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Fiscal Policy

In: Business and Management

Submitted By adityakalani
Words 2555
Pages 11
Fiscal Policy for Stabilization and Growth
Sessions 11 & 12
Reading: Chapter 5

What is Demand Management?
• Demand-constrained economy:
– Increase aggregate demand to tackle recession/depression

• Supply-constrained economy:
– Manage demand to control demand-pull inflation
2

Policy focus: Demand-constrained Economy

Aggregate demand

K

Potential output

3

Policy focus: Supply-constrained Economy

Aggregate demand

K

Potential output

Also: Long term – increase K to expand potential output
4

Recession/Depression
• Recession:
– Rule of thumb: two consecutive quarters of falling GDP

• Depression:
– “Severe” recession – no widely accepted definition:
• Decline in real GDP that exceeds 10%, or one that lasts more than three years • Other alternative indicators: bursting of asset, credit bubble, fall in general price level
5

Examples of Depression
(Using 10% GDP fall rule)

6

Economic Policy
• Two main policy instruments to influence aggregate demand (C + I + G + X - M): – Fiscal Policy:
• Through Government expenditure and revenue

– Monetary policy:
• Through Money supply and interest rates
7

Basic Logic of Demand Management
(to ↑ demand)

• Fiscal Policy:
–↑G – ↓ income taxes to ↑ C – (Also:
• ↑ tariff duties to reduce M • Provide incentives to ↑ X)

• Monetary Policy:
– ↓ rate of interest to ↑ C; ↑ I
8

Fiscal Policy and Demand Management in India

9

(see: http://indiabudget.nic.in)
• • • • • • • • • • • • • Economic Survey (presented before the Budget) Annual Financial Statement Budget at a Glance Budget Speech Budget Highlights Action Taken on Budget Speech Receipts Budget Finance Bill Explanatory Memorandum Appropriation Bill (vote on account before 31 March) Demands for Grants (Expenditure budget) FRBM Act, 2003 Statements Detailed Demand for Grants

Budget Documents

Expenditure classification
• Plan/Non-Plan classification • Economic classification • Functional classification

Economic Classification
Expenditure

Capital
Direct capital formation Financial Assistance (investments, loans, grants)

Revenue (= current)
Transfers (Pension, Subsidy, etc)

Consumption expenditure

Salaries and wages

Goods and Services for current use

Functional Classification
Expenditure

Developmental
Social Services (health, education etc)

Non-developmental

General (administration defence etc)

Economic services

Unallocable (interest, pension, subsidy etc)

Classification of Government Revenue
Total revenue

Revenue receipts

Capital receipts

Tax

Non-tax (dividends, interest and other earnings)

Direct (personal income, corporation etc)

Indirect (excise, customs duty etc)

Capital receipts
External loans (net)

Market borrowings, Small savings, Provident funds etc

Recoveries of loans

Disinvestment receipts

Govt expenditure/revenue
• Have significant impact on incentives, income, demand, production, prices, investment etc:
– Revenue:
• • • • Tariff Excise duties Income tax Corporate profits tax

– Expenditure:
• Subsidies • Other current expenditure • Capital expenditure

Measures of government budget deficit

• • • •

Fiscal deficit Revenue deficit Primary deficit Monetised deficit

Revenue Deficit
Revenue expenditure – Revenue receipts

Monetised deficit

Fiscal deficit financed through RBI credit

Fiscal Deficit
• Total expenditure – Revenue receipts – Nondebt capital receipts such as disinvestment receipts • Reflects the total new loans taken by the government to finance its expenditure

Revenue expenditure

Capital expenditure

Revenue receipts

Revenue deficit

Fiscal deficit

Primary deficit

Fiscal deficit – Interest payments

Government Deficits
• Reducing fiscal deficits is an important element in the Reforms package of the Washington Consensus • In India, reducing fiscal deficit has been one of the most important priorities of the Reforms Package since 1991 • Issue: Is fiscal deficit necessarily bad?

