Fiscal Policy: Definition, Objectives, Instruments & Types - UPSC Notes

Fiscal policy is one of the key tools deployed by a country’s government, as applicable, for managing the economic activity of the country. It is all about using government spending and taxes to steer the economy toward goals like growth, stability and equity. These financial mechanisms are important tools that, when properly managed, contribute to a balanced and sustainable economic environment.

This is one of the most important topics in General Studies Paper III under the UPSC examination. It gives the candidates knowledge about many economic concepts. It gives their roles in deciding the framework of the economy of the nation.

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Fiscal Policy Definition

Fiscal policy is the strategic use of government expenditure and revenue collection (taxation) by a government to influence a country's economy. Governments stimulate the below by manipulating the two of these levers:

• economic growth,
• control inflation,
• reduce unemployment, and
• stabilize the business cycle.

Fiscal Policy in India

Fiscal Policy is the policy of the Central Government in India. The Budgetary appropriation and tendency of government expenditure is incorporated within the paper. This happens to be a document presented by the Finance Ministry. The Indian socio-economic framework has a heterogenous nature. Fiscal Policy works as an instrument to bridge the inter-regional disparities. It aids in the development of inclusive growth accompanied by equitable dispersal of resources. In that respect, the annual document of the Union Budget is a premier one which outlines the fiscal policies of the government.

Read more about the Different Types of Funds in India here.

Objectives of Fiscal Policy

Fiscal policy aims to achieve various macroeconomic objectives, which include:

• More public expenditure on physical infrastructure, educational institutions, health care facilities, etc. are made to attain economic growth by fiscal policy. It encourages capital formation and, therefore, rises in productivity and GDP.
• Price control is another great objective. Fiscal policies try to achieve price stability. It helps in the protection of purchasing power and currency. Such policies regulate income and government consumption.
• It generates employment opportunities. This is through targeted spending on labor-intensive projects and programs and reduces unemployment.
• Taxes and public expenditures are used for income redistribution purposes. The use of progressive taxation and welfare programs ensures that there is fairer income distribution.
• This is another major goal of fiscal policy. It involves shielding the economy from shock. This maintains a smooth course of the business cycle. This requires that fiscal measures be counter-cyclical. This stabilizes the economy during booms and busts.

Learn more about Disinvestment and the Department of Investment and Public Asset Management (DIPAM) here.

Instruments of Fiscal Policy

Fiscal policy operates through several instruments:

• Government Expenditure: Direct spending on goods and services, infrastructure, defense, education, etc. influences economic activity. More expenditure in a recession will stimulate growth. Lesser expenditure in a boom will cool an overheated economy.
• Taxation: Taxes are one of the significant instruments of fiscal management. Changes in tax rates have a bearing on consumer expenditure and investment. Tax increases can cool down an overheating economy. Tax cuts will stimulate growth in a recession.
• Public Debt: Borrowing is utilized whenever expenditure exceeds revenue. This finances deficit budgets and promotes economic growth.
• Transfer Payments: Subsidies, pension, and unemployment benefits are transferred to the weak sections of society

Types of Fiscal Policy

Fiscal policy can be categorized into two main types:

Expansionary Fiscal Policy

It is employed during times of recession or slowdown of the economy. It means government spending can be increased, taxes reduced, or both, to boost economic activity.

Contractionary Fiscal Policy

This is implemented to control inflation and an overheating economy. It reduces government spending, increases taxes, or both to reduce overall economic activity.

Read more about Fiscal Consolidation here.

Difference Between Fiscal and Monetary Policy

Fiscal Policy and Monetary Policy are instruments of controlling the economy. However, they differ in many ways:

You can also read more about Taxation in India here.

Cyclicality of the Fiscal Policy

Fiscal Policy can either be pro-cyclical or counter-cyclical:

• Pro-cyclical: It acts in line with the business cycle and amplifies economic fluctuations. For example, an increase in spending during times of boom, which can result in overheating.
• Counter-cyclical: It runs against the business cycle and tries to level economic fluctuations. For instance, boosting spending when there is a recession with the motive of reviving the economy. Cutting spending when there is a boom to arrest overheating.

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