What is Fiscal Policy? Meaning, Tools, Methods, Importance, & FAQs

Meaning of Fiscal Policy

Fiscal policy refers to a policy that is concerned with the effects of government expenditure, taxation, and public borrowing on output and employment.

Fiscal policy is a policy concerning the receipts and expenditures of the government. It belongs to the budgetary policy of the government. It operates through changes in government expenditures, taxation, and public borrowings.

In the words of Musgrave, “Fiscal policy is concerned with those aspects of economic policy which arise in the operations of the public budget.”

Fiscal policy is used as a balancing device in the development of an economy. Modern fiscal policy is a way to win and maintain full employment by managing public expenditure and revenue in such a fashion as to keep an equilibrium between effective demand and supply services at a particular time.

In other words, the modern fiscal policy is nothing but the application of the principle of functional finance.

To quote Lerner, “The principle of judging fiscal measures by the way they work or function in the economy, we may call functional finance”

In short, it is the policy which concerned with the effects of government expenditure, taxation, and public borrowing on income, production, and employment.

An effective and good fiscal policy uses various fiscal agents like expenditure, taxation, and public borrowings in a proper combination to achieve the best possible results in terms of the desired economic objectives like maintaining economic stability, high employment, and accelerating economic growth.

Objectives of Fiscal Policy

Five key objectives of fiscal policy are:

• Optimum allocation of resources
• Full employment
• Price stability
• Equitable distribution of income and wealth
• Economic growth

Tools of Fiscal Policy

There are mainly four instruments or constituents of the fiscal policy, they are budget, public expenditure, public revenue, and public debt.

All these constituents must work together to make the fiscal policy sound and effective.

The main fiscal instruments are explained below:

Budget

A budget is a master financial plan containing a preliminary approval of estimates of public expenditure and revenues.

A budget is an estimate of government expenditures and revenues for a fiscal year, usually presented to the parliament by the finance minister.

In Nepal, the budget is submitted to the parliament by the finance minister in the month of Ashadh, each fiscal year. In order words, the estimated statements of the government’s anticipated revenues and expenditures are called a budget.

There are three types of budgetary policies:

• Balanced budgetary policy: When the government keeps its total expenditure equal to its revenue, as a matter of policy, it means it has adopted a balanced budget policy.
• Deficit budgetary policy: When the government spends more than its expected revenue, as a matter of policy, it is pursuing a deficit budget policy.
• Surplus budgetary policy: When the government follows a policy of keeping its expenditure substantially below its current revenue, it is following a surplus budget policy.

These budgetary policies affect the economy in different ways and different directions.

Public Expenditure

Public expenditure refers to all types of expenditures made by public authorities. The expenditures incurred by the central authorities (in running the government) in the form of expenditures on administration and maintenance of law and order are examples of public expenditure.

Expenditure made on education, health, transport and communication, public works, etc. is a familiar example of public expenditure incurred for the satisfaction of collective wants.

In the modern welfare state, the government has to undertake several social and economic activities for which it has to incur expenditure.

Public expenditure needs to be incurred in providing social security to the public (i.e. old-age pensions, unemployment allowances, etc.) in providing economic and/or social overheads (such as transport and communication, health and education, electricity, drinking water, etc.) in maintaining economic stability, in providing welfare activities and in promoting economic development.

Public Revenue

The government needs the income to perform a variety of functions. The income of the government which is obtained through sources such as taxes, grants, fees, borrowing, etc is called public income or public revenue.

Generally, government revenue implies the income raised from the public by the state through taxes. But taxes are not only the source of public revenue.

There are various other non-tax sources of public revenue such as taxes, prices, fees, fines and penalties, gifts, and profits, special assessments, etc.

Public Debt

Public debt is the debt that the government owes to or to the nationals of other countries.

The volume of public expenditure has increased over the years with the increase in the activities of the government. It is not possible to meet the expenditure through the traditional source of revenue, namely tax.

Therefore, the government is required to obtain additional revenue through borrowing. In modern times, borrowing by the government has become a normal method of government finance along with other sources of public finance such as taxes, fees, etc. Borrowing by the government leads to public debt.

The government can borrow from individuals, business enterprises, and banks. It can borrow from within the country and from outside the country.

The main objectives of government borrowings are: to meet the budgetary deficit, finance the war, finance development plans, fight depression, etc.

Read More: Objectives of Monetary Policy

Methods of Fiscal Policy

Methods of fiscal policy include:

Built-in Flexibility

The technique of built-in flexibility involves the automatic adjustment of expenditures and taxes in the reduction of cyclical upswings and downswings within the economy.