Fiscal Responsibility and Budget Management (FRBM) Act, 2003
• Central Government to reduce by 2008-09: – Revenue deficit to zero (and build surplus thereafter) – Fiscal deficit to 3 % of GDP • RBI prohibited from participating in the primary government securities market from April 2006

Some Direct Tax Reforms
• Rationalization of tax rates • Minimization of exemptions and concessions • Revamping of tax administration and computerization • Minimum Alternative Tax • Fringe benefit tax

Automatic Stabilizer
• Multiplier with proportional taxation (= t Y) =1/[1 – mpc(1 – t)] • Without tax, multiplier = 1/(1 – mpc) > with tax • Effects of autonomous shifts in AD is dampened • The mechanism of the reduction in the response of GDP to fluctuations in AD is known as automatic stabilizer • Automatic: No decision is required as when to apply • Business cycles are likely to be less severe in economies with higher rates of income taxation

IS-LM in India
• Prior to reforms, fiscal policy was the dominant tool of macroeconomic policy and monetary policy played a subservient role • Mainly financed through SLR and Treasury bill, RBI has less discretionary power to operate OMO

IS-LM in India
• 1995-96 to 2000-01:
– Growth rate of fiscal deficit: 20.9 per cent – Growth rate of money supply: 16.1 per cent Rightward shift of IS curve larger than LM curve and interest rates rose

• 2001-02 to 2005-06:
– Growth rate of fiscal deficit: 3.0 per cent – Growth rate of money supply: 13.7 per cent Rightward shift of LM curve larger than of IS curve and interest rates declined

Output increases accompanied interest rate decline. Also this time around improvement in transaction mechanism allow the demand for money to grow at a smaller pace despite the growth of output

IS-LM in India

Recent Crisis: Drivers of Recovery

Source: Gokarn - India's Economic Recovery - Drivers and Risks

Fiscal Trends in India since the 1970s

7 -0 06 20 3 -0 02 20 9 -9 98 19 5 -9 94 19 1 -9 90 19 7 -8 86 19 3 -8 82 19 9 -7 78 19 5 -7 74 19 1 -7 70 19

Central Govt total expenditure as % of GDP

25.0 20.0 15.0 10.0 5.0 0.0
Per cent

Year

7 -0 06 20 3 -0 02 20 9 -9 98 19

Central Govt Total Tax as % of GDP

5 -9 94 19 1 -9 90 19 7 -8 86 19 3 -8 82 19 9 -7 78 19 5 -7 74 19 1 -7 70 19

10.0 8.0 6.0 4.0 2.0 0.0
Per cent

Year

7 -0 06 20

Central Govt gross fiscal deficit as % of GDP

3 -0 02 20 9 -9 98 19 5 -9 94 19 1 -9 90 19 7 -8 86 19 3 -8 82 19 9 -7 78 19 5 -7 74 19 1 -7 70 19

10.0

8.0

6.0

4.0

2.0

0.0
Per cent

Year

7 -0 06 20 3 -0 02 20 9 -9 98 19 5 -9 94 19 1 -9 90 19 7 -8 86 19 3 -8 82 19 9 -7 78 19 5 -7 74 19 1 -7 70 19

Central Govt Total Direct Tax as % of GDP

5.0 4.0 3.0 2.0 1.0 0.0
Per cent

Year

7 -0 06 20 3 -0 02 20 9 -9 98 19 5 -9 94 19 1 -9 90 19 7 -8 86 19 3 -8 82 19 9 -7 78 19 5 -7 74 19 1 -7 70 19

Central Govt Total Indirect Tax as % of GDP

8.0

6.0

4.0

2.0

0.0
Per cent

Year

7 -0 06 20

Central Govt Revenue deficit as % of GDP

3 -0 02 20 9 -9 98 19 5 -9 94 19 1 -9 90 19 7 -8 86 19 3 -8 82 19 9 -7 78 19 5 -7 74 19 1 -7 70 19

