Modern fiscal policy involves the process of shaping taxation and public expenditure in order to (1) reduce the fluctuations of trade cycle and (2) to contribute towards the maintenance of a growing, high-employment economy free from excessive inflation or deflation.
When private investment and consumption spending create an inflationary (or deflationary) gap, it is the task of fiscal and monetary policy to offset the gap in the attempt to preserve price stability and full employment. The objective of fiscal policy is to achieve growth and full employment without inflation.
Fiscal weapons refer to taxation and expenditure policies. In this connection, modern economy is blessed with important “built-in stabilizers.”
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Without any discretionary action, tax receipts change automatically when income changes, thereby reducing the size of the multiplier and serving to wipe out part of any disturbance.
Because the automatic stabilizers never fully offset instabilities of an economy, scope is left for discretionary programmes. The principal weapons of discretionary fiscal policy are (1) varying public works and other expenditure programmes, (2) varying transfer- expenditure programmes and (3) varying tax rates cyclically.
Public works policy involves such time lags in getting under way as to make their use to combat short recession undesirable. Discretionary variations in transfer expenditures and in tax rates have greater short-run flexibility.
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When people dropped the notion that government budget had to be balanced in every year, they thought that the budget would be balanced over the business cycle—with boom-time surpluses just matching the depression deficits.
However, it is now realised that only by coincidence would the prosperity years just balance the recession years.
If we are faced by “secular stagnation” with private saving and investment schedules tending much of the time to produce deflationary gaps, fiscal policy may succeed in maintaining stable high employment only by having a long-term increase in the public debt.
If we are in for “chronic exhilaration” with demand so brisk as to lead much of the time to inflationary gaps, then active fiscal policy will have a bias towards surplus financing and a secular downward trend in the public debt.
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In connection with budget deficit or surplus some new concepts are introduced. First, there is the important concept of “fiscal drag or dividend.” Second, there is the concept of the “full employment budgetary surplus” (or deficit) as contrasted with the actual surplus or deficit.
Fiscal drag or dividend is the name for the automatic growth in tax revenues in an economy with a progressive tax structure and steady over-all growth.
Unless needed to fight an inflationary gap, fiscal drag has to be offset by (1) government expenditure increase on public goods deemed vital, and (2) tax-rate cuts that increase people’s disposable incomes and expenditures in the private sector.