It is also defined as the automatic adjustment in government expenditure and tax revenue in response to a rise or fall in GDP.

In this kind of fiscal policy, the government adopts a tax system and an expenditure program linked to GNP and unemployment. Under this system, changes in the budget are automatic and hence this technique is also known as an automatic stabilizer.

The various automatic stabilizers are corporate tax, income tax, excise taxes, old-age pensions, unemployment insurance, etc.

As instruments of automatic stabilization, taxes, and expenditures are related to national income. Given an unchanged tax rate, tax yields vary directly with national income, while government expenditures vary inversely with national income.

Discretionary Fiscal Policy

Under this policy, the government makes deliberate changes in the level and pattern of taxation, the size and pattern of its expenditure, and the size and composition of public debt.

The government makes the following types of discretionary changes in both direct and indirect taxes:

• Imposition of new taxes or abolition of old taxes
• Imposition of taxes on new tax bases
• Increasing or decreasing the tax rates

All these kinds of changes in taxation result in either a transfer of household incomes to the government or a reduction in such transfers.

The discretionary changes in the government spending include changes:

• The size of the government expenditure
• In the composition of government expenditure
• In the methods of financing government expenditure
• In transfer payments
• In overall budgetary surplus and deficit, and
• In the methods of deficit financing

Read More: Meaning of Business Cycle

Compensatory Fiscal Policy

It is a deliberate budgetary action taken by the government to compensate for the deficiency in or excess of aggregate demand.

The compensatory action is taken by the government in the form of surplus budgeting or deficit budgeting.

Under this policy, the government uses a greater degree of discretion than in automatic stabilization policy and this policy can be revised year after year.

Besides, the policy of surplus or deficit budgeting is adopted as and when the government is required to control inflation and deflation.

Importance of Understanding Fiscal Policy

Understanding fiscal policy is essential for comprehending how governments influence economic activity, stability, and growth.

Here are six key reasons why fiscal policy is important:

Economic Stabilization

Fiscal policy helps stabilize the economy during fluctuations like inflation or recession.

• Expansionary fiscal policy (increased government spending or tax cuts) stimulates demand during recessions.
• Contractionary fiscal policy (reduced spending or higher taxes) curbs excessive demand during inflationary periods, maintaining price stability.

This ensures a balanced economic environment and protects businesses and individuals from economic shocks.

Encourages Economic Growth

Governments use fiscal measures like increased spending on infrastructure, education, and healthcare to stimulate long-term economic growth.

Such investments create jobs, enhance productivity, and foster sustainable development, enabling economies to reach their potential.

Read More: International Trade Theories

Redistribution of Income and Wealth

Fiscal policy is a critical tool for promoting social equity.

Progressive taxation systems and welfare programs reduce income inequality by transferring resources from high-income groups to low-income households. This improves social harmony and reduces poverty.

Maintains Full Employment

By managing public expenditures and revenues effectively, fiscal policy ensures the optimal use of labor resources.

For example, during high unemployment, governments can implement public works programs to create jobs and boost employment rates.

Addresses Market Failures

Fiscal policy can correct market inefficiencies where private markets fail to allocate resources optimally.

Public spending on goods and services like education, healthcare, and infrastructure addresses gaps and enhances societal welfare.

Helps Manage National Debt

A sound fiscal policy ensures sustainable borrowing and repayment. Managing public debt efficiently avoids excessive deficits, ensuring future generations are not burdened with unmanageable debt levels.

By understanding these aspects, policymakers and citizens can evaluate fiscal measures effectively and support decisions that lead to economic prosperity and social well-being.

Read More: Leadership in Business

Fiscal Policy Vs. Monetary Policy

Fiscal policy and monetary policy are two key tools governments and central banks use to influence the economy.

Fiscal policy is managed by the government and focuses on taxation, public spending, and borrowing to regulate economic activity. For instance, increased government spending or tax cuts can stimulate demand during a recession, while higher taxes or reduced spending can curb inflation.

In contrast, monetary policy is implemented by a country’s central bank, such as the Federal Reserve or the European Central Bank, and involves managing interest rates and money supply. By adjusting these factors, central banks aim to control inflation, stabilize the currency, and encourage economic growth.

While fiscal policy directly impacts public services and government debt, monetary policy primarily influences credit availability and financial market conditions. Together, they ensure economic stability and sustainable growth.

Read Next: Macro Vs. Micro – Economics

FAQs on Fiscal Policy