Instruments of Fiscal Policy

21st January 2021 1 By indiafreenotes

A Contra cyclical Budgetary Policy:

The policy of managed budgets implies changing expenditures with constant tax rates or changing tax rates with constant expenditures or a combination of the two. Budget management may be used to tackle depression and inflationary situations. Deliberate attempts are made under this policy to adjust revenues, expenditures and public debt to eliminate unemployment during depression and to achieve price stability in inflation.

Contra cyclical policy implies unbalanced budgets. An unbalanced budget during depression implies deficit spending. To make it more effective, the government may finance its deficits by borrowing from the banks. During periods of inflation, the policy is to have a budget surplus by curtailing government outlays.

The government may partly utilize the budget surplus to retire the outstanding government debt. The belief is that a surplus budget has deflationary effect on national income while a deficit budget tends to be expansionary. During depression when we need an increase in the flow of income, deficit budgets are desired. Conversely, in inflation when we need to check the overflow of income, surplus budgets are favoured.

However, following a contra cyclical budgetary policy is not an easy task. Predicting a recession or an inflationary boom is a difficult job. Adjusting the budget to the fast changing economic conditions is still more difficult especially when budget is a political decision to be taken after a good deal of delay and discussion. Therefore, emphasis has also to be laid on adjustment of individual items of the budget in order to make it more effective as a contra cyclical fiscal policy weapon.

Public Expenditure:

Public expenditure can be used to stimulate production, income and employment. Government expenditure forms a highly significant part of the total expenditure in the economy. A reduction or expansion in it causes significant variations in the total income. It can be instrumental in adjusting consumption and investment to achieve full employment.

During inflation, the best policy is to reduce government expenditure in order to control inflation by giving up such schemes as are justified only during deflation. While expenditures are reduced, attempts are made to increase public revenues to generate a budget surplus.

Though it is true that there is a limit beyond which it may not be possible to reduce government spending (say on account of political, and military considerations), yet the government can vary its expenditure to some extent to reduce inflationary pressures.

It is during depression that public spending assumes greater importance. A distinction is made between the concepts of public spending during depression, that is, the concepts of pump priming and the ‘compensatory spending’. Pump priming means that a certain volume of public spending will help to revive the economy which will gradually reach satisfactory levels of employment and output. What this volume of spending may be is not specific. The idea is that, when private spending becomes deficient, then a small dose of public spending may prove to be a good starter.

Compensatory spending, on the other hand, means that public spending is undertaken with the clear view to compensating for the decline in private investment. The idea is that when private investment declines, public expenditure should expand and as long as private investment is below normal, public compensatory spending should go on. These expenditures will have multiplier effects of raising the level of income, output and employment.

The compensatory public expenditure may take the forms of relief expenditure, subsidies, social insurance payments, public works etc.

Essential requisites of compensatory public spending are:

(1) It must have the maximum possible leverage effects;

(2) It must not be mutually offsetting;

(3) It must create economically and socially desirable assets. But pump priming expenditures are of limited relevance in advanced economies where the deficiency of investment is not merely cyclical but also secular.


The fact that both taxes and transfer payments automatically vary with changes in income level is the basis of the belief in built-in-stabilizers. The term ‘stabilizers’ is used because they operate in a manner as counteracts fluctuations in economic activity. They are called ‘built-in’, because these come into play automatically as the income-level changes.

Taxes may act as a stabilizing influence upon the economic system if the tax structure is such that the amount of taxes collected by the government rises automatically with increases in national income, for in this case the effect will be to reduce the expansion of disposable income. From the stabilizing point of view, it means a slower rise in induced consumptions.

If the tax system is such that only the absolute amount of tax revenue but also the percentage of income paid in taxes increases with an increase in income, its stabilizing impact will be greater. That will happen if the rate structure of the tax system is progressive, that is, the effective rates rise as the level of income increases.

Similarly, the various forms of transfer payments also operate in a countercyclical fashion. Only such transfer payments have a stabilising effect as decrease in amount when income increases and increase when income declines.

For example, when employment is falling, payments to the unemployed automatically increase, thereby increasing the disposable income and vice-versa. It would be too much to presume that these stabilizers by themselves can smoothen fluctuations in income but most would agree that these are effective complements to discretionary actions aimed at stabilising the economy.

Taxation Policy:

The structure of tax rates has to be varied in the context of conditions prevailing in an economy. Taxes determine the size of disposable income in the hands of general public and therefore, the quantum of inflationary and deflationary gaps. During depression tax policy has to be such as to encourage private consumption and investment; while during inflation, tax policy must curtail consumption and investment.