6.0

4.0

2.0

0.0

-2.0
Per cent

Year

Central Govt Revenue expenditure as % of Total expenditure 100.0 80.0 60.0 40.0 20.0 0.0 -20.0

Per cent

1 -7 70 19

5 -7 74 19

9 -7 78 19

3 -8 82 19

7 -8 86 19

Year

1 -9 90 19

5 -9 94 19

9 -9 98 19

3 -0 02 20

7 -0 06 20

Central Govt revenue deficit as % of revenue expenditure 40.0
Per cent

20.0 0.0
1 -7 70 19 5 -7 74 19 9 -7 78 19 3 -8 82 19 7 -8 86 19 1 -9 90 19 5 -9 94 19 9 -9 98 19 3 -0 02 20 7 -0 06 20

-20.0 Year

Central Govt interest payments as % of revenue expenditure 40.0
Per cent

30.0 20.0 10.0 0.0
1 -7 70 19 5 -7 74 19 9 -7 78 19 3 -8 82 19 7 -8 86 19 1 -9 90 19 5 -9 94 19 9 -9 98 19 3 -0 02 20 7 -0 06 20

Year

Revenue Deficit
• Means that a part of the revenue expenditure, which does not bring any financial returns, is financed through loans • Is it sustainable?

Revenue expenditure

Capital expenditure

Revenue receipts

Revenue deficit

Fiscal deficit

Capital exp financed through loans

Fiscal Deficit
• Is Capital expenditure financed through loans necessarily bad?

Capital Expenditure

Financed By loans from

Household sector

Non-RBI Financial sector

RBI

Different ways of Reducing Fiscal Deficit

Revenue expenditure

Capital expenditure

Revenue receipts

Expenditure Reforms
• Difficult to control revenue expenditure such as wage bill, subsidies • Effectively:
– Reduction in capital expenditure – Lower interest costs due to lower fiscal deficits and lower interest rates – Higher user charges on non-merit subsidies

7 -0 06 20 3 -0 02 20 9 -9 98 19

Central Govt subsidy as % of Total expenditure

5 -9 94 19 1 -9 90 19 7 -8 86 19 3 -8 82 19 9 -7 78 19 5 -7 74 19 1 -7 70 19

15.0

10.0

5.0

0.0
Per cent

Year

Public sector GFCF as % of total at current price

7 -0 06 20 3 -0 02 20 9 -9 98 19 5 -9 94 19 1 -9 90 19 7 -8 86 19 3 -8 82 19 9 -7 78 19 5 -7 74 19 1 -7 70 19 7 -6 66 19 3 -6 62 19 9 -5 58 19 5 -5 54 19 1 -5 50 19

60.0

40.0

20.0

0.0
Per cent

Year

Is India a high tax country?
• Yes, In terms of total tax (indirect tax) ratio • Yes, in terms of direct tax rate in the past • But not, in in terms of direct tax ratio

Direct Tax Revenue = Tax Rate x Taxable Income
• In India, what used to be high was the income tax rate, not taxable income:
– In 1971-72, the highest marginal rate of taxation was 97.75%

• Tax base has been low, among others, because of:
– Various exemptions and concession – Black income, which by definition is not taxed and – Agricultural income is not taxed in India

8 -0 07 20 1 -0 00 20 6 -9 95 19 1 -9 90 19 6 -8 85 19 1 -8 80 19 6 -7 75 19 1 -7 70 19 6 -6 65 19 1 -6 60 19 6 -5 55 19 1 -5 50 19

Central & State Govts Total Tax GDP ratios

Year

5

20

15

Percent

10

0

Direct tax

Indirect tax

Total

Fiscal Policy & Budget Deficit
• • • • Will Re 1 increase in G lead to Re 1 increase in BD? Increase in G leads to higher Y through multiplier Higher Y would generate additional tax T What is the net effect on BD?

