What is Fiscal Policy

Key points:

• Fiscal policy operates through two primary tools: government spending and taxation.
• The fiscal deficit for 2026–27 is projected at 4.3% of GDP, compared with the revised estimate of 4.4% of GDP for 2025–26.
• Outstanding government liabilities are estimated at 55.6% of GDP in 2026–27.
• The government aims to reduce liabilities to approximately 50% of GDP by March 2031.
• Keynesian economics supports increased public spending and borrowing during economic slowdowns.
• Fiscal policy works alongside monetary policy to support economic stability and growth.

Also read: Growth stocks

Fiscal policy primarily operates through government expenditure and taxation. Through spending, the government injects money into the economy. Through taxation, it withdraws money from the economy.

For example, if the government wants to stimulate demand, it may reduce taxes. Lower taxes can increase disposable income for individuals and businesses, potentially supporting consumption and investment.

Government spending on infrastructure, public services, and development projects can also support economic activity and employment.

Conversely, higher taxes may reduce disposable income and spending. In some situations, this can slow economic growth and contribute to economic contraction.

The impact of fiscal policy depends on how spending and taxation measures influence demand in the economy. Governments may therefore adjust these measures according to changing economic circumstances.

Also read: Capital Adequacy Ratio

 

Fiscal spending can broadly be classified into three categories.

The Government of India and the Reserve Bank of India make fiscal and monetary policy decisions based on economic requirements and prevailing macroeconomic conditions.

Fiscal policy depends on government decisions regarding revenue collection and expenditure.

Historically, governments emphasised balanced budgets. However, major economic events such as the unemployment crisis in Great Britain during the 1920s and the Great Depression during the 1930s challenged this approach.

These events led economists and policymakers to reconsider traditional fiscal policy frameworks and explore alternative approaches to economic management.

The experiences of these periods contributed to the development of alternative approaches to economic management. They also influenced future discussions on the role of government spending and taxation in supporting economic activity.

Also read: Share trading

Economist John Maynard Keynes argued that fiscal policy should be used in a countercyclical manner.

Under this approach:

• Governments may run deficits during economic slowdowns.
• Governments may run surpluses during periods of strong economic growth.
• Fiscal intervention can help moderate extremes such as recession and inflation.
• Public expenditure can support demand during periods of weak economic activity.

The objective is to reduce the severity of economic fluctuations and support long-term stability.

Keynes argued that governments should finance fiscal stimulus through borrowing rather than through immediate spending cuts or tax increases.

Early applications of these ideas produced mixed results. During World War II, large-scale government spending significantly reduced unemployment but also contributed to higher inflation.

These experiences demonstrated that fiscal policy outcomes can vary depending on economic conditions and implementation.

Over time, economists refined fiscal theories to address challenges associated with inflation, unemployment, and economic growth. However, debate continues regarding the effectiveness of fiscal policy in controlling inflation.

Also read: BSE

Fiscal policy refers to government decisions relating to taxation and public spending. It is an important tool for influencing economic activity, employment, inflation, and growth.

Governments use fiscal policy alongside monetary policy to support economic stability. While Keynesian theories continue to shape modern fiscal frameworks, economists still debate the extent to which fiscal policy can effectively control inflation under different economic conditions.

Fiscal policy continues to be an important component of economic management. Governments use spending and taxation measures to respond to changing economic conditions and support broader economic objectives. The ongoing discussion surrounding fiscal policy reflects its significance in addressing economic challenges and promoting stability.