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Karnataka Class 12 Commerce Economics Fiscal Policy Complete Notes

Karnataka Class 12 Commerce Economics Fiscal Policy Complete Notes

Karnataka Class 12 Commerce Economics Fiscal Policy : This University identifies the regional needs and overall development of students of this back ward region of north Karnataka. A large number of students suffer from lack of communication skills and opportunities to develop their personality. The University has considered the region specifie and community specific needs and has introduced (a) Computer Applications, (b) Environ mental problems and Human Rights, (c) Indian Constitution and (d) Development of Communication Skills and personality as compulsory papers at the UG level Periodic ICT workshops are conducted for students and staff (teaching and non-teaching) to equip them with the skill to access and utilize electronic information.

Karnataka Class 12 Commerce Economics Fiscal Policy Complete Notes

Karnataka Class 12 Commerce Economics Fiscal Policy :  Economics borrows from multiple sciences e.g. sociology or law, to explain why and how people act to improve their well-being and wealth, e.g. behavioral economics borrows from psychology and history to analyse how past experiences may shape expectations about the future. This may lead to bad decisions.

Karnataka Class 12 Commerce Economics Fiscal Policy Complete Notes

Karnataka Class 12 Commerce Economics Fiscal Policy : Fiscal policy , taking the scope of budgetary policy , refers to government policy that attempts to influence the direction of the economy through changes in government taxes, or through some spending (fiscal allowances). Fiscal policy can be contrasted with the other main type of macroeconomic policy , monetary policy , which attempts to stabilize the economy by controlling interest rates and the supply of money . The two main instruments of fiscal policy are government spending and taxation .

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Fiscal policy therefore refers to the overall effect of the budget outcome on economic activity. The three possible stances of fiscal policy are neutral, expansionary and contraction:

A neutral stance of fiscal policy implies a balanced budget where G = T (Government spending = Tax revenue). Government spending is fully funded by tax revenue and overall the budget outcome has a neutral effect on the level of economic activity.

An expansionary stance of fiscal policy involves a net increase in government spending (G > T) through a rise in government spending or a fall in taxation revenue or a combination of the two. This will lead to a larger budget deficit or a smaller budget surplus than the government previously had, or a deficit if the government previously had a balanced budget. Expansionary fiscal policy is usually associated with a budget deficit.

A Contraction stance fiscal policy (G < T) occurs when net government spending is reduced either through higher taxation revenue or reduced government spending or a combination of the two. This would lead to a lower budget deficit or a larger surplus than the government previously had, or a surplus if the government previously had a balanced budget. Contraction fiscal policy is usually associated with a surplus.

Among the various tools of fiscal policy, the following are the most important:

Reflationary Fiscal Policy: It may be used to boost the level of economic activity during periods of recession or deceleration in economic activity. This is done by lowering taxes or increasing government expenditure. Deflationary Fiscal Policy: During a boom, i.e., when the economy is growing beyond its capacity, inflation and balance of payment problems might result. This can be achieved by increasing taxes or by reducing government expenditure.

Karnataka Class 12 Commerce Economics Fiscal Policy Complete Notes

Karnataka Class 12 Commerce Economics Fiscal Policy :  The role of fiscal policy for economic growth relates to the stabilization of the rate of growth of an advanced country. Fiscal policy through variations in government expenditure and taxation profoundly affects national income, employment, output and prices.


1. Meaning of Fiscal policy

2. Objectives of Fiscal Policy

3. Fiscal Policy for Economic Growth

Karnataka Class 12 Commerce Economics Fiscal Policy Complete Notes

Karnataka Class 12 Commerce Economics Fiscal Policy :  Fiscal policy means the use of taxation and public expenditure by the government for stabilisation or growth. According to Culbarston, “By fiscal policy we refer to government actions affecting its receipts and expenditures which we ordinarily taken as measured by the government’s receipts, its surplus or deficit.” The government may offset undesirable variations in private consumption and investment by compensatory variations of public expenditures and taxes.

Arthur Smithies defines fiscal policy as “a policy under which the government uses its expenditure and revenue programmes to produce desirable effects and avoid undesirable effects on the national income, production and employment.” Though the ultimate aim of fiscal policy in the long-run stabilisation of the economy, yet it can be achieved by moderating short-run economic fluctuations. In this context, Otto Eckstein defines fiscal policy as “changes in taxes and expenditures which aim at short-run goals of full employment and price-level stability.”

Objectives of Fiscal Policy

The following are the objectives of fiscal policy

1. To maintain and achieve full employment.

2. To stabilise the price level.

3. To stabilise the growth rate of the economy.

4. To maintain equilibrium in the balance of payments.

5. To promote the economic development of underdeveloped countries.

Fiscal Policy for Economic Growth

The role of fiscal policy for economic growth relates to the stabilisation of the rate of growth of an advanced country. Fiscal policy through variations in government expenditure and taxation profoundly affects national income, employment, output and prices. An increase in public expenditure during depression adds to the aggregate demand for goods and services and leads to a large increase in income via the multiplier process; while a reduction in taxes has the effect of raising disposable income thereby increasing consumption and investment expenditure of the people.

On the other hand, a reduction of public expenditure during inflation reduces aggregate demand, national income, employment, output and prices; while an increase in taxes tends to reduce disposable income and thereby reduces consumption and investment expenditures. Thus the government can control deflationary and inflationary pressures in the economy by a judicious combination of expenditure and taxation programmes. For this, the government follows compensatory fiscal policy.

Compensatory Fiscal Policy:

The compensatory fiscal policy aims at continuously compensating the economy against chronic tendencies towards inflation and deflation by manipulating public expenditures and taxes. It, therefore, necessitates the adoption of fiscal measures over the long-run rather than once-for-all measures it a point of time.