• ΔT = tΔY = t/[1 – c(1 – t)] ΔG • ΔBD = ΔG – ΔT = {1 – t/[1 – c(1 – t)]} ΔG

= (1 – c)(1 – t)/[1 – c(1 – t)] ΔG > 0
• If c = 0.8, t = 0.1  BD will increase by Re 0.64

Govt. Debt: The Traditional View
• Consider fiscal deficit financed by borrowing • Short-run: ↑Y, ↓u • Long-run: - Y and u back at their natural rates - closed economy: ↑r, ↓I - open economy: ↑ε, ↓NX (or higher trade deficit) • Very long-run: slower growth until economy reaches new steady state with lower per capita income

Fiscal Deficit
• Arguments against:
– Inflation (under what condition?) – Crowding out due to higher interest rates

• Arguments for:
– Increase in price level and interest rates depend on whether goods and credit markets are demand or supply constrained – In a demand-constrained economy, crowding-in is likely

Crowding Out Effect
Larger government loans

Higher interest rate

Lower private investment

Loanable Funds Market
Interest rate
S

8%

D

Rs 1200

Quantity of loanable funds (millions of rupees)

Crowding out
Interest rate

S

10%
8%

Amount of Govt loans

D2 D1
Quantity of loanable funds (millions of rupees)

But …
• Is the Supply of loanable funds given? • A rise in supply of securities by government leads to a rise in interest rate if demand for securities is given • But in a demand constrained system, if demand for bank credit is not adequate, then banks will also demand more securities (rather than keep the deposits idle) and hence demand for securities also rises • Moreover in a demand constrained system, as real income increases with rising government expenditure, savings and hence bank deposits also increase. (This will be so even in a supply constrained economy though at the cost of inflation through “forced savings”).

In a demand-constrained, interest rate may not increase with more fiscal deficits
Interest rate

S1
S2

10%
8% D2 D1
Quantity of loanable funds (millions of rupees)

In case of Output Gap
(Demand less than capacity) • More government expenditure (investment) particularly in non-competing sectors (such as agriculture, infrastructure) crowds in private investment • More government expenditure (investment) can contain fiscal deficits in future by:
– ↑ tax and non-tax revenue – ↓ expenditure (subsidies)

Crowding In Effect
Larger government expenditure

Improves business climate

Higher private investment

Thus
• In a demand constrained system:
– “Crowding in” can be stronger than “Crowding out” and hence fiscal deficit can be good for the economy

• But in a supply-constrained system:
– Fiscal deficit leads to “Crowding out”

• Was FRBM Act, 2003 premature?
– Recent recession shows that countries need to have the flexibility to respond to situations – Following fiscal compressions, capacity to absorb higher productive expenditure (in recession/depression) suffers – Budget estimates 2009-10, deficits lower 2008-09:
• Fiscal deficit: 5.5% (compared to 6% revised estimates, 2008-09) • Revenue deficit: 4% (compared to 4.4% revised estimates, 200809)

Is Government Debt a burden?
• Larger taxes as the economy expands and larger nontax receipts (profits of govt enterprises, interest on loans given) can service the government loans • Hence important to ensure that govt loans are utilized productively • But depending on the arrangements between the government and the central bank, what happens if fiscal deficit is financed through printing of money with no interest or repayment obligation on the part of the government?

The burden of Public Debt
• With reduced power to finance deficit by borrowing from RBI, GoI has to rely on public borrowing • Being non-monetized debt it will not raise the money supply and hence is less inflationary • Is this method of financing costless? • If public debt grows over time, the interest burden of servicing the debt will grow (even if r remains the same) • This will add to the deficit calling for further borrowing unless taxes are raised sufficiently • Volume of debt is not important; what matters is the debtGDP ratio

India: Debt – GDP Ratio

Interest Payment

The burden of Public Debt
• New debt ΔD = G – T + rD • Debt-GDP ratio d = D/Y  Δd/d = ΔD/D – ΔY/Y = ΔD/D – g • Δd = ΔD/Y – gd = (G – T)/Y + rd – gd = PD/Y + (r – g)d • If r > g for some reason, then the debt-GDP ratio can be kept stable only with a decline in PD • Reduction in PD may lead to falling g  the gap between r and g will increase making debt stabilization harder to achieve • What are likely effects of worsening debt-GDP ratio?

