What is fiscal policy?• Refers to the policy regarding the use of the

government’s revenue & expenditure program with a view to attaining certain macroeconomic goals

• Refers to “a policy under which government uses its expenditure & revenue programs to produce desirable effects & avoid undesirable effects on the national income, production & employment” – Arthur Smithies

Objectives of fiscal policy• To maintain economic stability by controlling business

cycles• To attain & maintain full employment in the economy• To ensure a steady rate of economic growth• To maintain price stability• To remove inequality in the distribution of income &

wealth• To remove balance of payments deficit• To remove regional inequality & to ensure balance

regional development

Tools of Fiscal Policy

• The fiscal measures which the government can adopt in order to achieve the objectives of fiscal policy are known as the tools of fiscal policy

• There are three main tools of fiscal policy:TaxationPublic Expenditure Public Debt

Tax revenue• A tax is a compulsory levy imposed by a public

authority on persons and organizations to meet public expenditures

• Thus, the above definition highlights the following points:i) A tax is the compulsory payment made to the government. Refusal to pay the tax is a punishable offence.ii) Every tax involves some sacrifice on part of the tax payer.iii) A tax is not a fine or penalty.

Tax Revenue as a tool of fiscal policy

• Aggregate demand can also be changed by change in the amount of tax revenue without any change in government expenditure

T ↑ → Yd ↓& corporate income ↓→ C ↓ & I ↓→ AD ↓

Objectives of taxation

To raise revenue, redistribute wealth, stabilize prices, foster economic growth, and promote social goals

Cannons of Taxation• Equity and fairness• Certainty• Convenience• Economy• Simplicity• Neutrality• Economic Growth & Efficiency• Transparency & Visibility• Minimum Tax Gap• Appropriate Government Revenues

Cannons of Taxation

• Equity & Fairness– Similarly situated taxpayers should be taxed

similarly.– Horizontal equity: people with equal capacity to

pay the same tax– Vertical equity: people with greater capacity to

pay the more tax– Fairness: Should really look at entire range of

taxes a taxpayer is subject to

Cannons of Taxation …..

• Equity & Fairness– Similarly situated taxpayers should be taxed

similarly.– Horizontal equity: people with equal capacity to

pay the same tax– Vertical equity: people with greater capacity to

pay the more tax– Fairness: Should really look at entire range of

taxes a taxpayer is subject to

Cannons of Taxation ….

• Certainty: – Tax rules should specify when the tax is to be

paid, how it is to be paid, and how the amount to be paid is to be determined.

– Ability to determine tax base and rate.– Basically, the level of confidence that exists that

the tax is being calculated correctly.

Cannons of Taxation ….• Convenience of Payment:

– A tax should be due at a time or in a manner that is most likely to be convenient for the taxpayer.

– Helps ensure compliance.– Appropriate payment mechanism depends on amount of liability and

ease of collection.• Economy of Collection:

– The costs to collect a tax should be kept to a minimum for both the government and taxpayers.

Cannons of Taxation ….• Simplicity:

– The tax law should be simple so that taxpayers can understand the rules and comply with them correctly and in a cost-efficient manner.

– Reduces the amount of errors.– Increases respect for the system.– Enables taxpayers to understand tax consequences of their

transactions.

Cannons of Taxation ….• Neutrality:

– The effect of the tax law on a taxpayer’s decisions as to how to carry out a particular transaction or whether to engage in a transaction should be kept to a minimum.

– Taxpayers should not be unduly encouraged or discouraged from engaging in certain activities due to tax law.

– Primary purpose of tax system is to raise revenue, not change behavior.

Cannons of Taxation ….• Economic Growth & Efficiency:

– The tax system should not impede or reduce the productive capacity of the economy.

– Tax system should be aligned with the economic goals of the jurisdiction imposing the tax.

• For example, should be aligned with jurisdiction’s economic goals for economic growth, capital formation.

• Should not favor one industry or type of investment at the expense of others.

Cannons of Taxation ….• Transparency & Visibility:

– Taxpayers should know that a tax exists and how and when it is imposed upon them and others.

– Enables taxpayers to know the true cost of transactions.– Enables taxpayers to know when tax is being assessed or

paid and to whom.

Cannons of Taxation ….• Minimum Tax Gap:

– A tax should be structured to minimize noncompliance.

– Tax gap = amount owed less amount collected.– Procedural rules needed to attain compliance.– Generally, is a need to strike a balance between (a)

desired level of compliance and (b) costs of enforcement and the level of intrusiveness of the tax system.

Cannons of Taxation ….• Appropriate Government Revenues:

– The tax system should enable the government to determine how much tax revenue will likely be collected and when.

– Need to have some level of predictability and reliability to enable governments to know how much will be collected and when.

– Generally, government realizes better stability with a mix of taxes.

Appropriate Government Revenues

The tax system should enable the government to determine how much tax revenue will

likely be collected and when.

• Need to have some level of predictability and reliability to enable governments to know how much will be collected and when.

• Generally, government realizes better stability with a mix of taxes.

Challenges• Desire to use the tax law for more than

raising revenue.

• Frequent changes to the tax laws.

• Not all ten principles can be achieved to same degree for all proposed changes - need to strike a balance though.

Tax Rate Structure

• Progressive: Greater is tax burden, higher the level of income

• Proportional: a fixed rate irrespective of income level

• Regressive: tax burden shifts to lower income group, that is, lower income group people pay a higher percentage of their income as tax

Government borrowing as a tool of fiscal policy

• Government can influence the level of economic activity through borrowings from the public & repayment of old debts

Budget balances• Deficit: Sum by which expenditure exceeds

government revenue• Surplus: Sum by which government revenue exceeds

government expenditure

• Revenue deficit: Revenue expenditure minus Revenue receipts

• Fiscal deficit: Total expenditure minus Total Revenue (excluding borrowings and other liabilities)

• Primary deficit : Fiscal deficit minus Interest payments

Government expenditure as a tool of fiscal policy

• Government expenditure act as an important lever to influence aggregate demand, output, income, employment, prices etc

• A change in the composition of government expenditure without a change in total government expenditure can also help to achieve certain macroeconomic policy

Canons of Public Expenditure• Cannon of Benefit• Canon of Economy• Canon of Sanction • Canon of Surplus• Canon of productivity

Reasons for Increasing public Expenditure

Welfare stateInflationDefense ExpenditureRepayment of Public debtAdministrativePopulation