FISCAL POLICY AND ECONOMIC GROWTH

It involves the use of government spending, taxation and borrowing to influence the pattern of economic activity and level of aggregate demand, output and employment. Changes in fiscal policy affect aggregate demand as well as aggregate supply. The effects of a government’s fiscal policy on economic growth have been deliberated upon extensively.  One school of thought is in favour of cutbacks in government spending. This may be justified by low productivity and inefficiency of government expenditures. Another view point emphasizes that governments play a central role in economic development by providing public goods, encouraging investment and providing some sort of direction for economic growth.

Fiscal policy has for very long been seen as a tool for demand management. This implies that changes in government spending and taxation can help control volatility of national output. The Keynesian school has shown very strong effects of fiscal policy on aggregate demand, output and employment when the economy is operating well below the full capacity and where a demand stimulus needs to be provided. It is argued that there is a clear role of the government to make use of fiscal policy to manage the level of aggregate demand in the economy. The Monetarist school, on the other hand, is of the view that government spending and tax changes have a temporary effect on aggregate demand, output and employment. They put forth monetary policy as a more useful instrument in controlling demand and inflationary pressure.

Government spending is divided into three main components. Transfer payments, current government spending and capital spending. Transfer payments are the welfare payments and they are primarily used to provide minimum standard of living for the low income sections of the society. Current government spending is related to the provision of state-provided goods and services. Capital spending includes expenditure on infrastructural development such as highways, roads, schools, hospitals, etc. Government spending is often justified on the basis of following  four grounds. Firstly, in order to provide efficient level of public and merit goods. Secondly, to provide a social safety net to help the poorest of the poor and redistributing income and wealth.  Thirdly, to raise necessary infrastructure through capital spending. Fourthly, for managing the level and growth of aggregate demand to meet macroeconomic policy objectives such as low, stable inflation and high levels of employment.

Turning our attention towards the revenue that flows into the state coffers from taxation we see that there are different kinds of taxes and the tax system of any country is very complex. Two main categories of taxes are direct taxes and indirect taxes. Direct taxes are levied on income, wealth and profit. Some examples are income tax, capital gains tax and corporation tax. Indirect taxes are taxes charged on spending such as excise duties and value-added tax. It is important to mention here the concepts of progressive, proportional and regressive taxes. When the marginal rate of tax rises as the income rises, we call it progressive tax. This means that as people earn more income, the rate of tax on each rupee earned goes up. In the proportional tax the marginal rate of tax is constant. For example a standard rate of tax of 15% across all income levels. With a regressive tax, the rate of tax falls as incomes rise. This implies that the average rate of tax is lower for people with higher incomes.

Changes to fiscal policy can affect the supply side of the economy and, therefore, contribute to long-run economic growth. Cutbacks in income tax are a useful way to improve incentives for people to actively seek work and also as a tool to enhance labour productivity. Some economic experts argue that welfare benefit reforms are more important than tax cuts in improving incentives. Government’s capital spending on the infrastructural development of a country helps in propping up investment across the economy. Lowering the rates of corporation tax and other business taxes can also be used to attract investments for local as well as overseas investors. Government spending can also encourage entrepreneurship and new business creation. Private business sector research and development has also strong correlation with government spending, tax credits and other tax allowances. And lastly, higher government spending on education, developing human capital, health and transport can also have important supply side economic effects in the long-run. A robust transport infrastructure is seen by a large number of businesses as absolutely necessary for a country to remain competitive in this highly integrated global economy.

Free market economists usually show skepticism against government spending in improving the supply side of the economy. They are in favour of lower taxation and tight control of government spending and borrowing to allow private sector to flourish. They also support smaller public sector so that the taxation levels can be brought down and thus private sector can grow. It must be kept in mind that targeted government spending and tax decisions have all the potential to have an overall positive impact over an economy. Proper incentives to individuals and businesses usually help increase the employment and investment levels.  There are multiplier effects associated with expansionary fiscal policy but these depend how much spare productive capacity is there in an economy, and how much increase in the disposable income is spent rather than saved.