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...1. What is fiscal policy? Fiscal policy is the use of government spending and consumption to influence the economy. We can also summaries fiscal policy as government policy that affects the macroeconomic condition. Government usually uses fiscal policy to improve unemployment rate, control inflation and to promote strong growth in the economy. 2. How can it be used to get the economy out of recession? First, the government may lower the tax rates to increase the economic growth. If less money is paid on taxes people have more money to spend or invest which will help to improve the economic growth. Secondly, increasing government spending also will help. Additional government spending will create more job opportunities, which will lower the unemployment rate. 3. How can it be used to get the economy out of the situation where the economy is in an expansionary period where we exceed long run potential. Expansionary fiscal policy will lead to an increase in government budget deficit. In this case government should decrease its spending and increase taxes. Lower government spending will decrease the aggregate demand. Increasing taxes and reducing government spending will decrease government’s budget deficit. 4. Do both situation results on different impact on inflation? Why or Why not? Yes, both situations result on different impact on inflation. Expansionary fiscal policy lead to inflation because of the higher demand of the economy, which is caused by......

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Fiscal Policy

...Reserve's recent policy decisions and place these actions in an international context. what happens when there is a surplus of imports brought into the U.S.? what is a specific product with an import surplus, and the impact that has on the U.S. businesses and consumer involded. The U.S. economy has faced significant headwinds, and, although the economy has been expanding since mid-2009, the pace of our recovery has been frustratingly slow. The headwinds include the effects deleveraging by households, the still-weak U.S. housing market, tight credit conditions in some sectors, spillovers from the situation in Europe, fiscal contraction at all levels of government, and concerns about the medium-term U.S. fiscal outlook. In this environment, households and businesses have been quite cautious in increasing spending. Accordingly, the pace of economic growth has been insufficient to support significant improvement in the job market; indeed, the unemployment rate, at 7.8 percent, is well above what we judge to be its long-run normal level. With large and persistent margins of resource slack, U.S. inflation has generally been subdued despite periodic fluctuations in commodity prices. Consumer price inflation is running somewhat below the Federal Reserve's 2 percent longer-run objective, and survey- and market-based measures of longer-term inflation expectations have remained well anchored. The global economic outlook also presents many challenges, as you know. Fiscal and......

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Fiscal and Monetary Policy

...Fiscal and Monetary Policy The textbook states clearly that the aggregate supply curve (and the economy in general) is heavily influenced by unemployment: “The Keynesian range of the curve is horizontal because neither the price level nor production costs will increase or decrease when there is substantial unemployment in the economy.” (Tucker) This shows that high unemployment should be prevented as much as possible, and quickly alleviated if it begins to rise. “Our Fiscal Policy Paradox”, written by Alan S. Blinder, explores the current fiscal and monetary policy options, and describes which options should be implemented in order to pull the economy out of the recession. The fiscal options that are given are: 1. New jobs tax credit 2. Government hiring 3. Cut sales taxes The tax credit for new jobs would simply be an incentive for employers to hire more people in order to decrease unemployment, which will increase spending in general, a key factor in pulling the nation out of its economic trough. This strategy has been pursued, but not effectively. The author explains: The government could offer tax breaks to firms that increase their employment above some base level. In fact, Congress did just that with the HIRE (Hiring Incentives to Restore Employment) Act in March. But it was legislated on a pitifully small scale and will expire at year's end. We need a larger version that stays around for a while. (WSJ.com) Providing such a credit would......

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