What is fiscal policy

The fiscal deficit for 2026–27 is projected at 4.3% of GDP, lower than the revised 4.4% estimate for 2025–26. The central government plans to bring outstanding liabilities down to about 50% of GDP by March 2031, with liabilities estimated at 55.6% of GDP in 2026–27.

Key takeaways

• Government spending and tax policies are tools used to influence demand, employment levels, and inflation.
• Keynesian economics supports higher borrowing and public expenditure during economic slowdowns to revive growth.
• However, the effectiveness of fiscal policy in controlling inflation continues to be debated and remains complex.

Fiscal policy refers to a government’s policies concerning spending and taxation. It is used by the government to manage its economic conditions and guide them in a planned manner. Fiscal policies are employed by a government to influence macroeconomic conditions to some extent. This can be done through policy changes targeted towards goods and services demand, inflation, employment, and economic growth.

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How fiscal policy works

Fiscal policy mainly operates through two instruments: government spending and taxation. In simple terms, the government injects money into the economy through spending while withdrawing it through taxes.

For example, if the Indian government aims to raise demand or consumption, it can reduce taxes. Lower taxes leave individuals and businesses with higher disposable income, encouraging spending and investment, which helps stimulate economic activity. Increased public spending on infrastructure and essential services can further support growth.

On the other hand, higher taxes introduced to boost revenue or restrain spending can slow economic activity. Such measures may weaken growth momentum and, in some cases, push the economy towards a phase of contraction or recession.

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Broadly, fiscal spending can be classified into three main types:

• Mandatory spending: This includes expenditure on welfare and entitlement programmes such as MGNREGA, the mid-day meal scheme, and similar initiatives.
• Discretionary spending: This relates to annual allocations made for administrative and operational needs, with national defence often accounting for a major share.
• Supplemental spending: This category is meant for budgeted items that are expected to need additional funding over time.

The government of India and the RBI make decisions on fiscal policy and monetary policy based on the needs of the economy to manage the macroeconomic conditions in the country.

A country's fiscal policy relies on the government’s decisions. Depending on its revenues, the government could decide to increase or decrease its spending.

Throughout history, governments have believed in maintaining a balance in their budgets. Globally, two major events in the last century have influenced this perspective: the unemployment crisis in Great Britain in the 1920s and the Great Depression in the 1930s.

As these crises were a direct result of the beliefs of the time, they prompted a radical change in the existing thought process about fiscal policies and eventually led to new streams of thought.
 

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One of the most popular reconceptualisations of fiscal policy was put forth by John Maynard Keynes. He was an economist who believed that fiscal policy use should be countercyclical. The idea is that governments should leverage their power to balance extremes like inflation and recession, expansion and contraction, and boom or bust.
 

He believed that, ideally, the government should face a deficit during an economic slowdown and a surplus during a boom period.

Keynes's new recommendations opined that government borrowing should finance fiscal stimulus rather than cutting expenditures or increasing taxes.

The initial application of Keynes’s strategy in the U.S. under President Roosevelt was underwhelming. Post this, World War II marked a shift in fiscal policy priorities as massive government spending almost eliminated unemployment. However, inflation reached new heights and the markets fell, leading to small periods of recession and swift economic progress.

Since then, these theories on fiscal policies have been further refined to iron out these issues. However, the role of fiscal policies in curbing inflation remains debatable to this day.
 

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