Fiscal Policy refers to the methods employed by the government to influence and monitor the economy by adjusting taxes and/or public spending. In doing so, the government aims to find a balance between lowering unemployment and reducing the inflation rate. The main tools of Fiscal Policy are changes in the composition of taxation and government spending.

Definitions

“By fiscal policy, we denote to government actions afflicting its receipts and outlays which are ordinarily taken as measured by the government’s receipts, its surplus or deficit.”

“A policy under which the government uses its outlay and revenue programs to produce desirable effects and avoid undesirable effects on the national earnings, manufacturing, and employment.”

Otto Eckstein defines fiscal policy as “changes in taxes and expenditures which aim at short-run goals of full employment and price level stability.”

Objectives of Fiscal Policy 

The following are the objectives –

  1. To uphold and accomplish full employment
  2. To alleviate the price level
  3. To soothe the development rate of the financial system
  4. To sustain symmetry in the balance of payment
  5. To endorse the monetary development of underdeveloped nations.

Instruments of Fiscal Policy

The following are the main instruments of fiscal policy:

1. Public Expenditure

Public Expenditure means expenditure incurred by the government of a country. It generates sufficient influence on aggregate demand and development activities of a country. The expenditure can be of two types:

  1. Expenditure incurred by the government to get goods directly influences aggregate demand.
  2. Public expenditure incurred on pensions, scholarships, educational and medical facilities to people, etc. This expenditure is known as Transfer Payment. It also raises aggregate demand.

2. Taxation

Modern states are welfare-oriented states and they have to use the money to achieve this end. Tax is the main source to acquire money. Aggregate demand can also be influenced by taxes. The government collects money by imposing different taxes to finance public expenditures and manage various development activities. Mainly, taxes can be classified into two groups-

  1. Direct Tax: Direct tax reduces the income of the people and a part of their income goes into the government treasury.
  2. Indirect Tax: Indirect taxes lead to a rise in the prices of goods.

Both direct and indirect taxes lead to a reduction in aggregate demand.

3. Public Debt

The third instrument of fiscal policy is public debt. Public debt means debt taken by the government from people or from the governments of other countries. The government has to take the help of public debt if public expenditure exceeds public revenue. Public debt can be of two types: Internal and External.

4. Deficit Financing

Public expenditure has to be incurred for economic development. This amount can be collected only through public debt, taxation, etc. So deficit financing has to be introduced. When there emerges a deficit due to excess of public expenditure over public revenue, this deficit is met either by borrowing from the central bank or by issuing new notes. Deficit financing can be used to meet government expenditures. It increases aggregate demand.