Role of Fiscal Policy in Economic Development

The important role played by the fiscal policy in a developing economy can be explained through :

  1. Fiscal policy during inflation,
  2. Fiscal policy during depression,
  3. Fiscal policy and unemployment,
  4. Fiscal policy and income inequalities and
  5. Fiscal policy and economic growth.

Fiscal Policy during Inflation

Inflation is a period in which the purchasing power with, the people in the economy is high. The first step to curb inflation is to control the purchasing power with the people. This can be done using all the tools of fiscal policy. For instance, during inflation, since the private expenditure is high the government should bring down the public expenditure so that, to that extent the income generation will be controlled. Alternatively, the government can increase the existing tax rates or impose new taxes. This will have the effect of taking away the purchasing power from the rich and well-to-do people thereby curbing the consumption expenditure. The tax revenue will then be used for public expenditure purposes which will also be low during inflation. Hence, there will be effective control of money supply in the economy. Another way in which the fiscal authorities can function is to indulge in public borrowing. The government may start borrowing from the people in large scale so that the disposable income with the people will be reduced bringing down the demand and prices. If voluntary lending is not effective, then the government may resort to involuntary lending or compulsory saving by the people. Through its debt management policy also the fiscal authorities can control inflation. The anti-inflation debt management requires the retirement or payment of bank-held securities or debts through budgetary surplus. But this is very difficult in practice as in a developing country the government cannot have budgetary surplus.

Fiscal Policy during Depression

Depression is a period characterized by low income, low employment and low consumption. Fiscal policy should change this situation. The government must adopt deficit budget in order to increase the income stream in the economy through increased injection of fresh purchasing power into the economy. Secondly, the government must encourage consumption and investment and for this purpose the taxation should be brought down. Liberalized corporate tax policy will also help to increase the corporate expenditure giving the necessary thrust for the revival of economic activity. Public expenditure during this period must be increased. The government can achieve this either through pump priming or compensatory spending. Pump priming refers to the initiation of investment activity by the government through its expenditure on public projects which will be followed up by the increased private investment. Compensatory spending is resorted to when the private investment is not adequate enough. Then the government also injects public investment through public projects. Public debt policy can be suitably modified to fight against depression. The government should borrow more from the rich people and spend this amount in large scale on public works, and social security projects. All these steps will help to protect the economy and enable it to recover from depression.

Fiscal Policy and Unemployment

Fiscal policy plays a vital role in generating employment opportunities in the developing countries. In a developing economy, it should aim at solving the problem of both cyclical unemployment and disguised unemployment. While the former is of temporary nature, the latter has the snow-balling effect. The latter refers to a situation in which more than the required number of people are employed in a job. In other words, by reducing the excess of labor from that job, the productivity or production will not be affected. Hence, it has been found that fiscal policy alone cannot solve this problem of unemployment in a developing economy. It has to be coupled with monetary policy. For instance, during inflationary period, the government should adopt surplus budget, along with hard money policy, while during depression, deficit budget should be combined with cheap money policy.

Fiscal Policy and Income Inequalities

The role of fiscal policy in removing income inequalities in a developing economy cannot be exaggerated. With public expenditure and taxation, the government can very easily achieve income equality. The government should devise its public expenditure scheme by focusing on the poor and down-trodden people in the society. It may provide cheap food, cheap cloth, subsidized housing, free medical aid, free education, etc., to the poor people thereby raising their standard of living. For this purpose, the government should raise funds by imposing taxes on the rich people so as to bring down their purchasing power. It may completely or partially relieve the poor people from the tax net. This has the effect of-taking away as much as possible from the rich people and spending on poor people. It may also resort to large dose of indirect taxes so as to make the rich bear the burden as the poor will be paying such taxes only if they spend on items on which the government has imposed heavy indirect taxes. Therefore, taxation and public expenditure are the two very useful instruments of fiscal policy which can bring about the income equality in a developing economy.

Fiscal Policy and Economic Growth

Economic growth calls for the application of all the tools of fiscal policy. In developing economy, there may be no shortage of real or physical resources, but there may be a severe shortage of financial resources which are required to utilize the physical resources. The object of fiscal authorities should be to mobilize much funds as possible so as to carry out large scale public projects. A very effective method of mobilizing financial resources is taxation. The government can resort to both the direct as well as indirect taxes so as to generate as much funds as possible from all those who have the ability to pay. Different type of direct taxes and indirect taxes may be levied to cover every section of the population. There can be specific taxes to curb certain consumption activities. Another instrument available is public debt. Apart from the voluntary lending schemes the government should also devise schemes to encourage compulsory savings. Resources mobilized in this manner should be spent in such a way that the infrastructural facilities are strengthened first. This should be followed by the expenditure on growth oriented industries and other related activities. Care should be taken to avoid creating or widening sectoral imbalance so that the benefits of growth will be shared by all the sectors in the economy. Government must use its planning machinery to identify the right priorities so that the hard mobilized funds are utilized in the best way possible. In this process now-a-days the governments also resort to deficit financing. It is considered as a means of financing economic development. But too much reliance on deficit financing will also be dangerous. However, fiscal policy can play a vital role in helping to achieve a rapid economic growth.

Credit: Global Business Environment-CU

About Abey Francis

Abey Francis is the founder of MBAKnol - A Blog about Management Theories and Practices - and he's always happy to share his passion for innovative management practices. You can found him on Google+ and Facebook. If you’d like to reach him, send him an email to: [email protected]
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