When there are deflationary tendencies in the economy, the government should increase its expenditures through deficit budgeting and reduction in taxes. This is essential to compensate for the lack in private investment and to raise effective demand, employment, output and income within the economy.

On the other hand, when there are inflationary tendencies, the government should reduce its expenditures by having a surplus budget and raising taxes in order to stabilise the economy at the full employment level.

The compensatory fiscal policy has two approaches:

(1) Built-in stabilisers; and

(2) Discretionary fiscal policy.

(1) Built-in Stabilisers:

The technique of built-in flexibility or stabilisers involves the automatic adjustment of the expenditures and taxes in relation to cyclical upswings and downswings within the economy without deliberate action on the part of the government. Under this system, changes in the budget are automatic and hence this technique is also known as one of automatic stabilisation.

The various automatic stabilisers are corporate profits tax, income tax, excise taxes, old age, survivors and unemployment insurance and unemployment relief payments. As instruments of automatic stabilisation, taxes and expenditures are related to national income. Given an unchanged structure of tax rates, tax yields vary directly with movements in national income, while government expenditures vary inversely with variations in national income.

In the downward phase of the business cycle when national income is declining, taxes which are based on a percentage of national income automatically decline, thereby reducing the tax yield. At the same time, government expenditures on unemployment relief and social security benefits automatically increase. Thus there would be an automatic budget deficit which would counteract deflationary tendencies.

On the other hand, in the upward phase of the business cycle when national income is rising rapidly, the tax yield would automatically increase with the rise in tax rates. Simultaneously, government expenditures on unemployment relief and social security benefits automatically decline. These two forces would automatically create a budget surplus and thus inflationary tendencies would be controlled automatically.

It’s Merits:

Built-in stabilisers have certain advantages as a fiscal device:

1. The built-in stabilisers serve as a cushion for private purchasing power when it falls and lessen the hardships on the people during deflationary period.

2. They prevent national income and consumption spending from falling at a low level.

3. There are automatic budgetary changes in this device and the delay in taking administrative decisions is avoided.

4. Automatic stabilisers minimise the errors of wrong forecasting and timing of fiscal measures.

5. They integrate short-run and long-run fiscal policies.

It’s Limitations:

It has the following limitations:

1. The effectiveness of built-in stabilisers as an automatic compensatory device depends on the elasticity of tax receipt, the level of taxes and flexibility of public expenditures. The greater the elasticity of tax receipts, the greater will be the effectiveness of automatic stabilisers in controlling inflationary and deflationary tendencies. But the elasticity of tax receipts is not so high as to act as an automatic stabiliser even in advanced countries like America.

2. With low level of taxes even a high elasticity of tax receipts would not be very significant as an automatic stabiliser doing a downswing.

3. The built-in stabilisers do not consider the secondary effects of stabilisers on after-tax business incomes and of consumption spending on business expectations.

4. This device keeps silent about the stabilising influence of local bodies, state governments and of the private sector economy.

5. They cannot eliminate the business cycles. At the most, they can reduce its severity.

6. Their effects during recovery from recession are unfavourable. Economists, therefore, suggest that built-in stabilisers should be supplemented by discretionary fiscal policy.

(2) Discretionary Fiscal Policy:

Discretionary fiscal policy requires deliberate change in the budget by such actions as changing tax rates or government expenditures or both.

It may generally take three forms:

(i) Changing taxes with government expenditure constant,

(ii) changing government expenditure with taxes constant, and

(iii) variations in both expenditures and tax simultaneously.

(i) When taxes are reduced, while keeping government expenditure unchanged, they increase the disposable income of households and businesses. This increase private spending. But the amount of increase will depend on whom the taxes are cut, to what extent, and on whether the taxpayers regard the cut temporary or permanent.

If the beneficiaries of tax cut are in the higher middle income group, the aggregate demand will increase much. If they are businessmen with little incentive to invest, tax reductions are temporary. This policy will again be less effective. So this is more effective in controlling inflation by raising taxes because high rates of taxation will reduce disposable income of individuals and businesses thereby curtailing aggregate demand.

(ii) The second method is more useful in controlling deflationary tendencies. When the government increases its expenditure on goods and services, keeping taxes constant, aggregate demand goes up by the full amount of the increase in government spending. On the hand, reducing government expenditure during inflation is not so effective because of high business expectations in the economy which are not likely to reduce aggregate demand.

(iii) The third method is more effective and superior to the other two methods in controlling inflationary and deflationary tendencies. To control inflation, taxes may be increased and government expenditure be raised to fight depression.

It’s Limitations:

The discretionary fiscal policy depends upon proper timing and accurate forecasting:

1. Accurate forecasting is essential to judge the stage of cycle through which the economy is passing. It is only then that appropriate fiscal action can be taken. Wrong forecasting may accentuate rather than moderate the cyclical swings. Economics is not an exact science in correct forecasting. As a result, fiscal action always follows after the turning points in the business cycles.

2. There are delays in proper timing of public spending. In fact, discretionary fiscal policy is subject to three time lags.

(i) There is the “decision lag,” the time required in studying the problem and taking the decision. The lag involved in this process may be too long.

(ii) Once the decision is taken, is an “execution lag.” It involves expenditure which is to be allocated for the execution of the programme. In a country like the USA it may take two years and less than a year in the U.K.

(iii) Certain public work projects are so cumbersome that it is not possible to accelerate or slow them down for the purpose of raising or reducing spending on them.


Despite the higher multiplier effect of government spending as against changes in tax rates, the latter can be operated more promptly than the former. Emphasis has thus shifted to taxation as the best fiscal device for controlling cyclical fluctuations. Thus when the turning point of a business cycle is already underway, discretionary fiscal action tends to strengthen the built-in stabilisers, as has been’ the experience of developed countries like the USA.

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