the budget that includes discretionary spending.

This gives the government less leeway for increasing or lowering spending.  Another inhibiting factor is working with estimations. When lawmakers put fiscal policies in place, they base their decision partly on the past behaviours of individuals.

It is risky to assume that people will for example respond the same way to a tax cut in the future as they have in the past. Although changes in fiscal policy affect the economy, changes take time. By the time the policy takes effect, the economy might be moving in the opposite direction.

In this case, fiscal policy would only add to the new trend, instead of correcting the original problem.

The pressure that people in authority experience in pleasing the citizens hinders fiscal policy as well. Expansionary fiscal policy (reduced taxes) is a popular choice, but it can’t be applied in every situation and thus puts the authorities in a predicament when contractionry policy has to be applied.

The execution of fiscal policy is not a simple task. It requires a coordinated effort from multiple pockets of the government which is very difficult to make happen. A problem prevalent in one part of the country may not be as troublesome in another or possibly the opposite of that. In order to be effective the fiscal policy has to be in coordination with the monetary policies of the central bank as well.

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