The Government and Fiscal Policy

Government in the Economy Nothing arouses as much controversy as the role of government in the economy.Nothing arouses as much controversy as the role of government in the economy. Government can affect the Macroeconomy through two policy channels: fiscal policy and monetary policy.Government can affect the Macroeconomy through two policy channels: fiscal policy and monetary policy. Fiscal policy is the manipulation of government spending and taxation. Fiscal policy is the manipulation of government spending and taxation. Monetary policy refers to the behavior of the RBI (Central Bank) regarding the nation’s money supply. Monetary policy refers to the behavior of the RBI (Central Bank) regarding the nation’s money supply.

Fiscal Policy Changes in the expenditures or tax revenues of the government, undertaken to promote full employment, price stability and reasonable rates of economic growth. It refers to nation’s policy relating to the government spending, taxing, borrowing and debt management.

Objectives Mobilization of resourcesMobilization of resources Acceleration of the economic growthAcceleration of the economic growth To minimize the inequalities of Income and Wealth.To minimize the inequalities of Income and Wealth.

Three main constituents of the fiscal policy Taxation policyTaxation policy Public Expenditure policyPublic Expenditure policy Public debt policyPublic debt policy All these constituents must work together to make the fiscal policy sound and effective

TAXATION POLICY The main objectives for which taxes are levied is to raise revenue by transferring resources from the public to government and the opposite applies when the government cut the taxes so that some resources are transferred from the government to public. It will depend on the tax system that how much it has impact on the economy.

The characteristics of good tax system are: Equity in distribution of tax burdenEquity in distribution of tax burden It should yield a satisfactory amount for the maintenance of a government.It should yield a satisfactory amount for the maintenance of a government. It should maximize social benefit that is redistribution of wealth and reducing the inequalities of income.It should maximize social benefit that is redistribution of wealth and reducing the inequalities of income. Therefore in the situation of recession the subsidies and tax cuts will increase the disposable income and hence increase the overall production of the economy and vice verca.

Impact of Other policies Public Expenditure It is the most potent weapon to raise the consumption and to increase the economic growth. Increased government expenditure will open new job opportunities in the economy, which means creation of demand for goods and services. It can lead to pump priming, which means increase in private expenditure through an injection of fresh purchasing power in the form of an increase in public expenditure. Such expenditure should be progressively raised in the depression and reduced when the economy is overheated. It is the most potent weapon to raise the consumption and to increase the economic growth. Increased government expenditure will open new job opportunities in the economy, which means creation of demand for goods and services. It can lead to pump priming, which means increase in private expenditure through an injection of fresh purchasing power in the form of an increase in public expenditure. Such expenditure should be progressively raised in the depression and reduced when the economy is overheated.

Public Debt policy In case of recession, the government can reduce the public borrowing so that there is more resources with the public to increase the consumption.

Expansionary Fiscal Policy The government uses expansionary fiscal policy to increase the amount of money available to the general public. They do this through lowering taxes and raising government spending.The government uses expansionary fiscal policy to increase the amount of money available to the general public. They do this through lowering taxes and raising government spending. An increase in government spending and/or a decrease in taxes designed to increase aggregate demand in the economy, thus increasing real output and decreasing unemployment.An increase in government spending and/or a decrease in taxes designed to increase aggregate demand in the economy, thus increasing real output and decreasing unemployment.

Contractionary fiscal policy Increasing taxes and lowering government spending. Decrease in government spending and/or an increase in taxes designed to decrease aggregate demand in the economy and control inflation.Increasing taxes and lowering government spending. Decrease in government spending and/or an increase in taxes designed to decrease aggregate demand in the economy and control inflation. This is applied when the economy needs to decrease output or national income.This is applied when the economy needs to decrease output or national income.