During depression, a general reduction in corporate and income taxation has been favoured by economists like Prof. A H. Hansen, M. Kalecki, and R.A. Musgrave on the ground that this leaves higher disposable incomes with people inducing higher consumption while low corporate taxation encourages ‘venture capital’, thereby promoting more investment.

But there are others who express grave doubts about the supposed stimulating effect of taxation reliefs on investment. It has been argued that even a heavy reduction in taxes does not alter an entrepreneur’s decisions.

Mr. Kalecki expressed the view that the policy of reducing taxes for increasing consumption and stimulating private investment is not a practical solution of the unemployment problem because income-tax cannot be changed so often. The government will have to evolve a long-term fiscal policy.


One practical difficulty of public finance is of making the fiscal tools flexible enough for prompt and effective use. For example, the tempo of business activity may change suddenly manifesting itself in booms and slumps but fiscal tools cannot be geared all at once to meet such situations. To overcome such practical difficulties, built-in-flexibility has to be ensured in the fiscal tools.

A fiscal system has built-in-flexibility if a change in employment in the economy brings about a marked compensating change in the government’s revenues and expenditures. Unemployment insurance schemes have built-in-flexibility on both the spending and taxing sides.

As employment increases, the money spent on dolls is automatically reduced. Price support programmes, some kinds of excise duties, especially those levied on luxuries, also have built-in-flexibility to some extent.

However, built-in-flexibility may prove inadequate to cope with strong deflationary and inflationary pressures. Therefore, formula flexibility (or flexibility by way of executive discretion) is required.

A system of formula flexibility provides for specific changes in the tax structure and the volume of government spending as necessitated by certain clearly-recognised problems in business activity. It requires decision making on the part of the administration about the necessary changes which must be given effect to without delay.

Executive discretion implies the delegation to the chief executive the authority to order whatever changes he thinks fit in government spending and tax structure. These measures are required to supplement the built-in-flexibility of some schemes.

Public Works:

Public expenditures meant for stabilisation are classified into two types:

(i) Expenditures on public works such as roads, schools, parks, buildings, airports, post-offices, hospitals, canals and other projects.

(ii) Transfer payments, such as interest on public debt, pensions, subsidies, relief payment, unemployment insurance, social security benefits etc.

The expenditure on building up of capital assets is called capital expenditure and transfer payments are called current expenditure. It has been recommended that governments should keep ready with them a list of public works which may be taken up when the economy shows signs of recession.

Such a programme of public investment will tone up the general morale of businessmen for investing. The primary employment in public works programmes will induce secondary and tertiary employment. As soon as the economy is put on the expansion track, such programmes may be slackened and may be given up completely so that at any time public investment does not compete with private investment.

Public works programmes suffer from a few limitations and practical difficulties. It is unrealistic to expect that public works will fill all the investment gaps of the private sector of the economy. To be genuinely effective in promoting investment during depression, public works require proper timing, proper financing and general approval of business and investing opportunities.

Public Debt:

A sound programme of public borrowing and debt repayment is a potent weapon to fight inflation and deflation. Government borrowing can be in the form of borrowing from non-bank financial intermediaries, borrowing from commercial banking system, drawings from the central bank or printing of new money.

Borrowing from the public through the sale of bonds and securities which curtails consumption and private investment is anti-inflationary in effect. Borrowing from the banking system is effective during depression if banks have got excess cash reserves.

Thus, if unused cash lying with banks can be lent to the government, it will cause a net addition to the national income stream. Withdrawals of balances from treasury are inflationary in nature but these balances are likely to be so small as to be of little importance in the economic system. However, the printing of new money is highly inflationary.

During war, borrowing becomes necessary when inflationary pressures become strong. In a period of inflation, therefore, public debt has to be managed in such a way as reduces the money supply in the economy and curtails credit. The government will do well to retire debt through a budget surplus.

During depression, on the opposite, taxes are reduced and public expenditures are increased. Deficits are financed by borrowings from the public, commercial banks or the central bank of the country. The public borrowing of otherwise idle funds will have no adverse effect on consumption or on investment. When budgets are deficit, it is very difficult to retire debts.

Actually, it pays to accumulate debt during depression and redeem it during a period of expansion. Along with this, the monetary authority (the central bank) must aim at a low bank rate to keep the burden of debt low. Thus, ‘public debt becomes an important tool of anti-cyclical policy.