What is fiscal policy

• Government spending and taxation help a government manage demand, employment, and inflation.

• Keynesian thought recommends increased borrowing and spending during downturns to stimulate growth.

• Effectively curbing inflation with fiscal policy remains debated and 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.

Fiscal policy measures are employed in conjunction with the monetary policy to achieve the overall goals of the economic policy. Monetary policy is not determined by the government but by the country's central bank. In India’s case, this is the function of the Reserve Bank of India (RBI). This includes full employment, economic growth at a high rate, and stability of wages and prices. These factors are considered the bedrock of an economic policy to different degrees. Be it any economy or government, employment and economic growth are direct contributors to a nation’s growth.

The primary tools of fiscal policy were developed over a century ago. In this article, we will understand how fiscal policy works, its different types, the early developments in fiscal policy studies, and more.
 

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How fiscal policy works

The two key instruments of fiscal policies are spending and taxation. In a way, the government is giving from one hand (through spending) and taking from the other (through taxation).

Let us take an instance of a fiscal policy change. Suppose the government in India wants to increase demand or consumption in the economy. To this end, it can lower taxes, which will directly increase spending among people and business investments. This step will directly stimulate the economy. Besides this, spending on public infrastructure and facilities can also potentially provide a boost to economic growth.

Conversely, when a government increases taxes to increase revenue or curb spending, the move can dampen economic growth and lead the country into a recession or contraction period.
 

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Primarily, there are 3 kinds of fiscal spending:

• Mandatory spending: This covers spending on welfare and entitlement programs like MGNREGA, mid-day meal scheme, etc.

• Discretionary spending: This refers to spending in a year earmarked for administrative tasks. Often, the biggest discretionary spending for a country is on national defence.

• Supplemental spending: This type of spending is reserved for items on the budget that are anticipated to require more funds in the future.

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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