Government in the Economy Tax rates are controlled by the government, but tax revenue depends on changes in household income and the size of corporate profits, which the government cannot control.Tax rates are controlled by the government, but tax revenue depends on changes in household income and the size of corporate profits, which the government cannot control. Discretionary fiscal policy refers to changes in taxes or spending that are the result of deliberate changes in government policy.Discretionary fiscal policy refers to changes in taxes or spending that are the result of deliberate changes in government policy.

Net Taxes (T), and Disposable Income (Y d ) Net taxes are taxes paid by firms and households to the government minus transfer payments made to households by the government.Net taxes are taxes paid by firms and households to the government minus transfer payments made to households by the government. Disposable, or after-tax, income (Y d ) equals total income minus taxes.Disposable, or after-tax, income (Y d ) equals total income minus taxes.

The Budget Deficit A government’s budget deficit is the difference between what it spends (G) and what it collects in taxes (T) in a given period:A government’s budget deficit is the difference between what it spends (G) and what it collects in taxes (T) in a given period: If G exceeds T, the government must borrow from the public to finance the deficit. It does so by selling Treasury bonds and bills. In this case, a part of household saving (S) goes to the government.If G exceeds T, the government must borrow from the public to finance the deficit. It does so by selling Treasury bonds and bills. In this case, a part of household saving (S) goes to the government.

The Economy’s Influence on the Government Budget Tax revenues depend on the state of the economy.Tax revenues depend on the state of the economy. Some government expenditures depend on the state of the economy.Some government expenditures depend on the state of the economy. Automatic stabilizers are revenue and expenditure items in the federal budget that automatically change with the state of the economy in such a way as to stabilize GDP.Automatic stabilizers are revenue and expenditure items in the federal budget that automatically change with the state of the economy in such a way as to stabilize GDP.

The Economy’s Influence on the Government Budget The full-employment budget is a benchmark for evaluating fiscal policy.The full-employment budget is a benchmark for evaluating fiscal policy. The full-employment budget is what the federal budget would be if the economy were producing at a full- employment level of output.The full-employment budget is what the federal budget would be if the economy were producing at a full- employment level of output.

The Economy’s Influence on the Government Budget The cyclical deficit is the deficit that occurs because of a downturn in the business cycle.The cyclical deficit is the deficit that occurs because of a downturn in the business cycle. The structural deficit is the deficit that remains at full employment.The structural deficit is the deficit that remains at full employment.

Financial Goals Profit maximization (profit after tax)Profit maximization (profit after tax) Shareholder’s Wealth MaximizationShareholder’s Wealth Maximization

Profit Maximization Maximizing the Rupee Income of FirmMaximizing the Rupee Income of Firm Resources are efficiently utilized Resources are efficiently utilized Appropriate measure of firm performance Appropriate measure of firm performance Serves interest of society also Serves interest of society also

Objections to Profit Maximization It is VagueIt is Vague It Ignores the Timing of ReturnsIt Ignores the Timing of Returns It Ignores RiskIt Ignores Risk In new business environment profit maximization is regarded asIn new business environment profit maximization is regarded as Inappropriate and Immoral. Inappropriate and Immoral.

Shareholders’ Wealth Maximization Maximizes the cash flow.Maximizes the cash flow. Accounts for the timing and risk of the expected benefits.Accounts for the timing and risk of the expected benefits. Fundamental objective—maximize the market value of the firm’s shares.Fundamental objective—maximize the market value of the firm’s shares.

Assignment Make a PPT on:Make a PPT on: Industry overview and Budgeting Implications related to your industry For this refer: Internet, Textbook, Library and other sources (Provide all the references ) the PPT at

Industry overview should include following points Overview of competitorsOverview of competitors Historical growth rate of industry (Last 5 years)Historical growth rate of industry (Last 5 years) Industry capacity, supply and demand scenarioIndustry capacity, supply and demand scenario Export and Import overviewExport and Import overview Recent Trends in the Industry regarding technology, price, product differentiation etc.Recent Trends in the Industry regarding technology, price, product differentiation etc.