The Concept of Fiscal Policy by Jolito Ortizo Padilla

Managing the economy is a complex task. The annual budget, which is the most important statement of fiscal policy , is eagerly awaited and attracts much media attention as the overall outcome is a very clear indicator of the state of the economy.In this statement , the Finance Minister outlines the government's spending and taxation plans for the year ahead.The direction taken in the budget should give a clear indication of the government's macroeconomic priorities.

In principal, there are three types of budget:

1. Budget Deficit -in this situation, projected government spending exceeds projected revenue from many forms of taxation.This is where the government sees the need to reflate the economy by increasing aggregate demand. Normally this is in response to a situation where there is a need to expand the economy in order to create more jobs and income.
2. Budget Surplus- in contrast ,this describes a budget where government revenue from taxation exceeds the projected expenditure by the government on social protection, health, care, education , transport and so on. Here the government has identified a need to deflate has identified a need to deflate the economy by cutting back aggregate demand.This is normally in response to a situation where the rate of inflation in the economy is higher than the government feels to be appropriate. It could also be in response to a deteriorating deficit in the balance of trade.
3. Balance Budget- as its name suggests, this is a neutral situation where projected revenue and government spending are equal. Within the budget though there is likely to be some re-allocation of taxation and expenditure.

As seen in the different types of budget, a government can deliberately alter tax rates and levels of government spending to influence economic activity.This is referred to as discretionary fiscal policy and can be used to influence aggregate demand. If a government wants to raise aggregate demand it will increase its spending or cut tax rates.Keynesians favor raising government spending because they believe this will have a bigger multiplier effect.This is because the rise in government spending,especially if it is on welfare payments, is most likely to benefit the poor who have a high marginal propensity to consume. In contrast, a cut in a tax rates may benefit mostly the rich who tend to have a low marginal propensity to consume.

A government can also allow automatic stabilizers to influence economic activity. These are forms of government spending and taxation which change, without deliberate government action to offset fluctuations in GDP. For example,during a recession government spending on unemployment benefits automatically rises because there are more unemployed people. Tax revenue from income tax and indirect taxes will in contrast fall automatically as incomes and expenditure decline.

Fiscal policy may also be employed to affect aggregate supply by changing incentives facing firms and individuals.In recent years , governments throughout the world have increasingly been using fiscal policy in this way to improve the competitiveness of their economies.

For fiscal policy to be effective it is important that the government can accurtaely estimate the impact that changes in government spending and taxation will have on economy. To do this they have a good idea of the value of the multiplier and an awareness of the possible side effects of policy measures. If governments underestimates the value of the multiplier , it may inject too much extra spending and thereby generate inflation and balance of payments problems. Fiscal policy instruments may also have undesirable effects. For example,a government may raise more tax in order to reduce aggregate demand. However , this may also have a disincentive effects and so reduce aggregate supply. This is true of progression taxation such as with income tax where rates increase as the level of earnings increases. Indirect taxes such as sales taxes and excise duties are regressive since they have to be paid at the same rate irrespective of income.

Some instruments of fiscal policy also suffers from significant time lags. Whilst changes in indirect taxes are relatively easy to effect, alterations in direct taxes and government spending take longer to implement and to work through the economy.

It can be difficult to raise taxation and lower government spending because of the political unpopularity of such measures and because of, in the case of government spending, the long term nature of some forms of government spending.For example, once a decision has been announced that the pay of government employees will be increased it would be difficult to reverse it and will commit the government to higher spending for some time.




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